Sunday, July 12, 2009

Term Life Insurance

I recently bought a term life insurance policy, and, in the process, learned some very good things about how it works, and how I should plan for it.  Listening to Dave Ramsey, the Primerica agent, and several others talk about insurance has helped me develop my own plan for term life insurance.

Some recommend 8-10 times your annual income as the determining factor in insurance (this, I believe, is a simplified version of Dave Ramsey’s approach).  While there is nothing inherently wrong in this approach, and it keeps things extremely simple, there is no real room to tailor the policy to your life, and so you just end up with a random amount of cash, arguably able to cover your family’s living expenses for 7-10 years (depending on the additional cost of the funeral, etc.).

Before we get into evaluating the factors I took under consideration for determining how much and how long my insurance should cover me, there are several things to keep in mind:

  1. Life Insurance should cover your spouse and children in the case of your death.  At the point of retirement, my income will be (ideally) passive, so I don't need to plan for term life insurance beyond retirement age.  In most cases, this means having a policy that will be effective until age 60-70.
  2. The younger a person is, and the shorter the term, the lower the cost will be for the policy.
  3. Health makes a huge difference in the price of the policy.  If you are a smoker, or have a family history of cancer/heart problems, your policy will cost much, much more.

So with these thoughts in mind, I used the following factors to determine our plan:

  • I am 35 years of age, leaving me 30 years to retirement.
  • We just purchased a house, with a 30 year mortgage.
  • I anticipate being in non-mortgage debt for less than 5 years.
  • My wife is pregnant with our first child.

These factors played heavily on the length and amount of insurance that we purchased:

  1. In the event of my death, my wife would need enough money to pay off all debts (including the house), plus have enough to live on for a while (5 to 10 years) so that she would have some time to begin generating an income.  Eliminating the house debt lowers her income requirement significantly, giving her an easier path to supplementing the income.
  2. In the event of my wife’s death, I would need enough money to provide care for our child, in addition to the money I already make.
  3. In 10 years, neither of us will have any kind of consumer debt.  Also, our income should be higher and our living expenses lower (inflation adjusted) than they are today.

Bottom line, we settled on a 30-year policy that had enough coverage for me that it would wipe out all debt obligations, pay for the funeral, and still have about 10 years of living expenses, if something were to happen to me tomorrow.  (Of course, as time goes on, our debt will be smaller, but there may be more dependents, so I decided on a single 30-year policy).  For my wife, we decided on a policy that would pay off the mortgage, cover burial, and take care of child care expenses for about 5 years.  We didn’t find it necessary to cover the consumer debt on her policy, since I am the primary wage earner.

Had our circumstances been different, what we settled on would have been different as well.  Instead of having no insurance in place, it would have been wise for me, in my 20s, to purchase about a 10-15 year policy covering all of my consumer debt, paying for the funeral, and a little extra.  Once I got married, I should have purchased a policy for my wife (and revised mine), taking my wife’s situation into account.  Since she brought her student loans into the marriage, and I brought my credit cards and vehicles in, we would need a policy that paid all of that off (plus a little).

Those policies are relatively cheap, because the amounts are not usually very high, the terms are short, and we were younger.

Now that our age and level of responsibility has increased, it was time to purchase a policy that would at least financially take care of our debt obligation.

Naturally, the policies now cost more than they would have when we were 10 years younger, but they would not have carried us all the way to retirement.  In the same breath, I did not want to purchase a policy that would cover us, but would seriously impede our ability to reduce our debt.  If our standard of living changes, I will probably re-evaluate and either change or add to our policy.  (Given inflation the way it is, and just the general tenor of things, I doubt I’ll ever decrease our coverage)

So, in summation, the way I picked Term Life was not based upon income, but expenses.  Rather than looking at life insurance as a replacement to income, I view it as a way to weather a storm.  A strong storm, to be sure, and one that I hope neither my wife nor I have to face.

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