Insurance Tip #3: The type of policy you buy may be as important as determining the amount of coverage you need

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This post is part of a series where personal finance expert Dan Solin provides 10 insurance tips no one else will tell you. See all 10, plus one bonus tip!

Almost one-third of all Americans have no life insurance. The average amount of life insurance held by those that have it is $146,000 -- far below what would likely be needed.

The focus of the insurance industry has been to persuade people that they need to purchase more life insurance. Unfortunately, the analysis is very complicated, confusing and fact intensive.

Among the various formulas used are multiples of your income, a "capital needs analysis" (which determines the income required to meet the needs of survivors) and a model that projects consumption and savings. The software to compute this model was written by famed economist Laurence Kotlikoff and financial columnist Scott Burns.

The amount of life insurance you should purchase may seem staggering. In your younger years (up to age 30), you may need insurance covering almost thirteen years of income.

An even more critical issue may relate to the kind of policy you buy.

Your need for life insurance generally decreases with age, because there is less projected income to insure.

This is significant because term insurance, which provides protection for a specified period of time but builds up no cash value, is relatively inexpensive when you are young. Permanent life insurance, also called cash-value insurance, has much higher premiums because it contains a significant savings element. It is generally designed to last for the life of the insured. It combines a death benefit with a tax-deferred savings element. The policy's cash value can typically be accessed by the policyowner in the form of withdrawals or loans, either of which would reduce the death benefit and may adversely affect policy performance.

If you are uncertain about whether you might need permanent insurance in the future, consider buying a term policy with a conversion feature. During the conversion period, you will be able to convert to a permanent policy without a medical examination.

You should also look into universal life policies. These are cash-value policies that provide additional flexibility to the policyholder. Death benefits and premium levels can be altered as policyholders' circumstances change. The initial premiums on these policies are quite low.

The bottom line is that the primary purpose of life insurance is to insure a continuing quality of life for your survivors when you have not accumulated sufficient assets to do so without life insurance.

Choosing the right kind of policy is critical to meeting that need.

See 10 more insurance tips from Dan.

Dan Solin is the author of The Smartest Investment Book You'll Ever Read (Perigee Books, 2006) and The Smartest 401(k) Book You'll Ever Read (Perigee Books, 2008).


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