Table of Contents
Table of Contents
What is Life Insurance?
Life insurance is a financial product that provides a lump sum payment, called a death benefit, to designated beneficiaries upon the insured death. In exchange for this coverage, the policyholder pays regular premiums to the insurance company.
Life insurance is important because it helps provide financial security for your loved ones after you're gone. It replaces your income to help your family avoid financial hardship. Providing them with financial resources to maintain their lifestyle, settle debts, cover children's education, handle daily expenses, and cover end-of-life costs such as funeral and medical bills.
What Is a Life Insurance Policy?
A life insurance policy is a contract that specifies the agreement between the insured person and the insurer. It details the coverage, premiums, beneficiaries, and terms under which the death benefit will be paid out. Key components of a life insurance policy:
- Policyholder: The person who owns the life insurance policy and is responsible for paying the premiums.
- Insured: The individual whose life is insured by the policy, whether they are the policyholder or another person.
- Beneficiary: The person(s) or entity designated to receive the death benefit when the insured passes away. Beneficiaries can be individuals, trusts, or organizations.
- Premiums: Policyholders pay regular payments, known as premiums, to keep the insurance policy active. Depending on the policy terms, premiums can be paid monthly, quarterly, annually, or as a lump sum.
- Death Benefit: The insurer pays a beneficiary a generally tax-free sum upon the insured's death, which is the primary purpose of a life insurance policy.
- Policy Term: The duration of time the policy is in effect. For term life insurance, this is a specified number of years (e.g., 10, 20, 30 years). For whole and universal life insurance, the policy is typically in effect for the lifetime of the insured, subject to maturity provisions.
- Cash Value: A feature of permanent life insurance policies (such as whole and universal life) that allows part of the premium to accumulate as a savings or investment component. The policyholder can borrow against or withdraw from the cash value, though it may reduce the death benefit.
- Face Value: The amount of the death benefit stated in the policy, not including any additional amounts that might be paid out through riders or policy features.
- Riders: Optional add-ons to a life insurance policy that provide additional benefits, coverage, or living benefits. Common riders include accelerated death benefit riders, disability income riders, waiver of premium riders, and accidental death benefit riders.
- Exclusions: Specific conditions or circumstances under which the policy will not pay the death benefit. Common exclusions include death due to suicide (within a certain period after the policy starts), death during the commission of a crime, or death resulting from risky activities.
- Grace Period: A set period of time after the premium due date during which the policyholder can still pay the premium without the policy lapsing. The policy may be canceled if the premium is unpaid within this period.
- Surrender Value: The amount the policyholder receives if they decide to terminate the policy before it matures or the insured dies. This is typically available with permanent life insurance policies and may be less than the total premiums paid.
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What Are the Types of Life Insurance?
Choosing the right type of life insurance policy helps ensure you meet your specific needs. Life insurance products come in two main categories: term life and permanent life. Both have potential advantages, depending on your needs.
Term Life Insurance
Term life insurance policies are the most basic and typically most affordable life insurance coverage. The policy provides temporary coverage in effect for a certain period — generally 10 to 30 years. Because it is temporary, term life insurance may have a lower premium than other types of life insurance.
If you pass away during this time, the life insurance company will pay your beneficiary the death benefit. If you outlive the term, the coverage will end.
Term life insurance includes the following types of policies:
- Convertible term life insurance allows you to swap your temporary term life insurance policy for permanent coverage. A health exam isn't generally required to make the change. You can qualify so long as you convert before the term policy expires. Accordingly, these policies can help keep your long-term insurance options open.
- Increasing term life insurance provides a death benefit that increases over the policy term, with higher premiums, to help maintain the payout's value against inflation over time.
- Decreasing term life insurance is a policy in which the death benefit decreases over time, usually at a predetermined rate. This kind of insurance is often used to cover specific financial obligations that diminish over time, like a mortgage.
- Renewable term life insurance allows the policyholder to renew coverage for an additional term without providing evidence of insurability, ensuring continued life insurance protection without new underwriting.
Permanent Life Insurance
Unlike term insurance, permanent life insurance policies provide coverage that lasts for as long as you pay the required premiums. In addition to paying a death benefit to your beneficiaries, they provide a cash value component that allows you to build cash value over time. You can access that cash balance to manage your own financial needs later in life.
Permanent life insurance includes the following types of policies:
- Whole life. The premiums remain the same throughout your lifetime. The cash value in a whole-life policy grows at a guaranteed fixed rate, regardless of market conditions.
- Universal life. With a universal life insurance policy, you can adjust your premiums and death benefits as your needs change. The policy's cash value must cover monthly charges if the premium payment is less than the initial amount or if a payment is missed. The universal life policy cash value accumulates based on current interest rates.
- Variable life. Rather than receiving a fixed rate of return, your contract value changes with the performance of the investment subaccounts you select. Variable life insurance policies present the chance for higher long-term gains but also risk losing value in a market downturn.
- Variable universal life. These policies provide a hybrid of sorts between variable and universal life insurance. Similar to variable insurance, your cash value return depends on the performance of your investments. However, you can adjust your premiums annually based on your changing circumstances.
Advantages of Life Insurance
Life insurance offers essential benefits for various reasons:
- It helps provide financial protection, ensuring your family can cover expenses such as medical bills, funeral costs, and debts.
- It replaces lost income, helping maintain financial stability.
- Some policies accumulate cash value, offering a source of funds for emergencies.
- Life insurance can also aid in legacy planning, allowing you to leave an inheritance or support charitable causes.
- Additionally, it can offer tax benefits and supplemental sources of retirement income, making it an essential tool for comprehensive financial planning.
Who Needs Life Insurance
Life insurance is essential for various individuals, including young adults, parents, homeowners, business owners, and retirees, as it helps offer financial protection for loved ones in case of untimely death.
The policy helps cover debts, replace income, and ensure financial stability for beneficiaries. Securing life insurance early can result in lower premiums, making it a cost-effective strategy for long-term planning.
Consulting with a life insurance professional can help determine the appropriate choices for life insurance coverage based on individual needs and circumstances.
How Life Insurance Works
Application and Underwriting
Before applying for coverage, you'll need to decide how much life insurance to purchase. Buying too much would mean paying for insurance you don't need, and buying too little could impact your intentions for the death benefit.
After deciding on the type, amount, and any optional riders for your insurance, the next step is to apply for coverage.
Applying for a life insurance policy involves an underwriting process where the insurance company evaluates your risk based on your health issues, lifestyle choices, occupation, and other factors. You may need to undergo a medical exam and provide detailed information about your medical history and habits.
Life insurance is more expensive for people with poor health or other risk factors because there is a higher chance of them passing away earlier. If someone is too high-risk, the insurer may deny their application altogether.
Choosing a Beneficiary
As part of completing your application, you will choose a life insurance beneficiary who would receive the death benefit if you died while insured. Naming a beneficiary helps avoid the potential delays and extra costs of probate by ensuring your money doesn't go to your estate.
You can pick almost anyone to be your beneficiary, including your spouse or partner, other family members, a business partner, or the guardian of your children. You could also pick a charity, trust, business, or other organization to receive the money.
Policy Activation and Coverage
If you qualify for coverage, the insurer will send you an offer listing how much coverage you qualify for and the premium. The contract will also list the policy number when the coverage would start, your beneficiary, your personal information, and any other legal conditions or agreements that apply to your life insurance coverage. If you are happy with their offer, you can accept the contract and purchase the policy.
Once approved, you'll start paying life insurance premiums to the insurance company. The cost of life insurance is determined by the type of policy, the coverage amount, your age, health, life expectancy, and other risk factors.
After the policy is activated, it provides financial protection for a specified duration (term insurance) or for your lifetime (permanent insurance). The policy remains in force as long as you continue paying the premiums.
What Happens After You Apply for Life Insurance?
Cash Value Accumulation
For permanent policies, such as whole or universal life insurance, a portion of your premiums goes into a cash value account. This account grows over time, earning interest rates or investment returns, and can be accessed through loans or withdrawals, although doing so may reduce the death benefit.
While having access to your cash value can be convenient, loans will accrue interest, and they may generate an income tax liability, reduce the account value and the death benefit, and cause the policy to lapse. Consider these details before taking a loan.
Filing a Claim
If the insured person passes away while the policy is active, a claim form must be filed with the life insurance company. A life insurance claim is how you notify an insurance company that someone covered by a life insurance policy has passed away.
While each company uses its own form, expect to include information like:
- The life insurance policy number, the deceased's name and social security number (SSN), and a brief description of the cause of death.
- Your information as the death benefit beneficiary includes your name, address, social security number (SSN), and relationship to the deceased.
- How you would like to receive the death benefit.
You then submit this completed form along with a certified copy of the death certificate.
With this information, the life insurance company will review the situation and ensure that the cause of death was not for an excluded reason. Typically, most life insurance policies don't pay a death benefit for certain causes of death during the contestability period, which is often the first two years of the policy.
If the claim is approved, the insurer will pay out the death benefit to the designated beneficiaries. The life insurance company can only pay the death benefit to the listed beneficiary. Typically, the government does not charge income tax on life insurance death benefits.
Policy Termination
A life insurance policy can be terminated if the policyholder decides to surrender it, stops paying premiums (after the grace period), or if the term of a term life policy expires. In the case of permanent life policies, the policyholder may receive the surrender value if they cancel the policy.
How to Get Started
For more help understanding how to buy life insurance, as well as planning your policy or understanding those of your family members, consider reaching out to a financial representative for more information. They can explain these topics in more detail and help to ensure that your coverage will meet your needs.
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