Insurance
The purpose of this section is to provide basic information about insurance; information which is not easy to find. One can get specific information without any problem. The main questions regarding insurance are:
- What is it for?
- How long is it needed?
- What should the amount be?
- When to make the purchase?
- What type of insurance should be purchased?
We will address these questions.
What is it for?
The key element is understanding the purpose of insurance. The primary function of insurance is to provide a safety net or security. Insurance agents will try to sell it as an investment vehicle but we defer. We do not want to take sides but we only want people to exercise caution. The investment component of insurance is not for everyone, therefore taking insurance as an investment is not for everyone.
As mentioned, the basic function of insurance is to provide security or a safety net, therefore the first and most important step is to understand the purpose of insurance or in other words what one is trying to protect. Also, keep in mind that insurance pays only when some event occurs, usually death. There are other forms of insurance as well which cover disability, long term care, critical illness but the main protection is against udeath.
The purpose or reason has to be identified first and clearly. Some examples are, Mortgage protection, Income protection for the family, Estate protection, Loan protection etc..
How long is it needed?
It represents the duration or time. Once the purpose or reason is identified then the next step is to address the time factor. Most people make mistake in determining the time factor as they get carried away because of emotions. Remember, controlling emotions is the single most important factor in determining the Insurance need. An example is suppose one is trying to protect the Income for the family in case of death then one must determine how long or for how many years the income is required for. This time factor is important since it helps to determine the Insurance type.
What should the amount be?
Third factor that is important pertains to the amount. Most of the people make serious mistake in determining this element as they become emotional and get carried away by the Insurance agent. Decision is not easy however, one has to be realistic. Remember you are determining the amount that should address the purpose for which Insurance is being taken after your death. Key point is after the death. No one can take care of the dear ones after their death till their dear ones die as well. Therefore, be realistic. Amount and time together determine the Insurance premium.
When to make the purchase?
Once you have determined the purpose, time and amount then next important decision pertains to when to buy the Insurance. Rule of thumb is, the earlier the better. However, since the main advantage of Insurance is to address provide security or safety net therefore, the best time to purchase the Insurance is during Settlement stage or between age 30 and 40. Look for explanation under GASP. When one is under the Settlement stage then foreseeing future responsibilities is easy. Therefore, safeguarding them is also easy by taking right amount of Insurance for the right amount of time.
What type of insurance chould be purchased?
This is the last factor but probably, the most important one as well. In essence there are only two types of Insurance, Term and Permanent. Both have their advantages and disadvantages. There is no right or wrong answer however, one should be careful when the agent is trying to push for the Permanent Insurance as Investment vehicle. Personally, we believe that Investment component of the Insurance is not presented by the agent properly or in other words is not understood by the people properly. Remember the purpose first. Insurance kicks in only when one dies. Lets review briefly the Insurance types. For detail explanation you can contact us or read over the web.
Term Insurance
Term usually means for a fixed period. Usually, the periods are 5 years, 10 years or 20 years. There is Term 100 as well but we will discuss it under Permanent. Term 5 is usually not very common since there are very few situations which can be addressed by this type of the Insurance. However, check with the agent if you really think this Insurance type is what you need. Since Term insurances are specific to fixed period therefore, the main purpose of this Insurance is to provide safety or security only. They protect the purpose. Premiums are primarily, determined by the age and amount. Once the period is over the protection is over as well. However, one can renew it but renewal increases the premium a lot depending upon the age. Most Term insurances give the option of converting them to Permanent but again Premiums increase. Therefore, whether to take Term 5, 10 or 20 depends upon the purpose. For example, if one is trying to protect the Income stream for the family then Term 20 might make more sense. However, one is trying to protect a loan then Term 5 or 10 may make more sense. Contact us for free advice.
Permanent Insurance
Usually Permanent Insurance is of two types – Whole Life and Universal life. However as mentioned under Term Insurance, there is another type of Permanent Insurance called Term 100. There is a big difference between Term 100 and the other two types of Permanent Insurance. The difference will become clear later. Whole life and Universal life both have 2 components – death benefit and cash reserve. Term 100 has very little or an insignificant amount of cash reserve. Insurance agents usually, position insurance as an investment vehicle because of this Cash Reserve component. We will not cover this cash Reserve component in detail about since a number of sites provide a very good explanation. However we will cover to the point that one can understand enough to make a correct decision.
The cash reserve component comes from the fact that protection is guaranteed for life without an increase in the premiums. Therefore the premiums of a permanent policy are significantly higher than for term policies. Since Insurance companies are charging higher premiums, part of this premium is put into the policy and invested on behalf of the policy holder. This grows over the time and in some cases can grow to quite a significant amount. Hence the notion of Investment.
Remember that the cash reserve component takes time to grow. In the beginning it is not a huge amount. One has to contribute for 10 years or more to see a growth. Also, remember that the cash reserve component (the growth part) is not tax free like the death benefit of the policy.
The cash reserve component can be used in 2 ways. One way is to pass it with Death benefit and second way is to take it out as a loan. The loan amount reduces the Death Benefit. Just keep in mind that you have to pay tax as well on this loan. Contact us to know how the tax is calculated as it is not simple. However, it is important to know that you have to pay the tax and death benefits are reduced. Therefore in general Permanent policies make sense for individuals who cannot use any other vehicle to reduce their taxes. Such policies provide a mechanism to defer taxes. Another aspect that is addressed by Permanent policies pertains to preserving your estate. Again, please contact us for a full explanation as it is not easy to explain it here. Just keep in mind that there are two cases where Permanent policies make sense – to defer taxes and to preserve taxes on your estate. Again, one has to decide if how important these 2 factors are before taking Permanent Insurance as premiums are very high in comparison to term insurance.
Think hard and think twice before deciding on Permanent Insurance. Contact us for explanation on the differences between Whole life and Universal life as our main aim is to address question of Term vs Permanent.
We feel that for of us it makes sense to take Term insurance and put the extra money into an investment vehicle. However it is very important to know the purpose, amount and time before taking a policy. Check under Ideas for an analysis.