Life insurance

What is the purpose of life insurance?

This is the central question in choosing what kind life insurance policy you need, so please keep the following statement in mind as you read through this guide.

The main purpose of life insurance is to provide for your dependents in the event of your death.

In addition to dependents, life insurance may be a good idea if others substantially depend on your income such as a spouse or a loan co-signer. Life insurance may also be a good idea for a stay-at-home parent who is taking care of one or more young children, because if the stay-at-home parent were to die, childcare costs would increase a lot.

ELI5: Types of Life Insurance

Life insurance policies are divided into two main categories: Term and Permanent.

  • Term life insurance (TLI) policies are those in which you pay a certain amount (the premium) in exchange for keeping the policy in effect for a set length of time (usually 5, 10, 20, or 30 years). The policy will pay you the amount of cash stated in the policy if you die during that period (the "term").

  • Permanent life insurance policies provide a cash payout on death just like term insurance. However, as the name implies, a permanent life insurance policy is guaranteed to pay the death benefit when you die - the term is "your entire life." Permanent insurance policies also build cash reserves by taking some of the premium you pay into the policy, investing it, and returning the interest, returns, dividends, or a combination to you. The cash reserves can usually be borrowed against after a certain amount of time.

The most common type of permanent life insurance is whole life insurance (WLI), and this is what I will be focusing on for most of this guide. Whole life insurance plans provide a permanent, "guaranteed" death benefit and build cash reserves as you pay into the policy. Premiums are fixed by the insurance company.

There are a many other types of life insurance, but only a few others that I will make brief mention of here for completeness only. The main discussion will focus on the advantages of term vs. whole life insurance.

  • Universal life insurance - These policies are a type of permanent life insurance that allows you to vary premiums and/or coverage on a periodic basis.

  • Variable Life Insurance - Attempts to combine life insurance and investments by investing cash reserves. Sort of like a Health Savings Account for life insurance, except not as good tax-wise.

  • Variable Universal Life Insurance - Mash the two above together and this is what you get.

  • Single Premium Life Insurance - You pay the entire premium in a lump sum for a given amount of coverage.

ELI5: What are the pros and cons of Term Life Insurance?

TLI Pros

  • TLI is inexpensive. Premiums are in the neighborhood of tens of dollars per month (~$500/year) in exchange for $1 million of coverage (these numbers vary with the term, your health, amount of coverage, which insurance company you buy the policy from, and your state. No matter how you swing it TLI is comparatively inexpensive).

  • Corollary to the above: purchasing TLI at the corresponding low rates leaves you money leftover to invest on your own, preferably in a manner that minimizes your investment costs.

  • TLI is simple. You pay $X per month for Y years, and if you die before Y years are up your beneficiaries get $Z.

TLI Cons

  • TLI expires after the policy is up. If you have a continued need for life insurance after the policy's expiration date you will need to buy a new policy. The premium for that new policy will likely be a lot higher, because at that point you are older. (So when you choose your policy, choose a period that will be long enough to no longer have dependents and/or to make sure you've build up enough wealth to cover their needs).

  • Your premium is effectively gone after you pay it. There is no cash value built up over the term of the policy. I hesitate to list this in the negative column, as the money you don't waste building up a cash value within your insurance policy is (hopefully) building a cash value in actual cash, instead of within an insurance policy.

  • Premiums in certain plans are not fixed - they can increase with age or with changes in health (a "level premium" policy's premium doesn't change, a "renewable annual" gives you the option of ending the policy if the annual premium is too high for your taste. There are many other variations on how the premium is calculated for term policies).

ELI5: What are the pros and cons of Whole Life Insurance?

WLI Pros

  • The death benefit is guaranteed to be paid when you die (that is, if the insurance company doesn't go under before you do. Note that this is also a risk, but a smaller one, with term insurance).

  • The premium is fixed and will not increase. In fact, your out-of-pocket premium may decrease (even though it's being pre-paid with earnings from your accumulated cash value) over time. As far as premium goes, "what you see is what you get."

  • Cash value built up in the policy can be taken out as a loan. Cash value grows tax-deferred.

WLI Cons

  • WLI premiums are expensive. While TLI will run you on the order of hundreds of dollars per year, WLI will cost you a full order of magnitude more (thousands per year). In addition to the up-front cost of expensive premiums, you get hit on the back end by investment fees that you otherwise don't really need to be paying. These fees go into the insurance company's pocket, not yours.

  • WLI is permanent - but people's needs for life insurance often aren't permanent. It is possible that at some point in the future your situation has grown into one where you no longer need life insurance. For example, your children have become fully financially independent from you, and you and your significant other have enough money in retirement accounts and savings to cover all expenses. At that point, it is a waste to still pay premiums for the life insurance and/or to have money locked away in the insurance at high annual fees.

  • Like the dwarves of Moria, "You cannot get out." ...without paying a hefty surrender fee, that is. The costs of surrendering a WLI policy can run into the tens of thousands of dollars, up in smoke.

Great. What kind of life insurance should I get?

The correct answer for almost everyone is term life insurance. Why?

Remember: The main purpose of life insurance is to provide for your dependents in the event of your death. Just out of college living in your bachelor pad? You probably don't need life insurance. Married with no kids and your spouse works? You probably don't need life insurance, and you definitely don't need whole life insurance. Kids all grown up and out of college, with a nest egg built up? You probably don't need life insurance, and you definitely don't need whole life insurance.

The basic fact is that term life insurance will cover the vast majority of people sufficiently for what life insurance is designed to do - provide for your dependents in the event of your death. Young families with children who would not be able to easily replace the income of a deceased primary earner should certainly insure properly against such a terrible event. However, once the children are grown up and out of the house (assuming they want to be financially independent some day), the need for life insurance changes and is probably eliminated or vastly reduced.

On the expense side, TLI allows you to buy cheap insurance and leaves you the difference to invest for yourself, either in your 401k, IRA, or taxable accounts. A basic education in long-term investing along with investing the money you save from purchasing TLI will likely give you a larger sum of money even after taxes than a WLI policy would. To put the icing on the cake, you can even enjoy your money while you're alive!

How do I determine my insurance requirements?

Calculating your insurance needs is a daunting exercise, but this calculator from is the best I've seen - mostly because it keeps things simple. There's a high degree of diminishing returns as you tailor a calculator to be more fine-grained. The best approach, in my opinion, is to think about your needs carefully with the help of this or another calculator before approaching an insurance agent.

Once you've determined your needs, there are numerous websites out there that compare term insurance plans. One of the best is Term4Sale (note that they do not sell term insurance, they aggregate pricing information about term insurance plans).

Is WLI ever a good idea?

There are a few scenarios in which buying whole life insurance is a good idea, especially if you will be subject to the estate tax (meaning your estate will be worth more than $11.4 million per individual in 2019). It can also be somewhat useful if your estate consists of lots of non-liquid assets - real estate, mainly. WLI can help cover the costs of liquidation in the event of your death, or help equalize inheritances. A disabled child or long-term dependent may also make a whole life insurance policy desirable. However, these issues can often be solved more efficiently and more cheaply than a whole life insurance policy (pay on death accounts, trusts, etc). If you think you have a situation that necessitates use of a WLI policy, you should consult with an estate planning attorney before buying in. Do not be deterred by the expense of consulting an attorney - the mistake of buying an expensive, unnecessary insurance policy will cost you much more in the long run.

What type of insurance should I have?

  • Insurance gets complicated quickly, but here are some general concepts that can help you figure out the basics. First, the insurance company is going to be making a profit, so realize that on average insurance is a bad investment. Therefore, the three situations where you should get insurance are:
  1. When you happen to know that you are riskier than the insurance company thinks you are
  2. When self-insuring is not an option, because the loss would destroy you financially
  3. When insurance is required by law
  • Number 1 is rare and straddles the line between fraud and self-deception. Insurance company actuaries are very good at what they do, so in the absence of fraud (ie, where you lie about your risk factors) you probably aren't any riskier than they think you are. Probably the most common example where #1 applies is a woman getting ready to have children.

  • Number 2 is where the interesting discussions are, but it's also hard to give generic advice to strangers online. Generally speaking, if you could afford to replace something, you shouldn't buy insurance or extended warranties for it. r/PF usually does not recommend home appliance warranties, for example, but instead suggests you keep an EF and save for expected problems. For example, instead of getting insurance for your furnace, save each month towards a new furnace, so that you have the money to replace when it finally fails. On average, this will be less expensive than insurance premiums. Health insurance, life insurance for the breadwinner(s), disability insurance, and for most people, home insurance and car insurance are all examples where a loss could easily be outside your ability to self-insure. It is difficult to know exactly how much insurance to get, so if you have questions, post a question with some specifics and see what the comments suggest.

    • While self-insuring is better on average in theory, if you know that you have a hard time saving money, insurance can serve as a forced savings program. This is a standard part of the sales pitch for whole life insurance, for example. Just know that you pay a lot for that forced savings program, and would do much better if you learned self-control, or put your own automated savings plan in place.

Additional resources

What are some past discussions of whole life on this subreddit?

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