How Life Insurance Works
Premiums on term life insurance are usually paid (monthly, quarterly or annually) for between 10 and 30 years, depending on the particular policy you’ve chosen. One of the ways that life insurance works is that you pay a fixed rate for the length of the policy and the value of the insurance does not change. Whether you die tomorrow or 20 years from now, your beneficiaries would still receive the same dollar amount of insurance settlement. Therefore, if you have a $500,000 term life insurance policy, as long as the premiums are paid it provides $500,000 worth of coverage from the day you buy it until the day the term ends or it is paid out.
The Effects of Inflation on Life Insurance
In the U.S., the rate of inflation has averaged between 3 to 4 percent per year. This means that what you can buy with a dollar changes from year to year. Basically the purchasing power of American’s dollars decrease by 3-4 percent per year – in direct relation to the inflation rate. With insurance, even though the dollar amount of the benefit stays the same, the more years that pass, the less the payout will buy for your beneficiary. For this reason, choosing the right amount of term life insurance is more difficult because you have to estimate how big a bite inflation will take out of the eventual benefit.
Due to Inflation the amount of life insurance you buy today will not be worth the same amount ten years from now. Assuming a 3% inflation rate over each of the ten years, your insurance policy would be worth at least 30% less by the time you reach the tenth year and with compounding the effect is even worse. So, after ten years a $400,000 life insurance policy might only have the purchasing power of $280,000 in today’s dollars.
Thus if you were counting on providing the equivalent of $400,000 to your beneficiary and you lived ten years they would receive the $400,000 all right, but would only be able to buy $280,000 worth of stuff with it.
Inflation Life Insurance Riders
A rider is a special clause attached to an insurance policy that usually costs you extra. It is possible to get an inflation rider for insurance policies. It is more common in the world of long-term care insurance but it is possible to get them for life insurance as well. Of course it will increase your premiums as well. Another method of hedging against the effects of inflation is to buy additional coverage every few years. For instance, if you have a $100,000 ten year term insurance policy you could buy another one after five years that would boost your coverage and in effect extend the coverage for 15 years.
In that case your coverage would look like this:
Of course you could purchase another policy in year 10 for say $150,000 to continue to cover for the loss due to inflation and extend the policy a further 5 years. One problem with this plan is that you could become uninsurable due to accident or illness and not be able to continue to buy new policies. Another problem is that life insurance tends to get more expensive the older you get. However, with life spans getting longer insurance companies have been able to reduce the rates overall, which tends to counteract the age issue to some extent.
However, the future is not all bleak. Naturally, as years pass, your expenses will decrease after a certain point. Your children grow up and move out of the house reducing your expenses, you get the mortgage paid off, etc. As your own expenses are reduced, your need for additional life insurance coverage decreases, and your money, even with inflation taken into effect, may stretch a little further in the event of a life insurance payout. Also, hopefully your savings will increase as will the value of your investments, offsetting the effect that inflation may have on your ability to provide for your dependents after your demise.
In the case of hyperinflation you see an extreme example of what inflation can do to a life insurance policy:
Every month my father had made the payments faithfully,” recounts Levy. “It was a twenty-year policy, and when it came due, he cashed it in and bought a single loaf of bread.
- What is Hyperinflation?
- Confederate Hyperinflation Rates
- Zimbabwean Hyperinflation
- Life Insurance Over 50
- Term vs. Whole Life Insurance
- Whole Life Insurance
- Life Insurance Benefits
- Individual or Group Life Insurance Policies?
- What are I bonds?
About the Author:
This article was written by Karl Stockton.
Photo Credits: Photo is a modified version of a photo taken by Katelyn Fay