Life insurance: costs and benefits

With several different types available, one is likely perfect for you.

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Let's look at the top five reasons people give for not owning life insurance.

1. Too Expensive: "I just cannot afford it right now."

2. Confusing: "We looked at proposals from three companies – page after page of numbers. What does it all mean? I haven't the slightest idea!"

3. Too Many Types: "I checked into term insurance, whole life insurance, universal life, variable life, single premium and survivorship insurance. But which one is right for me?"

4. No Trust: "Those big insurance companies claim to have billions in reserve funds. But one of the biggest insurance companies has been on the ropes for months. Who can you trust?"

5. Don't Plan to Die: "Someday, when I plan to die, I will consider life insurance. But for now – don't worry, be happy!"

Five Reasons to Own Life Insurance There are several reasons for you to purchase life insurance. If you were to pass away, the death benefits could provide resources quite important to your family. These  benefits include payment of your funeral and final expenses, paying off mortgages or other debts, living expenses or income for a surviving spouse, inheritance for children and payment of estate taxes.

*Final Expenses and Funeral Costs Usually there are medical expenses during the last weeks of life. These frequently range from $5,000 to $10,000. Your memorial service preparation and costs can also easily exceed $10,000. Total final expenses can often be more than $20,000.

*Pay Debts and Mortgages The payment of debts or a mortgage is a one-time expense. Depending on the amount of your mortgage, this could cost anywhere from a few thousand dollars to many hundreds of thousands.

*Living Expenses for Spouse The largest amount of insurance is typically purchased to provide both economic security and an investment that will add to the spouse's other annual income. A reasonable method is to estimate a 5% return on the investment. For example, if a spouse needed another $50,000 of income over and above the amount paid by retirement funds, Social Security and other earnings, insurance equal to $1,000,000 invested at 5% would produce this amount.

*Inheritance for Children Permanent insurance is frequently used as a method of providing an inheritance for children. Many parents who make substantial gifts to charity plan to use life insurance as a means of providing additional inheritance for them or other family members.

*Estate Taxes If your estate is large, there may be a substantial payment of federal or state estate tax. If you own a business or other assets that are intended to be transferred to family, your estate could be subject to this tax. Life insurance can be an excellent method to provide funds for its payment. Normally, for larger estates the insurance is owned by an irrevocable life insurance trust so the insurance itself is not subject to estate tax.

Determining the Life Insurance Amount A fairly simple way for you to determine the total amount of needed insurance is to add up your one-time expenses, then calculate the amount of insurance invested at 5% necessary to benefit a surviving spouse, children or other family members. For example, if your one-time expenses are $200,000 and your spouse desires additional income of $50,000, the total insurance would be $1,200,000. This amount includes $200,000 for expenses and $1,000,000 invested at 5% to produce the annual income.

More sophisticated calculations are available online. Use your favorite search engine to look for "life insurance needs calculator," and select from the free public calculators.

How Life Insurance Works Life insurance started because individuals were concerned they might pass away and not provide sufficient resources for family; young families typically need a substantial fund and lack the ability to save enough in a short period of time.

If many thousands of individuals pay premiums and those funds are invested, a pool of funds will be available to compensate individuals. The life insurance company hires actuaries who determine the probable number of individuals who will pass away in a given year. Especially for younger persons, out of a pool of 100,000 only a few will pass away in a given year. As a result, the company is able to receive all the premiums and invest them in the insurance reserve fund. The earnings and a portion of the funds are distributed each year to pay claims for those who pass away.

The insurance funds are primarily invested in bonds. The insurance company generally receives 1-1.2% to cover its overhead and costs. The balance is returned through insurance proceeds to beneficiaries.

Life Insurance Policy Categories Insurance is generally divided into two categories – term insurance and permanent insurance. Term insurance is the least expensive type and is favored by younger people and many financial planners. It is available with an annual renewable term (ART) or with a fixed payment for five years, 10 years, 15 years or longer.

Because term insurance does not include any investment or cash value, it enables the largest potential policy to be purchased for the least cost. Due to intense competition within the insurance industry, prices on term policies and level-pay term policies have moved lower in recent years. Young couples often purchase a 10- or 15-year level term policy. This option provides excellent coverage at reasonable cost. Some types of term policies also include the ability to convert to whole life or universal life at a future time; if the conversion is elected, there will be a substantial increase in the premium.

Permanent insurance includes several types. The traditional favorite is whole life insurance, but there are also universal life, variable life and survivorship life insurance.

*Whole Life The traditional whole life policy involves both insurance and a cash value. The premiums are substantially higher than term insurance because the policy will build a savings element or cash value. During the first year, much of the cash value may be used by the insurance company to cover the commission payment to the sales representative, but over time the cash value may increase. The owner of the policy has the right to borrow against the cash value at favorable rates. Whole life is frequently fixed in terms of premiums paid and death benefit. The insurance company determines the probable return of its reserve fund and, based on the age and health of the insured person, calculates and commits to a fixed benefit in exchange for a certain premium.

*Universal Life Universal life was created to provide an option for people who would consider purchasing term insurance and investing an additional amount in mutual funds. With universal life, the policy is invested and a cash reserve is built up. The reserve growth covers the cost of the policy. Universal life policies may include flexible options for increasing or decreasing premium payments. Of course, the cash value of the policy will change with a modification of the premium schedule.

*Variable Universal Life If the insured desires to own life insurance but also potentially gain from investments in stocks and bonds, a variable policy may be appropriate, wherein the insured typically is permitted to invest in different mutual funds managed by the financial services company. If the mutual funds increase in value, the policy cash value will increase.

*Survivorship Life For a couple, an attractive option is to purchase a survivorship policy. This policy pays a death benefit after both spouses pass away. Because two persons are insured, it frequently is possible to obtain insurance even if one spouse is in poor health. Quite often, this insurance can be purchased at an acceptable premium because two persons must pass away before the death benefit is paid. It is particularly useful for providing funds to pay estate taxes if a business is to be transferred from parents to children after they both pass away.

Life Insurance Beneficiaries In most estates, life insurance does not pass through the probate process. The insurance policy is a contract between the insured and the insurance company. The person who purchases the insurance has the right to name the beneficiaries. Normally, a primary and a secondary beneficiary are named. It is also possible to divide the insurance policy among several children or other beneficiaries.

A common designation is for the spouse to be a primary beneficiary and the children to be the contingent beneficiaries with equal shares. If the spouse were to predecease the insured or they were to pass away in a common accident, the children would receive the insurance proceeds.

Minor children should usually not be the beneficiaries of a policy. In many states, if a minor child receives a substantial inheritance, a conservator must be appointed to manage the assets. This is quite expensive and also has the disadvantage of transferring the assets to the minor child when they become an adult.

A much better arrangement is to transfer the policy to a living trust for the benefit of the minor children, or to create a trust and a will for their benefit and transfer the policy to the estate to fund that trust.

Prudent Purchase of Insurance Life insurance is an important decision, and it is helpful to learn about the different types. Most individuals will also visit with a chartered life underwriter or other representative of a financial services company.

The representative can conduct an insurance needs analysis and suggest the appropriate type of insurance. It is helpful for you to do sufficient research to understand the reasons why many individuals choose term insurance or permanent insurance. Most young couples decide to purchase term insurance to maximize coverage. In addition, the use of online calculators to determine insurance funding will also provide you with a better understanding of the appropriate amount. What is recommended by online calculators can vary greatly, so understanding your probable needs is quite important.

Insurance Company Ratings Insurance companies are rated by several sources. AM Best, S&P Global, Moody's and other ratings services are available. You should be certain to ask for the ratings of any company if a representative suggests purchasing a policy from them. It is also easy to go online and do a search for "insurance company ratings" to obtain the actual ratings for most financial services companies.

The American Legion’s Fund Development program is a way of establishing your legacy of support for the organization while providing for your current financial needs. Learn more about the process, and the variety of charitable programs you can benefit, at legion.org/plannedgiving. Clicking on “Learn more” will bring up an “E-newsletter” button, where you can sign up for regular information from Planned Giving.