Buying life insurance? Put the horse before the cart

Life insurance has gotten a bad rap because of the confusing array of products and the way in which they’re sold.

Most of us know someone who’s been sold a life insurance policy they later realized was either unnecessary or unsuitable to their needs. There are thousands of Americans walking around today with the wrong kind and wrong amount of life insurance coverage and, in most cases, it’s costing them more than it should to suit their needs.

A big mistake people make in choosing life insurance is putting the cart before the horse — that is, they pick a product and try to fit it into their circumstances rather than the other way around. Another is buying insurance without having their plan reviewed by an objective third party.

Before even looking at the different flavors of life insurance, it’s important to understand how much insurance you need by running two separate analyses.

The first is a capital needs analysis, which assesses debt, income needs, and the nuts and bolts of providing for survivors should you unexpectedly leave this world. The second is a human life value analysis, essentially an economic impact statement that tabulates what you bring to your family and surroundings.

Unfortunately, life insurance tends not to be purchased with this kind of nuance.

Historically, agents have used 10-times income as a starting point for coverage, without accounting for factors such as debt, savings, income-earning years, and life expectancy. It’s a one-size-fits-all approach to lives that can be radically different.

Once you know how much insurance you need, you can move on to thinking about the type of policy that will best protect your family.

The varied spectrum of life insurance policies may seem daunting, but they essentially boil down to two main types: term and permanent.

Term life insurance covers you for a fixed period of time, with 10, 20, and 30 years being the most common durations — the longer the period, the higher the premium. These policies are designed to cover those financial needs which usually fade as you approach retirement such as mortgages, salary, college costs, and so on. One advantageous plus of term insurance is its flexibility based on life changes. Just like car insurance, you can stop paying premiums and switch if off whenever you want. Or you can increase the coverage based on long-term changes such as marriage, more kids, or owning a bigger house.

Permanent life insurance comes in several different flavors, including whole life and indexed universal life. They vary in their level of flexibility and some come with a savings element. A common theme is that the policy usually covers you for your whole life and includes additional benefits. Those benefits, and the fact that its almost certain to pay out at some point, come at the cost of significantly higher premiums.

It’s important to understand that there’s no right answer here; everything depends on a family’s particular circumstances and needs.

Take two 35-year-old heads of household, each with three young kids, a mortgage, and a stay-at-home spouse. The only difference is that the second family has a special-needs child who is likely always going to be financially dependent. Both families need a life insurance policy, without which a breadwinner’s death would risk plunging the surviving family members into a financial crisis.

For the first family, term insurance could be an attractive option. It enables them to select a coverage period that gets to them when their kids leave the nest and the parents become eligible to tap their retirement savings. And they’ll pay substantially less in premiums than they would for a permanent life policy.

For the second family, it’s not so simple. The long-term care obligation they have for their special-needs child could make the higher premiums and superior benefits of a permanent life policy a worthwhile option.

That’s just one example. There are myriad other ways in which unique circumstances could affect the best choice, which could include the possibility of having separate term and permanent policies.

The other alternative people have increasingly been drawn to — indexed universal life (IUL) — offers a savings element and provides permanent coverage. This may well make sense for those who lack discipline in their savings or who feel more at peace because of the guarantee of no market losses that IUL policies offer.

These policies are more complex than they appear, with more moving parts than what’s apparent on the surface. It’s important to understand that in addition to capping market returns, IUL premiums are usually much higher than for term-life policies and may have significantly higher sales and administrative fees than a conventional retirement account.

Given the vast landscape of life insurance products and multifarious family and financial circumstances, buyers will be well served by having their plans reviewed by an objective third party before signing on the dotted line.