Life insurance is one of the pillars of personal finance, deserving to be considered by every household. Yet, despite its almost universal applicability, there remains a great deal of confusion, and even scepticism, regarding life insurance.
Perhaps this is due to life insurance’s complexity, the attitude of those who sell it or merely our preference for avoiding the topic of our own demise. However, armed with the proper information, one can simplify the decision-making process and arrive at the right choice for you and your family.
The following nine things are crucial when considering life insurance:
If anyone relies on you financially, you need life insurance. It’s virtually obligatory if you are a spouse or the parent of dependent children. But you may also require life insurance if you are someone’s ex-spouse, life partner, a child of dependent parents, the sibling of a dependent adult, an employee, an employer or a business partner. If you are stably retired or financially independent, and no one would suffer financially if you were to pass away, you don’t need life insurance. You may, however, consider using life insurance as a strategic financial tool.
Life insurance does not simply apply a monetary value to someone’s life. Instead, it helps compensate for the inevitable financial consequences that accompany the loss of life. Strategically, it enables those left behind to cover the costs of final expenses, outstanding debts and mortgages, planned educational expenses and loss of income. But most importantly, in the aftermath of an unexpected death, life insurance can lessen financial burdens at a time when surviving family members are dealing with the loss of a loved one. In addition, life insurance can provide valuable peace of mind for the policy holder. That is why life insurance is vital for the bread winner of a single-income household, but still important for a stay-at-home spouse.
Life insurance is a contract (called a policy). A policy is an agreement between a life insurance company and someone (or occasionally something, like a trust) with a financial interest in the life and livelihood of someone else. The insurance company pools the premiums of policyholders and pays out claims—called a death benefit—in the event of death. The difference between the premiums received and the claims paid out is the insurance company’s profit.
There are four primary players, or roles, in a life insurance policy. These roles are fulfilled by the insurer, the owner, the insured and the beneficiary. The insurer is the insurance company, responsible for paying out claims in the case of a death. The owner of the policy is responsible for premium payments to the insurance company. The insured is the person upon whose life the policy is based. The beneficiary is the person, trust or other entity due to receive the life insurance claim—or death benefit—in the case of the insured’s passing on. For example: I am both the owner and the insured for two life insurance policies (with two different insurers, as it happens). My wife is the beneficiary of each. We walk through the numbers together at least annually (and after major arguments, to prove that I’m still worth more alive!).
Life insurance is a risk management tool, not an investment. While some life insurance policies have an investment feature that may offer a degree of tax privilege, insurance is rarely an optimal investment. There’s usually a better, more efficient tool for the financial goal you’re trying to accomplish. If you haven’t yet filled up your emergency cash reserves, paid off all non-mortgage debt, increased your retirement fund savings to the maximum, contributed to an education savings plan (where appropriate); and put money aside for large purchases you expect in the next decade, then you most likely need not concern yourself with life insurance containing an investment component. (You’ll see why in #7.)
Life insurance can be extremely expensive, but it can also be surprisingly inexpensive. If you apply for a bells-and-whistles permanent policy, the amount of the premiums alone might cause you to need a life insurance benefit right then and there! But most people are pleasantly surprised when they see the relatively low premiums of a plain-vanilla term policy. For example: A healthy, non-smoking, 30-something male, would pay an extremely competitive and affordable premium for a 20-year term policy with a million rand death benefit. That same individual might be required to pay ten, or even twenty times as much for a variable or whole life insurance policy with a matching death benefit. No, a term/perm comparison is not an apples with apples comparison. I would hazard to guess, however, that a recent widower cares little for bells-and-whistles but a great deal for the death benefit. Of course, a smoker will likely pay twice as much for any of the above. Someone with health problems could pay triple or more (or simply be declined for coverage).
Determining the optimal life insurance policy for you doesn’t have to be complicated. While we could get really granular with a detailed life insurance needs analysis, it’s more important to create something you comprehend than it is to postpone an important decision due to life insurance’s intimidating complexity. In the vast majority of situations, a household would be well cared for simply by buying enough life insurance to reflect all or most of the insured’s income for a term as long as the household expects to need that income.
Therefore, consider this simple but effective strategy for determining how much life insurance your household needs. Multiply a wage earner’s income by 15 and purchase a policy with an equivalent death benefit for a term that extends the time the insured would presumably retire. Why 15? Because it works. But it works because it results in a number that should re-create 75% of a wage earner’s income if the death benefit was conservatively invested to earn 5% (hopefully plus a bit more for inflation) annually.
Here’s an example:
Dave earns R100 000.
R100 000 x 15 = R1 500 000 death benefit
R1 500 000 earning 5% annually produces R75 000 of income.
Consider using a ‘real’ person to assist you with your estate planning. There are many online tools one can use to estimate the money you should spend on a policy that meet your requirements. But once you’ve done that, I would recommend contacting a ‘real’, ‘live’ financial advisor who can walk you through the application and underwriting process. The premiums at a given insurance company are identical whether you apply online, via a toll-free number or through a broker. Indeed, a knowledgeable and dedicated insurance broker or advisor may help you save money by choosing the best product for your particular situation. Underwriting, by the way, is the necessarily tedious process the insurance company implement to determine your risk profile: based on your current health, past health, the health of your parents and siblings and enough other questions to make anyone blush. Answer truthfully—but succinctly.
Know your options when cancelling an existing life insurance policy so you don’t leave money, or coverage, on the table. If you have a policy that isn’t appropriate for you—or you simply no longer need it—it’s important to proceed carefully. First, if you realise that you have overpaid for a policy that doesn’t meet your needs, but you still need life insurance, don’t cancel the wrong policy until the right policy is in place. Who knows, you could learn of a health complication that might result in the new policy being declined for. Then you’d be left without any coverage. If you have an existing term policy you no longer need, you can simply cease premium payments and it will go away. If you have an unnecessary permanent policy with a cash value, however, you should analyse its present and expected future investment value, as well as any prospective tax complications, before cashing it in. This can be done by requesting an “in-force illustration” and a “cost basis report” from your advisor.
I suspect we prefer not talking about life insurance because we don’t like talking about death. No shocker there. But open and honest discussions about planning for an unexpected death can be surprisingly life-giving. And even if you don’t buy that, chances are good that obtaining life insurance is still an important part of your long-term and comprehensive financial plan.
Article Written by Tim Maurer
Edited and revised by Marinus Lourens