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Insurance 101

Let’s be honest, most people find personal insurance complicated. There are so many types of coverage, and the options and differences between individual plans can be overwhelming. That’s why we always recommend working with a professional to sort through the details and fine print.

Here’s a look at the basics to help you get started.

How Does Insurance Work?

The basic idea behind insurance is making sure you have enough money if something bad happens. In a nutshell, you pay money (your premium) over time, to ensure you are financially covered if something bad happens.

Do I Really Need Insurance?

That depends on your situation. One of the benefits is that your dependents will be taken care of if you are no longer able to provide an income. We typically think of a spouse or children who are not yet supporting themselves. Sometimes we have others to care for, such as ailing parents, siblings or other friends and family members.

But those without these kinds of responsibilities have another angle to consider—who will look after you should you no longer be able to earn a living or care for yourself? Insurance can provide the financial stability to ensure you are well taken care of.

What Are The Chances?

Although unpleasant to think about, the reality is that accidents, illness and death are a part of life. Even those who look after themselves face significant risk of facing these issues. For instance, a non-smoking, healthy 45-year-old male has a 46% likelihood of facing disability, critical illness or death before the age of 65.

This reality should cause us to soberly and responsibly consider the risks and the implications for ourselves and our families.

What Kind Of Insurance Do You Need?

There are three basic types of insurance: life, disability and critical illness.

Life Insurance

Life insurance provides coverage in the event of your death. If you have dependents, it can provide a tax-free, lump sum of money that can be used for any number of items. These can be immediate expenses such as funeral and burial costs . They can also address longer term needs such as children’s education, providing a monthly income and helping with retirement. (See more about term life insurance in this article.)

Disability Insurance

Disability insurance provides income replacement should you no longer be able to earn an income due to a disability. It’s essential if you or your family depend on your income to meet monthly expenses. Many people have coverage through their work plans to protect them. It’s important to understand the details of that coverage. (You can learn more about disability insurance in this article.)

Critical Illness Insurance

Critical illness (CI) provides a lump sum of money in the event that you face a critical illness such as cancer or a heart attack. It can be used to deal with unexpected medical bills, extended time away from work, or other expenses. It can be an important buffer to prevent you from dipping into retirement savings. It is attractive for any working individual, especially those who do not have three to six months of income saved for an emergency.

Example

Let’s say you’re 45, making $75,000 per year, and planning to retire at 65. You can expect to earn $1,500,000 (20 years x $75,000) by the time you retire.

That’s a large amount of money that your household would be missing if they lost that income source.

How Much Insurance Do You Need?

For any of these types of insurance, the amount you need depends on a variety of factors, and changes dramatically over the course of your life.

When you are young and single, your priority may be critical illness and disability as you have a lifetime of earning ahead of you.

If you have a spouse, children and a house, you likely have your greatest insurance needs. The immediate and long-term financial stability of your family could be deeply affected if you were to die,  or become ill or disabled. You need to consider things like household expenses, the mortgage, children’s education and retirement savings for your spouse.

Determining how much of that lost income to insure is based in large part on cost. With the demands on the monthly income, balancing what you need now with protection for the future is a personal decision. It should be carefully discussed with involved family members and your financial planner.

But it’s important to remember, protecting your assets is crucial. We can’t drive a car or get a mortgage without insurance. A well-balanced financial plan needs a solid base of coverage to protect households from a range of financial risks –including loss of income.

How Is Insurance Priced?

Insurance companies use a complex mix of information to set their prices such as current age and health, family history, and mortality rates. Basically, the more likely you are to receive a payout from the insurance, the higher the price. In other words, if you’re young and in great health, insurance companies know that statistically you are less likely to die or get sick than someone who’s older and not as healthy. So you will, on average, pay much less than the older, unhealthy person.

Smart Tip

Life insurance can be a nice way to boost the income of those you leave behind because benefits are not taxable. If you named a beneficiary of a $100,000 policy, he or she would receive all of the money tax-free.

What’s The Difference Between Term And Permanent Life Insurance?

As you might expect, term life insurance protects you for a set amount of time, such as 10, 15 or 20 years. Permanent insurance protects you for the rest of your life. And if you think about the pricing concept above, you can probably guess that permanent is more expensive than term. Becauselike it or not—we’re all going to die sometime, making a permanent policy one that will inevitably be paid out.

Permanent insurance can be an attractive option for those who want to lock in a reasonable premium while they are younger, to avoid paying much higher ones when they are older.

Conclusion

The take-away from this chapter is simple: think hard about what you’d do if something happened to you. What financial implications would arise for you or your family? Even something as simple as paying for a funeral can do some damage to a piggy bank.

There are always more exciting ways to spend your money than to pay for insurance. But not having coverage when you need it is just too scary to ignore. Finding a balance between the coverage you need and what you can afford is a key aspect of sound financial planning.