The Causes of Underinsuring Life Insurance

The dangers of underinsuring life insurance needs is just a lesser version of having no life insurance at all. We have already spoken about the issue of over-insuring (which you won’t find from many life insurance agents) but the opposite is equally pressing. It’s important not to let short term cost considerations jeopardize your families’ future financial health so let’s look at how to avoid underinsuring term life.

Underinsuring usually results from two different causes. The first is to not be able to adequately estimate what your needs are in the first place and the other is to ”go cheap” on term life and hope for the best. Both are equally dangerous so let’s tackle these first.

How much term life do you actually need? This is tough because it requires you to look into the future…always a daunting task. First, we need to quickly recap what term life is designed to do. The best way to think of it is that term life is about replacing lost income over a long period of time. Underinsuring usually occurs when the amount chosen does not truly match what is being lost or the length of time is not adequate to carry your dependents out to a point where they are financially stable. For the first part of this equation, how much term life should you consider?

We have provided our handy term life insurance tool to help provide a preliminary estimate. Essentially, you want to take the amount of income you make each year now and project it forward over a period of time that accounts for the most costly years in terms of raising a family or providing for a loved one. This can be 10 years for older couples or up to 30 years for new families. It really depends on your personal situation. Where many people go wrong is to forget the power of inflation to wear down the purchasing power of your money over longer periods of time. Our term life estimator tool takes this into account. To give you a quick example, if the average inflation rate over the next 10 years is 4% per year, your money towards the end of that period will be worth only 60% of what it can purchase today. For example, a meal that costs $10 now will likely cost $14 10 years from now in equivalent dollars. That may not seem like a big deal but when you’re looking at $50K being eroded to $30K after 10 years, you can see where the issue is. The longer the period of time, the more powerful this effect can be so make sure to include this in your calculation. Simply missing the effect of inflation is underinsuring life insurance in itself.

The other way people underinsure is to choose a period of time that’s not adequate. If you have young children and you choose 10 years of term life insurance, the protection will end right when things are starting to get very expensive. College is right around the corner and who knows how much that will cost at the rate we’re going. Yes, you can always buy more coverage at the end of the 10 year window (assuming you can qualify based on health then) but at a much higher cost since age is a huge contributor to cost. It makes more sense to buy a longer term that adequately addresses your time needs now at a much lower cost per dollar of protection.

Going back to our original two causes of underinsuring life insurance, short term cost savings at the expense of long term stability is rooted in the same error that causes people not to buy life insurance at all. If you see two plans and one is $75 per month while the other is $100 per month, you start to think of all the things you can do with that additional $25 per month. That’s human nature and especially true for Americans where the future is some nebulous, far-off realm not to interfere with today’s pursuit of happiness. However, let’s use the same inflation that degrades our benefit to address this issue. Term life insurance is great because the premium is fixed. This means you will pay the same $100/monthly for the length of the policy. Assuming a 10 year period, that $100 is really being eroded by an average of 4% annually. So in year two, it really feels like $96, then $92 in year three and so on. By the end of the term, you feels like $60 in terms of what it can purchase. It only hurts now! Use this tool to help you avoid the dangers of underinsuring your term life needs.

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