Wednesday, June 20, 2012

How To Buy Life Insurance

Cutting Through The Sales Literature, Marketing And Misinformation

Many people at some point in their lives come to the realization that if they were to unexpectedly die their families would be in serious financial difficulty.  Often this realization happens when you start having children or take on a major financial commitment, such as a large mortgage.  A natural response is to buy life insurance to protect themselves, but all too often people do not buy the right amount, don't buy the right kind, or don't buy it from the right provider.  There isn't a great deal in the way of common sense guides out there and the insurance industry and the agents have a vested interest in pushing certain types of products to less-than-well-educated customers.  In addition, the insurance industry seems to thrive on producing an endless array of complex products which often sound a lot better than they are.  This will be an attempt to offer some basic guidelines of buying life insurance coverage.
The first question you should ask yourself is, "do I really need a life insurance policy?"  While it is a bit morbid, consider what your family/survivors' financial picture would be if you were no longer on the right side of the grass.  Do they depend heavily on your earnings to make it?  Or does your spouse substantially out-earn you and could comfortably cover all the household expenses on their income alone?  Do you have kids and are you expecting to support them through college?  Do you have sufficient net worth such that the family would be able to meet expenses over time without your earnings?  What you should try to do is estimate what the family's shortfall would be in terms of money if you croak.  A good rule of thumb is that it takes about 25 times the amount (in face amount of life insurance coverage) of the monthly shortfall in income to replace the lost earnings stream.  Don't forget offsets such as any life insurance coverage you may have through your employer (most places I have worked have automatically covered me for 1X my annual salary), Social Security survivor benefits (can be significant if you have children), any pension benefits you might have earned, or other offsets.  Finally, once you think you have come up with a reasonable amount, add at least a 10% margin of error to the coverage amount you came up with.  Life insurance is generally inexpensive for younger people compared to the potential downside of not having enough, so err on the side of safety.

Once you have a reasonable idea of how much coverage you need, the next step is to determine what type of policy is most appropriate for you, and you should do this before talking to an insurance agent or other salesperson.  It would be nice to get lots of detail and information about different types of policies before you make a decision, but the decision is usually pretty simple and as soon as you contact an insurer or agent the snow job sales effort will begin.  I will try to make it extremely simple: if you are under 40 and not quite high net worth ($5MM or better), it is very likely that a 20 year term life policy will be a good choice.  Many permanent life insurance (e.g. whole life or universal life) policies are sold to people for whom it is not suitable or necessary, often under the pretext that these policies offer some sort of magical, tax sheltered investment opportunity within them.  For the vast majority of people 40 or under and not very high net worth, this is (to put it bluntly) a lie.  Stick with term.  Most term policies include a "conversion" option which allows you to trade in your term policy for a permanent policy at a later date without going through underwriting again, so if your circumstances or preferences change down the road you can relatively painlessly switch.  Why is term a better choice for the typical consumer?  It provides mortality coverage at a far lower cost (when I bought my term policy, the cheapest permanent option was a universal life policy with a premium of 6 times the cost as the term policy) than a permanent policy and the "investment" portion of most permanent policies is a lousy investment in virtually all cases.

When might you need a permanent policy rather than a term policy?  There are a few circumstances under which something more than a term policy might be appropriate.  First, if you have very high taxable income you may find a highly specialized permanent policy to be an option to grow your money tax deferred.  Far less than 1% of the US population fits this mold.  Second, if you have a spouse or child who is permanently disabled or sick, you may want to consider permanent insurance which would help take care of them if you expire (an advisor or attorney who can set up one or more trusts may be a wise investment as well).  Finally, if you have a large or complex estate or one with an illiquid significant asset, permanent life insurance may be an important part of an estate plan.

Now, on to how to buy a policy.  If you are buying term and are in generally good health, the easiest way to buy is to go through the website of an independent broker (such as or directly to the website of life insurers who sell direct to the public (such as USAA, TIAA-CREF, and many others).  Plug in your stats, pick a face amount, and voila!  You get a quote on the spot, which will be verified upon the completion of underwriting.  Before you ask to have underwriting done on you and a policy issued, see below for some suggestions on making sure that the attractively priced policy is offered by an acceptable insurer.  Once the policy is finalized, write a check and you are done.  It is a good idea to revisit your coverage, needs and plans every 5 years or so.

If you are given a higher price once underwriting is complet, you are not in generally excellent health, or you are buying something other than a term policy, you will want to seek out an independent insurance agent or broker.  Make sure that this is not an agent tied to one particular company!  You want to deal with someone who is not beholden to any one insurer, understands which insurers are likely to offer the best rates for your particular situation, and will not push you too hard toward a more expensive, complex product that you do not need.  If you are not comfortable with an agent or broker you speak with, walk away and find another one.  The agent or broker will help you find the right policy at the best price.  But before you ask for underwriting to be done, you will want to make sure that the insurer is of an acceptably high quality to be "married" to for the long term.

Once you do your shopping around and get quotes (either directly or through an agent/broker), you need to screen the insurers offering the most attractive quotes.  The easiest way to do this is to find the insurer's website and look up their "about us" page.  Generally speaking, you want an insurer with a claims-paying rating of at least Aa3 (Moody's)/AA- (Standard & Poor's)/A+ (AM Best).  The larger the company at a given rating, the more stable they are likely to be over time.  Finally, if you have a choice pick a mutual insurer over a shareholder-owned stock insurer.  Why pick a mutual?  Stock companies are beholden to shareholders who want to see high returns, generous dividend payouts, and are perfectly happy to see financial engineering done to achieve these goals. Policyholders are still important, but they have to compete with shareholders.  In contrast, in the case of mutual insurers the policyholders actually own the insurer.  There are no outside shareholders and mutual insurers tend to be more focused on maintaining financial stability over the long term (decades) rather than the next quarter's earnings report.  A large, well-run mutual insurer is typically much harder to kill than a stock insurer of the same size.  Insurers do not have the FDIC backing up policyholder claims (they only have state guaranty associations that are not backed by the states and have limited funds on hand), so insurer stability over the life of your policy is very important.

Finally, I would be remiss if I did not point out that anyone considering buying life insurance should also make sure they have adequate long term disability insurance coverage.  Statistically, people under 50 are far more likely to have a disability insurance claim than a life insurance claim and disability can be just as devastating to a family's finances.  Make sure you are covered.  Many employers offer this coverage, so check your benefits package before you start shopping insurers.

As always, consult your advisors, do your own due diligence, and be careful.  I am just some random stranger tapping away on the internet.

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