Table of Contents

How do insurance companies classify individuals for rate purposes?

In order to be able to shop for the best premiums, itís a good idea to know how premiums are calculated by insurers. Bear in mind that premiums vary among insurance companies, and it is a good idea to ask several insurers for their rates.

Insurance companies place individuals into four risk groups: preferred, standard, substandard, or uninsurable. A terminal illness at the time you apply for insurance will render you uninsurable. Having some type of chronic illness will place you in the substandard category. People with conditions such as diabetes or heart disease can be insured, but will pay higher premiums.

If you have a high risk job or hobby, you will be considered substandard, a high risk.

The premiums charged will be commensurate with the category you are placed in. Thus, a standard risk will pay an average premium for similarly situated insurers.

Tip Tip: One companyís category for you may not hold with another company. Thus, it still pays to shop for insurance with other companies even though one may have labeled you "substandard."

Tip Tip: Once an insurance company approves you for coverage, you cannot be dropped unless you stop paying your premium.

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What questions should I ask my life insurance agent?

Here are some questions to ask about policies:

  • How do cash values accumulate? An early, rapid build-up is generally preferable.

  • How has the policyís cash value performed in the past? You can get this information from a publication called Best Review, Life and Health. Determine how the policy performed in comparison with the companyís projection and with other insurers.

  • Are any special features merely bells and whistles, or do they add value for you?

  • What is the companyís rating with Best, Standard & Poorís, and Moodyís? You can find these publications in public libraries. The rankings should be in the top three to ensure that a company has financial stability.

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What should I watch out for when buying life insurance?

Many insurance agents work on commission, and therefore may tend to promote those policies or other investments that pay the highest commission, investments which may not be suitable for your needs. The cost, buried in commissions, can be quite high. Here are some things to watch out for.

Policy provisions that are hard to understand and compare. Many insurance company products contain investment features as well as insurance elements. Because these insurance products are very complex and have many variations, most clients cannot understand them. As a result, rates cannot easily be compared.

Pushing inappropriate policies. Often, agents will try to sell a policy that provides the largest commission to the agent. The investment may be completely inappropriate for your needs. Make sure your agent carefully identifies your needs and explains why the policy is suitable for you. You may want to have your other financial advisors, such as your accountant, review recommended policies before purchase.

High commissions and overhead. Sometimes 50% of your first year premium goes into the pocket of the insurance agent. In addition, insurance companies can have very high overhead (and, usually, advertising budgets). These costs get paid from only one source: your investment return. Make sure your review the costs of any recommended policy.

Low returns. Insurance company investments usually provide low rates of return due, in large part, to the companyís need to have a large buffer against any miscalculations and also because most insurance companies are not very good at selecting investments. (After all, their primary emphasis is on insurance.)

Tip Tip: If you want both insurance and investment returns, un-bundle your needs. Get your life insurance from the insurance company (at the lower premium for pure, term insurance) and put the premium savings (the investment element) into a more profitable investment vehicle, where your return at age 65 will be substantially higher than through the insurance companyís annuity.

Safety of investment. Many insurance companies have shaky foundations. (Even the venerable Lloydís of London is in financial difficulty.) And because unexpectedly high claims can wipe away the financial foundation, the insuredís investment (as well as life insurance proceeds) can be lost. Check an insurerís rating before purchasing a policy.

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How do I compare the cost of several insurance policies?

In most states, there are rules, set by a group of state insurance regulators, requiring the agent to calculate two types of cost indexes that can help you to shop for a policy. You can use the indexes to compare policy costs.

One type of index, the net payment index, gauges the cost of carrying your policy for the next ten or twenty years. The lower the number, the less expensive the policy. This index is useful if you are most interested in the death benefit aspect of a policy, as opposed to the investment aspect.

The other type of index, the surrender cost index, is useful to those who have a high level of concern about the cash value. This index may be a negative number. The lower the number, the less expensive the policy.

These two indexes apply to term and whole life policies. With universal life policies, focus on the cash value growth and the cash surrender value to make comparisons. "Cash surrender value" is the amount you receive if you cancel the policy. It is not the same as "cash accumulation value.

If you are shown two universal life policies, and they have the same premium, death benefit, and interest rate, then the one with the higher cash surrender value is generally the better policy. Be aware that the projections of cash values given by some insurers may use unrealistic assumptions, and therefore might be misleading.

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Do I really need life insurance?

The purpose of life insurance is to provide a source of income for your children, dependents, or whoever you choose as a beneficiary, in case of your death. Life insurance can also serve other estate planning purposes, such as giving money to charity on your death, paying for estate taxes, or providing for a buy-out of a business interest.

Whether you need to buy life insurance depends on whether anyone is depending on your income. If you have a spouse, child, parent, or some other individual who depends on your income, you probably need life insurance. Here are some typical families and a summary of their need for life insurance:

  1. Families or single parents with young children or other dependents. The younger your children, the more insurance you need. If both spouses earn income, then both spouses should be insured, with insurance amounts proportionate to salary amounts.

  2. Adults with no children or other dependents. If your spouse could live comfortably without your income, then you will need less insurance than the people in situation (1). However, you will still need some life insurance. At a minimum, you will want to provide for burial expenses, for paying off whatever debts you have incurred, and for providing an orderly transition for the surviving spouse.

  3. Adults with no children or other dependents. If your spouse could live comfortably without your income, then you will need less insurance than the people in situation (1). However, you will still need some life insurance. At a minimum, you will want to provide for burial expenses, for paying off whatever debts you have incurred, and for providing an orderly transition for the surviving spouse.

  4. Single adults with no dependents. You will need only enough insurance to cover burial expenses and debts, unless you want to use insurance for estate planning purposes.

  5. Children. Children generally need only enough life insurance to pay burial expenses and medical debts. Many advisors recommend self-insuring for children rather than buying an insurance policy.

  6. Retirees. There is less of a need for life insurance after retirement, unless it is to be used for estate planning purposes. You may need to provide an income for the second spouse to die if your retirement assets are not large enough. Further, you will need some insurance to pay burial expenses, final medical costs, and debts.

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How much life insurance should I buy?

Determining how much insurance to buy requires you to invest some time in calculating, first, your current annual household expenses, and then your assets, debts, and other sources of income. Your financial advisor can assist you in this computation.

The ideal amount of coverage is the amount that would allow your dependents to invest it after your death and maintain their desired standard of living without touching the principal. Although the old rule of thumbóto buy five, six or seven times your annual salaryómay serve as a starting point, it is no substitute for making the calculations to find out how much you really need.

Itís important to be as accurate as possible in estimating your familyís needs, since an underestimation could lead to your being underinsured, and an overestimation will lead to money wasted on unnecessary coverage.

Tip Tip: To accurately estimate your familyís annual income needs, itís helpful to have the following documents with you: A checkbook register for one year, a yearís worth of credit card statements, and last yearís tax return.

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What type of life insurance should I buy?

Once you have an idea of how much coverage you need, you can decide which type of insurance product would be best to fill those needs. Although the array of insurance products may seem confusing, there are really just two types of insurance.

Term Insuranceó, in which you pay for coverage for a specified amount of time, and if you die during that time the insurer pays your survivors the death benefit specified.

For individuals age 40 or less, a term policy will almost always be less costly than a whole life policy. Although term policies do not build cash values, many are convertible to whole life policies without a physical exam. Thus, a term convertible policy may be a good option for someone who is under 40. There are various types of term insurance.

Renewable. With the typical renewable term policy--the most common type--the policy renews automatically every year. You do not need to take a physical or verify the fact that you are employed. The premium goes up at the beginning of each new term to reflect the fact that you are older. Most renewable term policies can be renewable until you reach age 70 or so.

Re-entry. With this type of policy, you must undergo a physical exam after a certain period, or pay an extra premium.

Level. With level term policies, the premium is guaranteed to stay the same over a certain period. This period may be shorter than the term of the policy.

Decreasing. With a decreasing term policy--a good option for insuring mortgage payments--the face amount of the policy decreases over time while the premium payments remain the same.

The second type of insurance is Cash valueówhole life or universal lifeówhich, in addition to paying a death benefit, also provides you with some other redeemable value.

Term life insurance is most effective when you do not need coverage for your entire lifetime, while cash value or whole life insurance is generally considered to be permanent insurance.

The two most common types of cash value life insurance are whole life and universal life.

Whole Life. This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death.

The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level," in insurance parlance. Thus, when you are younger, the premium you pay for whole life will be greater than what you would pay for term, but when you are older, the premium will be much less than a term premium.

Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash valueóit is tax-deferred.

You can borrow against your cash value, at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit.

Dividend-paying whole life policiesótermed "participating" policiesóare usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders, while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies.

Note Note: Term policies can also be participating, but the dividends paid are usually minimal. Term policies can also be participating, but the dividends paid are usually minimal.

Universal Life. Universal life, also known as "flexible premium adjustable life," is similar to whole life, but offers more flexibility in terms of payment of premiums and cash value growth.

With a universal life policy, your monthly premium amount is first credited to your cash value. The company then deducts the cost of your death benefit and the expenses of the policy. These costs are about equal to what it would cost to buy term coverage. As with whole life, your cash value grows at a fixed minimum rate of interest. The growth of the cash value is tax-deferred, and you can borrow against it or make partial withdrawals.

A special feature of universal life is that you can vary the premium paid from month to month. You can pay more or lessówithin certain limitsówithout jeopardizing your coverage. You can let the cash value absorb the premium. If the premium payments fall too low, your policy may lapse. Some states require the insurer to tell you when your cash value is at a dangerously low point; in other states, the insured will have to maintain a careful watch on the amount of cash value if premiums are skipped.

Other Types

In addition to the two types of cash value life insurance discussed, there are other variations.

Variable Universal. Variable universal life allows you to choose the investment for your cash value. You have a potentially greater cash value growth, but you also have added risk, depending on the type of investment you choose.

Variable Whole Life. With variable whole life, the death benefit and cash value will depend on the performance of an investment fund that you choose. Again, you have potentially greater reward, with its accompanying risks.

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Should kids have life insurance?

Since the purpose of life insurance is to provide for dependent survivors, children generally need at most enough life insurance to pay burial expenses and medical debts. Yet 25% of cash-value life insurance policies sold covers the life of a child under 18. (Note: Cash value life insuranceói.e., whole life or universal life--combines a death benefit with a savings or investment element.)

Alternatives. Other ways of covering the costs of a childís death include (1) using funds already set aside for college and (2) taking out a rider on a parentís policy (if available).

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How do I balance life insurance with my other investments?

Get term life insurance if you haven't bought a policy yet. Then invest as much as you can in tax-deferred IRAs and 401(k) plans. Especially if your money is in stock funds, you should have bigger gains than with a cash-value policy.

If you already have a cash-value policy, don't sell it. Just realize that it is a conservative, long-term investment. The cash value eventually may be substantial because it is a tax-deferred investment. It may take 15 years or more, however, to produce a respectable return, similar to high-quality corporate bonds or long-term CDs. Balance your policy with investments, such as stock funds, that have a higher, long-term return.

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