Life Insurance: What kind? How much?

By Leslie Kane,
Senior Editor

Unles you choose your policy carefully, you could end up paying too much, or being left without coverage.

Thinking about life insurance is about as exciting as discussing bunion surgery or reading the footnotes of a coding manual. But dull doesn't mean simple. So even though you can get price quotes and buy coverage over the Internet without ever meeting an agent, you need to be cautious.

"If you're not, you could wind up with the wrong type of policy, insufficient coverage, or unexpectedly high premiums later on," says Brian Grodman, a financial planner with Grodman Financial Group in Manchester, NH.

To avoid those and other potentially disastrous pitfalls, consider these important questions when deciding what to buy.

How long will you need coverage?

"Most people need coverage until they have enough money saved to retire without working part time," says Bob Barney, president of Compulife Software, a company in Nicholasville, KY, whose Web site (www.term4sale.com ) helps consumers compare term life insurance rates nationwide. "If you can afford full retirement, then you have enough that your surviving spouse can live off your retirement nest egg without insurance to supplement living expenses."

You may want to keep it longer, though, under certain circumstances—to leave money for your kids or grandchildren, for instance. "Or say you own a horse farm that may be worth a few million dollars by the time you die," says Barney. "If the estate tax is still in effect when your kids inherit the property, they'll have a substantial tax bill to pay. Insurance can provide the money to pay the tax."

Should you get permanent or term life?

Permanent life insurance builds up a cash value: Part of each premium you pay is invested, and that money grows tax-deferred. If you decide you don't need the insurance, you can cash in the policy and get back much of the cash value.

Permanent insurance comes in several basic types. Traditional whole life means the premiums are fixed. The insurer chooses the investments and pays you interest on the cash value. With variable life, you get to choose the investments from a limited list of stock, bond, or money-market portfolios. The policy's cash value will fluctuate with your investment returns; the premiums and the death benefit may also vary. Universal life gives you flexibility in the amount of premium you pay each year as well as the face value coverage you get. Insurers also sell variations on these basic policies. (For more on choosing a permanent policy, See "Buying life insurance that meets your needs," Dec. 14, 1998.)

A term policy provides no cash build-up; when the term ends, so does your coverage. But the premiums for term life insurance are much lower than those for a permanent policy. That makes term attractive for people who can foresee an end to their insurance needs. "Term insurance also provides the only way for most young doctors to afford adequate coverage," says Grodman.

That tends to make term coverage more popular than permanent. But again, it's important to consider how long you'll need the coverage. "If you need to have insurance for as long as you live—which could mean into your 90s—you won't be able to get term through that age," notes Barney. Even if you could, the cost would prove prohibitive. Unlike with a permanent policy, you must renew term insurance periodically—perhaps as often as annually—at increasingly higher premiums. And each time you renew, you have to prove that you're still insurable.

A possible solution is to buy a term policy with a conversion feature that will allow you to switch to a whole life policy later on. That way, you get the best features of term and permanent insurance. "Usually the conversion feature must be exercised before the tenth year, even if it's a 20- or 30-year policy," says Grodman. You'll enjoy up to 10 years of low premiums, and you can then get whole life, if you want it. The conversion option costs nothing. More important, you can convert without undergoing a medical screening—a critical benefit when you plan to keep the coverage for the long haul.

There's one old argument for buying permanent coverage that no longer holds up, however. "In the past, insurance agents promoted it as a forced savings vehicle for people who lack the discipline to put money aside on a regular basis," says Rick Adkins, a financial adviser with The Arkansas Financial Group in Little Rock, AR. "Today, with the prevalence of 401(k) plans and emphasis on individual investing, that's no longer a good enough reason."

How long a term should you buy?

If you opt for a term policy, the next challenge is figuring out the most cost-effective way to get the length of coverage you'll need.

Term insurance comes in lengths of one, five, 10, 15, 20, 25, and 30 years. In general, the shorter the term, the lower the annual premium. For example, a five-year $500,000 term policy from Valley Forge Life Insurance would cost $415 a year for a 40-year old man in good health. He'd pay $535 annually for a 20-year term policy from the same company, and $1,635 a year for a 30-year policy.

Naturally, you don't want to pay for a longer term than necessary. But buying, say, a 10-year term policy to get the lower premiums, even though you suspect you may need insurance after that, would be a mistake. Renewal premiums are ticking time bombs.

"For a young family man, a 10-year term policy is a terrible idea," says Barney. "In the 11th year, the cost to renew the policy skyrockets. Say you're a 40-year-old in the best of health, living in Pennsylvania, and you want a 10-year term policy with a face value of $250,000. You can get such a policy for an annual premium of $135. After 10 years, the annual premium for the same policy will be $2,500. By age 60, it will escalate to $6,365. "By contrast, if you bought a 20-year term policy, you'd pay $225 annually for the whole term," says Barney. "It's smarter to go for the longer term."

Some folks try to outwit the insurer by buying a short-term policy, then looking for a more competitive rate at another company when the term is up. "The problem is, you have to qualify for the plan on the basis of your health," says Barney. "If you've developed diabetes, high blood pressure, heart disease, cancer, or another severe illness or health condition since you bought the first policy, you'll pay much higher premiums on the new one," says Barney. That's if you can even get insurance.

"Insurers rate health by categories, all of which are some variant of preferred plus, preferred, regular plus, and regular," says Barney. "Below those is substandard. To qualify for the best rate, you'd have to be as healthy as an astronaut—but you couldn't actually work as an astronaut, since a dangerous vocation would disqualify you from getting the best rate."

Most people qualify as regular or regular plus. If you're extremely overweight, have diabetes, or are being treated for heart disease or other diseases, you'll likely be considered substandard. "Substandard ratings go in grades along a scale, indicating increasingly worse health," says Brian Grodman. "Each tier on the scale charges a 25 percent higher premium than the prior tier."

What's the right amount?

"It's critical to buy as much insurance as your family will need to maintain their current lifestyle and take care of major needs if you were to die tomorrow," says Barney. Figure out your current cost of living, then project how much your family would need to cover college costs and carry on without your income, for as long as necessary. Be sure to account for inflation. For help, use the life insurance calculators at www.quotesmith.com or www.tiaacref.com/lins/index.html .

Brace yourself for a high number. If your family needs, say, $70,000 a year to live, a $700,000 lump sum will keep them going for only about 13 years, factoring in 3 percent annual inflation, assuming they'll invest the money, get at least a 7 percent after-tax return, and avoid a market plunge. A physician who wants to make sure that his or her young children can go to college could need $1 or $2 million to ensure that the family can live comfortably and fulfill its goals.

Where's the best place to buy?

Once you know how much you need and what to look for, you can start shopping for a specific policy. An insurance agent can help—particularly if you're considering permanent insurance, since those policies vary widely from insurer to insurer. To find a good insurance agent, ask colleagues or check with a financial planner. Contact your state insurance department to make sure an agent is licensed and has no disciplinary actions pending.

Agents tend to push permanent policies, because they make bigger commissions for selling them. That's fine if you also believe permanent insurance is the right choice for you. But if you want term, don't let an agent's sales talk sway you.

If you want term, you can also compare quotes among companies nationwide at www.term4sale.com or at www.quotesmith.com, as well as at many other Web sites. But don't be bamboozled by seemingly low prices. Companies quote the rate for people in the best health, and as we noted earlier, you probably won't get that rate.

Adkins recommends comparing the Preferred Plus rate among various companies, because it's always the lowest rate a company charges. "That lets you compare apples with apples," he says. "Then look for a company with a pattern of low rates among several different terms and ages."

Make sure you read all the fine print. You'll find that seemingly clear terms don't always mean what you think. Amazingly, for instance, "level premium" doesn't necessarily mean that premiums remain level throughout the life of the policy. "A company may offer a 20-year level term policy for, say, $295 annually," says Barney. "But the small print says they guarantee the level premium only for 10 years; after that, they could raise it to anything. If you want premiums that truly remain level, buy a guaranteed level term policy. You'll pay a bit more, but it's usually worth the extra cost."

Beyond price and terminology, it's important to look at the company's financial stability rating. "You want to make sure that the company will still likely be around when you'll need it to pay off," says Adkins. All states have a guaranty fund to help pay obligations if an insurance company goes under, but you're still better off if your insurance company continues to operate profitably. Check the reliability of a potential insurer with Weiss Ratings ( www.weissratings.com ) or AM Best (www.ambest.com). You can probably get copies of those companies' publications at your local library.

Annual premium* for a $500,000 policy

5-year term $415

20-year term $535

30-year term $1,635

*For a healthy 40-year-old man.

Source: Valley Forge Life Insurance

Should employed doctors buy their own insurance?

If you're a salaried employee, chances are you have term life insurance through a group policy offered at work. Your employer has most likely purchased a group contract that lets you buy additional coverage, often in multiples of your annual salary.

Although it's easy and convenient to check off a multiple of your salary, it's better to calculate and buy the amount of life insurance you'll actually need. For help in figuring the optimal amount for your family, use the life insurance calculators at www.quotesmith.com , or www.tiaacref.com/lins/index.html .

You might find that buying additional insurance on your own makes more sense. What will happen to your group policy when you retire or change jobs, for instance? It's best if you can convert your coverage to an individual policy without having to qualify on a health basis. If you won't be able to do so, look into getting your own individual term policy.

Moreover, Uncle Sam considers group life insurance over $50,000 a taxable fringe benefit. So in addition to your share of the premiums for a group policy, you'll pay federal income tax on a premium amount determined by IRS tables. Your state may also assess a similar tax. The older you are, the greater the amount subject to federal tax. So before you opt for group coverage, you may want to compare its total cost, including income taxes, with the premium for a policy you could buy separately. IRS Publication 525 explains how to calculate the federal tax.

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Leslie Kane. Life insurance: What kind? How much?.

Medical Economics

2002;13:44.