How to choose the right amount of life insurance?

When setting up a life insurance plan you can usually choose any amount of insurance you’d like. So, how do you choose the right amount for you? We’ll look at five key areas people consider when choosing the right amount of life insurance.

Mortgages
For people with a family or who share a mortgage with a partner, life insurance is usually crucial. Most people in this situation choose to make sure they have enough life insurance to ensure their mortgage is paid off if they pass away.

Other debt
If you have debt that you would not like to be left to family or a partner, than including provision for this in your life insurance is a good idea. This makes sure that your partner or family are not left in financial trouble if you pass away unexpectedly.

Replacement income
This is particularly important for the main income earner in a household. If they were to pass away, there could be a huge financial impact on the other family members. For this reason, people often choose to add a sum for a replacement income into their life insurance. For example, a person might decide that they want to provide an ongoing income of $50,000 to surviving family for a period of 15 years (in many cases until children are grown). This makes sure that the financial impact of death is greatly lessened.

Education
A child’s education can be very costly. To provide for this kind of cost, an amount can be added to your life insurance – meaning that funds are available for education in the future.

Funeral costs
If you don’t have adequate savings for these, then you could choose to use life insurance to cover this expense. Also most life insurance plans have an immediate funeral grant – which can help with funeral and final costs.

Life insurance - saving money with stepped or level premiums.

In New Zealand, when you start a life insurance plan you usually can choose from two premium types: “stepped” premiums or “level” premiums. The difference is simple. Stepped life insurance premiums are designed to increase with age – so as you get older the cost of your insurance will increase every year. On the other hand, a level premium does not increase with age – so you getting older makes no difference to the cost of the life insurance.

Which is better? The answer depends on how long you are likely to need your life insurance for. At first glance a level premium looks more expensive – and in the first years after setting up your policy, it will be higher (around twice to three times the cost of a stepped life insurance premium is a good rule of thumb). However, because a level premium doesn’t increase with age, it can become much cheaper over the long term (say over 10 years).

So while a stepped premium is cheaper in the short term, in the long term it can cost a lot more. And in the very long term (say when you are in your 60s or 70s), a stepped life insurance premium is likely to be totally unaffordable.

In New Zealand, people have financially dependent children and debt for much longer than in the past. For this reason a level premium can sometimes be the only affordable long term life insurance option.

So, if you’re deciding between a stepped and level premium the main point to consider is how long you might want to keep your life insurance. If you might need it for only the short term (say less than 5 years), it’s highly unlikely that a level premium will be cost effective. In this case, a stepped life insurance premium will probably be the best option.

However if you might have a long term need for your insurance – for example you have young children or a long mortgage term, then look into level cover. You can ask your life insurance broker to compare the costs of both options for you – and you’ll easily see which makes more sense for you.

Level life insurance - where the smart money is

Are you finding that every year your life insurance is getting more and more expensive? After the age of about 35, that’s what tends to happen with life insurance premiums. In fact, at some point they will become unaffordable.

You see, a life insurance premium is calculated by actuaries who consider only one thing – the “numbers”. The numbers tell them that when you are 25 years old, there is a very low probability of you passing away. So when you are 25 years old, the cost of your life insurance reflects this. At the age of 50, the numbers tell them that the probability of you passing away has increased significantly, so they charge accordingly. By the time you are 60, the probability of you passing away is relatively high – you know where this is going. (see http://www.stats.govt.nz/analytical-reports/nz-life-tables-2000-2002/default.htm)

There is one way of avoiding this situation though. If you need your life insurance long term, you can choose a “level premium” option. This simply means that you choose a term when you start the contract - 10 years, 20 years, or even to the age of 80. Your premium is then calculated over the term of the contract and aggregated so that the cost stays the same – no annual increases. You don’t have to commit to the full term that you choose – you can still cancel the contract at any time. But it is a great way of ensuring that your cover is sustainable.

Level premiums are more expensive at the start (normally around double the cost), but in the long term they work out to be far more cost effective. This is particularly evident if you start a level premium when you are young – it’s the smartest way to do it.

Some insurers (see www.inform.co.nz) can guarantee your premium until your 80th birthday. That means that if you are 30, you would know exactly what the cost of your life insurance would be to the age of 80 – and it’s probably not as expensive as you think at this age.

If you want to set your cover up to be sustainable, investigate level premiums. It’s where the smart money is.