Protecting your beloved family is everyone’s utmost priority and needless to say, life insurance is the perfect solution to finally be stress-free and relaxed regarding financial security.
Focusing on the primary outlook, life insurance promises to protect and safeguard the future of your family, and in particular, it ensures peace of mind. Essentially, life insurance is a contract between an individual and the insurance company.
If you are new to the concept of life insurance, you must have various questions about how life insurance works, what is the need for this insurance, or how life insurance works as an investment.
To answer all your queries and concerns, the following article will cover all the aspects of life insurance and its working. Further, there will be a plethora of legal and financial terms whose familiarity will prove advantageous to you. So, follow this detailed guide on how life insurance works.
What Is Life insurance?
The first and foremost point is defining the definition of life insurance in layman’s terms. What is life insurance? It is a way to protect your family or business by signing a contract between you (the policyholder) and an insurance company.
Life insurance can serve a diverse range of benefits and purposes. Ranging from replacing homes to paying outstanding debt, life insurance can be utilized for a vast number of things including covering college tuition or funeral expenses.
Owning a life insurance policy is a must for every person who desires to guarantee the financial security of family members and surviving loved ones, after his/her death. Basically, the insurance company will pay a handsome amount known as a death benefit to your beneficiaries after your death in exchange for your premium payments.
How does life insurance work when you die?
Many citizens want to get familiarized regarding the working of life insurance and what happens after the insured person dies. Well, the explanation lies in the concept of death benefit which is discussed below.
What Is a Death Benefit and why is it paid? The money paid by the insurance company after your death is known as a death benefit. It is essentially a payout to the beneficiary of a life insurance policy, annuity, or pension when the insured passes away. For life insurance policies, death benefits are not subject to income tax and beneficiaries receive the death benefit as a lump-sum payment.
The beneficiaries named by the insured can use the money for whatever purpose they desire. In the majority of occurrences, the money is utilized to pay everyday bills or a mortgage, put a child through college, etc.
How does life insurance work when you live?
In other case scenarios, you outlive the life insurance policy’s tenure. What’s next? You are faced with two other options. Namely, the policy will simply end and you’ll no longer be covered. Or your insurer may allow you to convert all or a portion of the policy into permanent life insurance.
What are premiums?
Let us revise what exactly are premiums. They are the payment paid by the policyholder in exchange for your life insurance policy coverage. The premium is either paid once a month or once a year and that’s how life insurance works. Now, let’s dip our toes in garnering a comprehensive understanding of what elements can perhaps affect the cost of life insurance premiums.
Age – The older you are, the more expensive the life insurance is since older policyholders are seen as having a higher risk.
Gender – Regardless of occupation, males and females tend to pay different rates for all types of insurance. Men pay more due to shorter life expectancy.
Cigarette – use: Because smokers are more likely to develop significant health issues, they require more coverage and will always pay a higher rate than non-smokers.
Health: There are various health concerns that directly correlate to higher life insurance premiums. Pre-existing conditions like disease makes the receiving of insurance difficult..
Lifestyle: When we discuss lifestyle, it encapsulates engaging in hazardous activities like skydiving, etc. Daredevil activities are bound to increase the cost of your premiums.
Apart from the burgeoning list of elements mentioned above, many other things can sway how much a life insurance policy costs. Longer-lasting policies tend to have higher premiums.
Types of life insurance
While there are different types of life insurance policies, all of them have a similar attribute and core functionality. They are designed to provide money in the form of a lump sum, to your “named beneficiaries” after one’s death.
With a life Insurance policy, you can take care of your family the right way but the question arises what kind or type of life insurance suits you the best? To match people with different criteria and requirements, the system has introduced types of life insurance for the ease of citizens.
Primary, there are two types of life insurance: term and permanent life. The two types of life insurance are discussed in detail below.
Term life Insurance
The first type of life insurance we will be discussing is Term Life Insurance which is unarguably the most affordable and most popular type of life insurance. Term Life Insurance rose to unprecedented fame among its admirers and acquired the majority of the market with 71% of purchasers preferring it according to the Insurance Barometer Report.
The principal reason behind its acclaim is that it provides coverage for a certain amount of time and the premium payments stay the same amount for the duration of the policy. The policy lengths can vary from 10, 15, 20, 25, or 30 years. In case of the policy holder’s demise within the term of the policy, his/her named beneficiaries can easily claim and receive the death benefit money without tax.
Furthermore, once the term policy reaches its expiration date the policyholder has the facility to renew the coverage by the increment of year. The increases in time are termed as guaranteed renewable. However, each year of renewal is more expensive than the previous year and has higher rates.
The term life insurances are the most favorable policy because they last a specific number of years and in case of expiration, there are no payouts. While it’s the cheapest life insurance it has a fair share of a disadvantage since in case an individual outlives his/her policy, their named beneficiaries won’t receive a payout.
Permanent life insurance
Next up, we discuss Permanent life insurance that can be whole or universal. How does payment life insurance work? They provide lifelong coverage and are more expensive than term life.
The permanent life insurance policies are bound to be permanent if the policyholder meets the monthly premium payments and can offer a cash value component. The duration of these policies is not fixed and they can last for the duration of the insured one’s life.
Such life insurance slowly yet surely builds valuable cash value whose component accumulates on a tax-deferred basis over the life of the policy. In simpler words, it performs the role of the saving portion of the policies.
Since there is a possibility that the policyholder can borrow against the policy’s cash value or make a withdrawal, then one can decide to end the policy and get the cash value. This way the surrender charge will be discarded.
The following policy is a gradual phenomenon and the cash value may build slowly over many years. Hence, an individual/policyholder cannot assume that he will have access to a lot of cash value right away. To view your projected cash value, you need to check your policy illustration.
Ultimately, these policies can easily last one’s entire life and include a cash value component that can be withdrawn or borrowed against while the person is still alive. Next up, we describe the several varieties of permanent life insurance
Whole life insurance is a permanent life insurance policy that ensures a fixed death benefit for the named beneficiaries alongside a hefty amount of cash value savings component for the policyholder.
Like everything in the world has its benefits and potential downsides, the same norm goes with whole life insurance that can easily last until the policyholder’s death. The precondition of smooth working is the payment of premiums.
Working on the dazzling mechanism of “set it and forget it”, the following life insurance states that the premiums stay the same and the insured person can get a guaranteed rate of return on the policy’s cash value. The fulfillment results in the death benefit amount not changing. Typically, whole life insurance is far more expensive than term life so citizens who desire to tone down the financial expenses have to explore other options in the insurance niche.
The second type of permanent life insurance is universal life insurance which offers far more flexibility than a whole life insurance policy. Facilitating the user with many conveniences, the policyholder can easily alter his/her premium payments and death benefit within a certain amount of limits. By opting for a universal life insurance policy, the cash value will build depending on the policy type.
Let’s take help from this example where we suppose that an indexed universal life insurance policy will have cash value tied to an index. The variable policy will have ranging investment subaccounts.
Dubbed as the most flexible permanent life insurance option, it provides policyholders with the ease to pay premiums at any time and reduce or increase their death benefits. However, they are subjected to market fluctuations because the cash value component is invested in stocks.
Universal life insurance
Due to the minimal cash value, a universal life policy is cheaper than whole life. However, a missing payment could forfeit the policy leaving the insured person empty-handed.
Further, we have burial insurance which is a small whole life policy with a small death benefit. The value of the death benefit is somewhat between $5,000 and $25,000. Majorly, this kind of insurance is designed to cover only funeral costs and final expenses.
According to the statistics, more than 40 million people wish to have life insurance but have not availed of the insurance plan. The reason is quite simple since people tend to overestimate the cost of life insurance.
The Survivorship life insurance confirms two people under one policy, usually a married couple. The policy pays out the death benefit to the beneficiaries only when both of the spouses have passed away. Commonly known as “second to die life insurance”, the survivorship life insurance is part of a larger financial plan to fund a trust or pay federal estate taxes.
Choosing the right life insurance policy type
After carefully analyzing diverse life insurance policies, one might want to determine a final verdict over which is the best life insurance policy after all?
Well, the answer varies from person to person considering one has to keep in regard his/her financial condition, priorities, and age. The availability of all of the life insurance options available is bound to be a complicated choosing process because let’s be honest, decisions are hard.
Hence, avoid having second thoughts and go for the option which suits you the best. Start with preliminary options and carefully weigh the pros and cons of term life and permanent life insurance.
Opt for a term life insurance policy if you require life insurance for a specific amount of time. It’s also a good choice if your budget is limited. If that’s not the case, a permanent life insurance policy will last for the duration of your life. Also bear in mind that the cash value isn’t typically intended for beneficiaries. They will get the policy’s death benefit, not the death benefit and the cash value.
What does life insurance cover?
As the intricate working of life insurance continues to get explored, one might feel compelled to ask the question about what does life insurance cover? Various life insurance products are designed to protect the policyholders from unexpected events. Some examples are listed below:
- Life cover – The death benefit which pays a lump sum when the policyholder dies
- Total and permanent disability insurance – The following insurance will provide a lump sum to cope with rehabilitation and also bear living costs
- Trauma insurance – It covers all the expenses if the insured individual is diagnosed with a major illness like cancer, tumor, etc.
- Income protection insurance – It pays a small amount of money if the policyholder is unable to earn due to illness or injury
Why do people buy life insurance?
Due to the advent of technology, a plethora of finance-saving plans keep on getting introduced in the market. The majority also invests in various kinds of life insurance and we bear in mind that life insurance plays a crucial role in the financial plan.
Nevertheless, it is hard to determine whether investing in life insurance is perpetually a smart investment or not. The prime reason why people invest in life insurance is to cover funeral and final expenses, according to a 2020 survey by LIMRA and Life Happens. Other reasons could include various thought processes but the most popular ones are listed below:
- Burial/Final expenses: 84%
- Supplement retirement income: 57%
- Transfer wealth: 66%
Moreover, many people are also motivated to subscribe to such policies because they need to ensure their loved ones are provided with financial security. Besides eversince the world has been hit with the pandemic, the rising inflation and financial crisis have emerged as top concerns amongst the aftermath of battling with COVID-19.
How to get life insurance?
Prior to checking the cost, one has to go through the tedious process of getting life insurance. While the process is fairly effortless it has some steps which guide you to complete your paperwork without any hassle.
Delving into the details, Life insurance policies are typically purchased by the person whose life is meant to be insured. Moreover, the spouses, family, or others can also take out a policy for them if they prove they have an insurable interest.
Consumers are required to complete an application, phone interview, and several official documents. A medical examination is also mandatory unless they opt for a no-exam life insurance policy.
While the eligibility criteria can significantly vary from company to company, the basics remain the same and almost all companies will require the following criteria to be fulfilled as mentioned below:
A medical checkup is mandatory for eligibility. However, the applicant for policy holding can apply for a no-exam life insurance policy. Otherwise, it is compulsory to undergo a medical exam before opting for a life insurance policy.
Furthermore, at the completion of the application, the policyholder must present all the needed documents.
- Proof of identity citizenship, and age
- Proof of residency.
- Proof of income
- Social Security number
How does life insurance work as an investment?
Evaluating a life insurance policy, do people often assess and gauge if the life insurance could be used as an investment in the future? Answering the frequently asked question, Yes, in the right situation and used correctly, life insurance can actually be considered an investment.
While the majority of life insurance is purchased for risk management, life insurance, largely because of its tax benefits, can also be used as an investment. Apart from the fact that the cash value is associated with permanent insurance, the death benefit of a policy can generate millions in tax savings for a wealthy family.
However, financial professionals may argue over the merits of life insurance as an investment because primarily its working mechanism supports premature death or securing a loved one’s financial future.
How much does life insurance cost?
Once you have decided and you are certain regarding the kind and type of insurance you wish, the next question that arises in your mind is how much does the life insurance cost?
Despite the policies of life insurance floating for quite some time, the majority of citizens still often fail to utilize these policies. The grounds of being unaware of plans and pricing is the pre-gained perceptions about affordability.
Hence, the citizens have made earlier assumptions about the value resulting in discouraging people from buying the life insurance they need. Here’s a breakdown of what you need to know about how much life insurance costs so you benefit from the best offers.
The cost of life insurance can get influenced by several factors where the type of insurance you choose to opt for plays the most crucial role. For example, a term life insurance policy is less expensive than a whole life insurance policy.
Below, we discuss the factors that lead to fluctuation in cost and diversify the insurance plans:
Age – If you buy the policy when you are young, that will automatically mean that you will be paying less because the chances of your death are lesser.
Gender – Gender also determines how much life insurance will cost. Women tend to live longer than men. This means that males generally pay more for life insurance than females.
Health – Your health plays a major impact on your life insurance rates. During the medical exam, the insurer examines your medical conditions to calculate your life expectancy.
Lifestyle – LIfestyle also hugely impacts the cost of life insurance. For example, your driving history, criminal record, and occupations can result in higher rates.
How to choose a beneficiary?
Subsequent to finalizing the process of life insurance, the last step is choosing the beneficiary who will claim the death benefit after one passes away. The policyholder has the authority to name multiple beneficiaries.
Further, he/she can also decide what percentage they each will receive when they die. Additionally, there is a possibility that you name contingent beneficiaries in case the primary beneficiaries have died. There is a possibility that you opt for naming trust by creating a revocable living trust and naming it as the life insurance beneficiary. For example, the trust money could be used to take care of children.
In the occurrences where someone decides to name a trust the beneficiary of your policy, an attorney is hired to structure the trust correctly. Moreover, it is advised to work with a financial planner so a larger and better financial plan can be designed. It is important to update your beneficiary selections regularly because events such as marriage or divorce can be impactful.
How does a beneficiary make a claim?
Named beneficiaries who are selected by the policyholder to claim the death benefit after their demise can easily claim the hefty amount after following a standard protocol.
The claims are paid at the earliest opportunity given that all conditions have been satisfied and the said beneficiary has all the documents required for clearance. Typically, the insurance company doesn’t contact themselves rather the beneficiary has to initiate the claiming process. Below is the list of the documents that are necessary for the claim:
A copy of the death certificate is needed to be submitted. Claims are typically paid within 30 days after the insurer receives the necessary documents
Benefits of life insurance
At last, life insurance provides a number of useful benefits including
- Life Insurance payouts are tax-free: Life insurance payouts are not considered income for tax purposes and hence the beneficiaries do not have to report the money when they file their tax returns.
- Dependents won’t have to worry about living expenses: Life insurance policies help people avail themselves of certain benefits like they do not have to worry about their living expenses or other major costs.
- Life Insurance can cover final expenses: When someone has a life insurance policy, their beneficiaries can use the money to pay for their burial expenses easily. Some insurers offer final expense policies.
- Coverage for chronic and terminal illnesses: Various life insurance companies offer endorsements that allow you to access your death benefit if you are diagnosed with a terminal illness and are expected to live less than 12 months.
- Policies for retirement savings: If you purchase a whole, universal, or variable life insurance policy, it can accumulate cash value in addition to providing death benefits. As the cash value builds up over time, you can use it to cover many expenses.
Basic life insurance need calculation
Here is how you determine your life insurance with a basic equation to a general outlook regarding how much is your need.
[Financial obligations you want to cover] – [existing assets that can be used toward bills] = Your life insurance need
By the terminology Financial obligations, you can possibly cover income replacement, mortgage, large debts, and your children’s college tuition. “Existing assets that can be used toward bills” will include elements like existing life insurance, savings, college 529 savings, and funeral expenses.
