I defined what Financial Independence means to me here. One of the pillars of my financial independence is Life Insurance. In this post, I will talk about how I went about choosing life insurance coverage for my family.
General Principles for choosing Life Insurance
There are few questions to answer when it comes to life insurance. Let us take each one and expand on it. After that, we can talk about the choices I made and why.
- Yearly family budget
- Term life or whole life
- Policy Term
- Policy value
- Which life insurance company
- What age to buy it at
Yearly Family Budget
The first step in planning for life insurance is knowing what the yearly budget is going to be. There are many free budgeting tools available online and many financial planners as well. It is well worth the effort and/or the cost to come up with a solid expense budget. Make sure to include future expenses as well. For example, I do not have a house yet…we rent at $2500 pm. In future, when I get a mortgage, I anticipate the mortgage cost to jump to $4500. So, use $4500 as part of the budget. Likewise, if you plan to extend the family in future, scale up the cost by the number of kinds you plan to have OR number of people you need to support. Run with this budget for a month OR two and see how accurate the budget is. It will take 1-3 months to iron out all the kinks….but if you are off by $1000 for the whole year, no big deal; if you missed a $20000 expense, it can prove painful. Once you have a yearly budget done, move onto the next step.
Term or Whole life insurance
There are two main types of life insurance: term life and whole life.
- Term life is for a fixed time interval…say 20yrs for example. If I buy a 20 yr policy && die within the 20 yrs, then the policy amount will be paid to my family. If I do not die during the 20 years, then I get *zero* dollars on policy maturity. I.e. term life insurance is a bottom less pit, a black hole, etc etc. The advantage is that it tends to be cheaper than whole life insurance.
- There are options that can be added to term life insurance policies that can convert the term life policy into a while life policy when the term life reaches maturity. These options are called Riders, which cost a yearly premium. For example, a 20 yr term life with a rider to convert it to a whole life costs an additional $200 per year. NOTE that this $200 per year is just to have the rider. To convert it to whole life, some additional premium will need to be paid…the rider only gives the opportunity to pay the premium to convert to whole life i.e. the conversion is not free.
- Whole life insurance is for the entire life of the insured. Whole life policies build cash value by way of premiums and dividends. Values for death benefits and premiums are usually determined at policy issue, for the life of the contract, and usually cannot be altered after issue. Since the person may live well into the nineties, the risk of payout carried by the Insurance company is higher too. So, whole life insurance tends to be an expensive proposition.
- In the first few years of mortgage payment, the payment mainly feeds the interest and the principal does not reduce much. Just like that, the insurance agent gets a lot of the commissions in the first few years of the whole life policy and the policy itself does not build value.
Policy Term
If whole life is chosen, then this question does not arise. If term life is chosen, then what should be the policy term chosen? The idea I liked was to protect the family from any emergencies for the earning years of the primary income earner in the family. Usually, it is until 65 years of age.
Policy value
The idea I liked was this. When the primary income earner dies suddenly, the remaining spouse will be in no shape to start working OR continue working as the case may be. So, life insurance should provide sufficient buffer to replace the yearly budget for a sufficient number of years. I.e. if the yearly budget is $100K, then providing 10yrs of income replacement will mean a $1million policy.
Which life insurance company
Life insurance is offered by many companies….Guardian, Mass Mutual, Northwestern, Fidelity, etc etc etc….The company I chose to protect my family for the next 30 years should itself be able to survive for the next 30 years. There is no guarantee that past performance will lead to future performance as well. But, I went about collecting the ratings of all insurance companies from rating agencies like S&P, Fitch Ratings, AM Best, etc. The top ones came out to be the following:
- Guardian and Mass Mutual (equal)
- Metlife
- NorthWestern Mutual
- Prudential
What age to buy it at
Earlier the better 🙂 I say this because usually one’s health is much better in 20s than in the 40s. The insurance is much cheaper when one is younger and healthier. So, better to buy as early as possible…when there are people who start depending on your salary.
My design principles in choosing Life Insurance
The design principles I used were
- Protect my earning years
- Reasonable and fixed monthly cost
- Stable Life Insurance company
Protect my earning years
When I starting thinking about Life Insurance, I wanted to protect my family from any emergencies for my earning years i.e. until 65-70 years of age. I may achieve financial independence earlier than that..if so, the life insurance will be a luxury. If not, I did not want my family to suffer.
Reasonable and fixed monthly cost
I decided upon Term Life Insurance because of two reasons…it was cheaper was one reason and spreading the risk was another.
What do I mean by spreading the risk? I decided to invest the difference between term and whole life in the stock market. Historically, the growth from stock market has proved to be better than the growth of the whole life insurance. So, paying for term and investing the difference also spreads the risk….all risk on the insurance company (whole life) vs risk in the insurance company (term life) plus risk of the investments (in many companies).
So, my selection was Term Life Insurance and not Whole life with a policy term of 30 years i.e. until I am 70yrs of age. 65 would have been good, but there was no policy for that many years. By 70 yrs, I hope to have a reasonable financial plan for my family 🙂
The approval process took a long time but the policy has been approved! It costs me a packet every month…a bottomless pit…but, at least my family is covered until 70yrs of age.
Stable Life Insurance Company
Based on my ratings data collection, both Guardian and Mass Mutual were fine. I decided to go with Guardian Life Insurance…the Guardian folks were more prompt in approaching me and thus they were chosen 🙂
Conclusion
Hopefully, the above longish post has given a flavor of how to select an insurance policy and the knobs that are available for people to fine tune the choices to protect their family.
Humble FI 