Life insurance basics explained

Hey there, time traveller!
This article was published 18/05/2007 (6758 days ago), so information in it may no longer be current.

A lot of people have been asking me lately about life insurance. Specifically, they want to know how to determine their need for insurance, the best mixture of term insurance versus permanent, and what all the different names for permanent insurance mean.

Over the next few weeks, we will try to answer these questions and give you some real insight into how to optimize your personal life insurance plan.

Life insurance is, at its core, a simple concept and product. You and an insurance company sign a contract under which the insurance company promises to pay a lump sum of money, tax-free, to whomever you specify, providing they accept you as a normal risk, you tell them the truth about your health and habits and you pay the premiums you promise to pay.

However (and life insurance professionals will hate me for saying this), the industry has made it pretty complicated. In fairness, part of this complication stems from the attempts to develop very specialized products. Sometimes, though, the complication comes from the jargon used, and the fact that insurance people who deal with this stuff day-to-day forget that it can look and sound like a puzzle to the rest of us.

Remember that life insurance is simply the guaranteed delivery of dollars on death. If the death of a certain person would create a financial hardship for others, then insurance is often the best solution to that problem.

These needs might be temporary and best addressed through relatively low-cost term insurance. Or the needs might be permanent, best addressed by permanent insurance, which goes by names such as whole life, universal life, or term-to-100.

There are two general steps to analyzing need. The first is to look at the people to whom you are married or with whom you are in business, and ask yourself what the effect would be on you, your family or the business if that person died. You might also ask the question, “What would be the situation for them if I died?”

Then, quantify this need, as to dollars and a time period. Calculate how much cash would be needed to pay off all liabilities and generate the income required. This will identify the amount of insurance needed and how long it will be necessary, which helps identify whether term insurance or permanent insurance is a better solution.

When asked about insurance needs, people sometimes say things like, “Oh, I have insurance.” Great, but that’s a little like heading out on a seven-day hiking trip in the backwoods and saying “I’m OK, I have some food.” Does this mean four Power Bars and a bottle of water, or a seven-day supply of rations, based on a realistic estimate of the amount of food that will be required each day? To do this right, you would add up the number of meals, the expected calories to be expended and a reasonable reserve for unexpected contingencies. You would not want an extra-large reserve, as this is extra weight to carry.

The analogy carries through to life insurance. You need to sit down and take the time to add up the needs. If you consciously decide to be under-insured, then you are making a decision to have your family or business partners share the risk. That’s neither good nor bad, as long as it’s a conscious decision. By the same token, you probably don’t want to have excess insurance, because you are then paying for protection that is not really needed.

If your personal need for life insurance is to replace your income for your family, you may be amazed at the amount of life insurance you actually need. If your income is $50,000 and it all needs to be replaced on your death, you may need as much as $1 million of insurance. At a return of five per cent, this would only produce $50,000, ignoring taxes and inflation.

In my view, the need to protect family and children in the event of the death of a breadwinner may be the most critical need there is. However, business partnerships can be very important as well.

Next week, we will explore these business needs for insurance, then move into the different types of permanent insurance.

In the meantime, spend a few minutes calculating your possible needs, so you can put all of this into context.

David Christianson is a fee-only financial planner and investment counsel with Wellington West Total Wealth Management Inc. His column appears Fridays. You can e-mail him at dchristianson@wellwest.ca