When Buying Life Insurance, Avoid These Little-Known Mistakes

There's fairly wide knowledge of some common mistakes in buying life insurance. Savvy people with dependents know to beef up what they receive from work-provided policies, for example, because the death benefits from those are too small if you have a family.

Smart shoppers also know to avoid procrastinating about getting life insurance. The older you are, the higher the premiums will be — and the longer you'll live without the peace of mind a policy brings.

Other life insurance missteps are less known. Making them risks costing you time, money and security.

Over-attention to small differences in financial stability

Agencies like AM Best rate insurance companies for financial stability — the size of their capitalization, and so their readiness to honor their obligations for the policies they have written. Few major insurers have on of the lowest scores. Most are rated either superior (A++, A+) or excellent (A, A-).

The insurers with superior scores are deemed to have the strongest ability to meet their obligations. Yet the excellent group also excels in stability, the agency says. While the differences among these two groups are significant, they should not dominate your buying decision over all other factors.

As with banks, it's extremely rare for an insurance company to fail. This industry is highly regulated and companies are subject to rigorous oversight of their operations. Also, just as bank customers are protected by the Federal Deposit Insurance Corporation, in the rare event of an insurance company failure, there are state guarantee associations that serve as a safety net to protect consumers.

Ideally, you should choose an insurance company that belongs in one of those two top stability categories, of superior and excellent. Yet you could be doing yourself — and your wallet — a disservice by nixing a policy that otherwise seems tailor-made for you just because the insurer's financial strength is deemed to be merely outstanding rather than superlative.

Favoring policies just because they have an investment component

So-called permanent life insurance policies have a cash value component that is designed to grow over the years. That can help make such policies a fine choice for some investors. But few people should compare their life insurance options primarily by investment potential.

The cash value in a permanent insurance policy grows tax-deferred. That can be appealing to people who intend to leave a large financial legacy to their heirs, and have exhausted the contribution limits of other investment options that have tax advantages — like 401(k)s and IRAs. Permanent life insurance can also suit seniors who have outlived their term life insurance coverage or don't have enough savings to pay for final expenses, such as medical care and funeral costs.

Excepting these and a few other scenarios, though, a term life policy is a better option for most people.

For one, premiums for permanent life insurance are considerably higher than for term life insurance. Also, the cash-value portion of a permanent policy is invested for you by the insurer in a way that won't necessarily align well with your portfolio needs. These investments tend to be conservative, with wealth preservation prioritized over rapid growth. That won't suit the risk profile of many investors, including most younger ones.

Based on your financial needs and investing time horizon, you might be better off paying lower term life premiums and putting additional money that would have gone towards a permanent life policy into a portfolio of stocks and bonds that aligns with your investing time horizon and risk tolerance.

Opting for a no-exam policy due to its reduced hassle

Traditionally, life insurance underwriting involves an evaluation of your family's medical history and a comprehensive physical exam including bloodwork. If this strikes you as inconvenient or stressful, you might gravitate towards no-exam life insurance policies that offer coverage without the traditional exam.

If you do so, however, you could find yourself paying more than you have to, and settling for a smaller death benefit than you'd like.

If you're in middle age or younger, and in decent health, the most comprehensive and cost-effective coverage is almost always available if you're willing to undergo a medical exam. No-exam policies tend to have lower death benefits, and their premiums are considerably more expensive.

Some no-exam policies, known as the "guaranteed issue" type, are sometimes marketed and sold as "final expense" policies. This hints at the lower death benefits that are typical of these policies. Often, the payout is enough only to cover funeral and burial costs.

Also, if you're facing a choice between guaranteed-issue policies and traditional ones that require a full exam, you might want to explore another option that offers a middle ground. Simplified-issue life insurance replaces an exam with the submission of detailed medical data, which is then analyzed by an algorithm that uses it to predict risk.

The maximum death benefit from simplified-issue policies (often between $100,000 and $500,000) may fall short of the most you can obtain with a traditional policy. But it should exceed what you'd secure with a guaranteed-issue policy, and may suffice for the needs of people who want a six-figure benefit without undergoing an exam.

The bottom line on buying life insurance

Even if you're familiar with life insurance, some best practices fly in the face of conventional wisdom about buying a policy. By learning how to avoid under-the-radar errors, you can level up your game and make the most of your life insurance investment. When you find an insurance company that appears to meet your needs, talking to them can help you make the best policy decisions to protect you and your family for years to come.