How Does Life Insurance Work?
A life insurance policy is a contract you enter into with an insurance provider. If you die within the coverage period and the policy is still in force, you agree to pay a premium, and the insurer agrees to pay a death benefit to one or more beneficiaries.
Purchasing life insurance is an essential component of any financial plan. A life insurance policy's benefits can help your family maintain their lifestyle, attain their goals, replace your income, or simply pay your funeral and burial expenditures.
There are various types of life insurance policies available in the insurance sector. Choosing the optimum sort of policy and level of coverage isn't always simple. Understanding the many types of life insurance and how they operate might assist you in determining which, if any, are appropriate for your needs.
Types of Life Insurance
There are two types of life insurance policies: term life insurance and permanent life insurance. Both policies pay a death benefit to your designated beneficiaries, however term policies only cover you for a set length of time, whereas permanent insurance can cover you for the rest of your life. Both types of plans require you to pay premiums in order to retain them in force.
Term Life Insurance
- Protection is restricted in duration, often ranging from one to thirty years.
- It is less expensive than permanent life insurance.
- It may be renewed without taking a medical exam once the term expires.
- Some policies have a "return of premium" rider that reimburses a portion of your premiums if the death benefit is not paid.
Permanent Life Insurance
- Permanent policies provide lifetime coverage.
- Permanent life insurance products accumulate tax-deferred cash value.
- You may be able to borrow against or withdraw from a cash value once it has accumulated.
- Depending on the type of insurance, cash value earns interest in a variety of ways.
- You can change your premium payment, enhance your death benefit, or both with some permanent life insurance policies.
Types of Term Life Insurance
Term insurance is not intended to last forever. It is frequently referred to as "pure" insurance because it contains no monetary value "savings" component.
Level term: These policies feature a fixed death benefit and fixed premiums throughout the specified term.
Decreasing term: These insurance have a declining death benefit (which is frequently used to cover a mortgage).
Convertible term: These policies, which often have higher premiums, allow you to convert your term policy to permanent life insurance.
Types of Permanent Life Insurance
Permanent life insurance contracts have a savings component known as cash value, which can be borrowed against or withdrawn from. However, doing so may have an impact on policy and may have tax implications.
Whole life insurance: One of the most prevalent types of permanent life insurance is whole life. As long as premiums are paid, it has a guaranteed level premium and a guaranteed death benefit. In the event that the policy lapses, it has a nonforfeiture value. Some whole life plans give out dividends.
Universal life insurance: This type of policy earns a cash value based on a money market or similar rate of return, and guarantees a minimum interest rate.
Indexed universal life insurance: Indexed universal life insurance is similar to regular universal life insurance in that it earns a cash value based on a money market rate of interest, but it is linked to an index of investments, such as the S&P 500, and includes an interest rate guarantee.
Variable life insurance: Variable life insurance products allow you to invest the cash value component in the stock market, typically through mutual funds provided by the insurer. However, if your investments underperform, your cash value will fall, and you risk having your premium increase and your policy lapse. Some insurers offer death benefit guarantees and no-lapse provisions to mitigate these risks. You can change the death benefit and premiums on some policies.
Guaranteed issue whole life insurance: This type of insurance is often only available to persons aged 50 to 85, and it does not require you to answer health questions or undergo a medical check. Guaranteed issue life insurance is often limited to $25,000 in coverage and is intended to pay final expenses.
How Much Does Life Insurance Cost?
The price of life insurance varies greatly. A $250,000 20-year term policy for a healthy 25-year-old, for example, might cost $12 per month, whereas the same coverage for a 45-year-old smoker might cost $111 per month. The amount of coverage, or face value, you acquire, as well as the type of policy you purchase, affect how much you'll pay for life insurance. If you die, your beneficiaries will receive the face value.
Permanent life insurance is more expensive than term life policies with the same coverage amount, or face value, since they include a cash value, which boosts premium payments.
Risk
Life insurance firms charge premiums based on the amount of risk they must assume. A young, healthy person will often pay less for life insurance than an older person with a history of medical difficulties. Life insurance premiums are determined by various factors, including:
- Age
- Gender
- Health history
- Family health history
- Tobacco use
- Hobbies
- Occupation
Based on 2018 data, men and women had life expectancies of 76.2 years and 81.2 years, respectively, according to the Centers for Disease Control and Prevention. Women may be able to acquire a lower life insurance rate than males because they live longer.
Smoking, hazardous jobs, a history of irresponsible driving, or dangerous hobbies like rock climbing or skydiving raise carriers' risk, which insurers may reduce by charging a higher insurance premium.
Some providers take into account your financial past, whether you've declared bankruptcy, as well as your criminal background and driving record.
How To Buy Life Insurance
Depending on the type of life insurance purchased, the purchasing process may differ.
Buying Through Your Employer
Many firms include group life insurance as part of their benefit packages. Term life insurance is often provided by group plans, however some employers also provide permanent life insurance. A group life insurance policy may cap the death benefit at one to two times your yearly pay, but it normally does not require you to complete a medical exam, making it appropriate for those who would otherwise be considered uninsurable.
You can usually enroll in a group life insurance plan through your employer's human resources department. When you quit your job, some insurance companies allow you to preserve your coverage through a process called insurance portability.
Buying an Individual Policy
When you purchase a term or permanent life insurance policy, the insurer normally needs you to fill out an application that contains questions about your medical history and the medical history of your family. To determine eligibility, the provider may also need you to undergo a medical checkup.
During the exam, the nurse or physician will collect blood and urine samples to assess your blood sugar levels, test for nicotine or substance misuse, and screen for illnesses such as an abnormal liver or HIV. If you are eligible for coverage, you will often be given a conditional binding receipt. The underwriting procedure could take a few days or a few weeks, after which the carrier will issue your policy.
The exception to the normal rule is guaranteed issue insurance, which is written with no medical exam and few or no health questions. Because coverage is normally restricted at $25,000, insurers can do this.
How Life Insurance Pays Out
When the insured dies, the beneficiary must file a claim with the insurance company and present a certified copy of the deceased's death certificate. The insurance will typically pay the death benefit in one flat sum. If you borrow against your cash value and die before repaying it, the carrier will deduct the amount owed from your death benefit.
When you buy your policy, you can specify how the death benefit will be paid. Alternatively, the policy's beneficiary may elect not to receive a lump-sum payment. Optional payouts include:
- Lump sum: The death benefit is handed out in full in a single lump sum payment.
- Installments: The insurer pays out the death benefit and interest earned over a defined length of time, such as five years.
- Interest income: The recipient receives recurring payments for the insurance policy's interest while the insurance company retains the death benefit. When the original beneficiary dies, the beneficiary names a secondary beneficiary to receive the death benefit.
- Lifetime income: Based on life expectancy, the insurer gives the beneficiary a fixed monthly payment for the rest of his or her life. Payments cease when the beneficiary dies, therefore a beneficiary may get more or less than the policy's death benefit in some instances. There are variants that pay a lifelong income based on two lives (joint life with survivorship) or that guarantee a minimum number of yearly payments (period certain).
Beneficiaries are usually exempt from paying federal income tax on the proceeds of a life insurance payment. If you choose an interest-earning option, however, the IRS requires you to declare any interest earned on your tax return.
Who Needs Life Insurance?
Purchasing life insurance makes sense for the majority of people. If you are unmarried and do not have children, you may simply require enough coverage to meet your final expenses. However, if you anticipate having an insurance requirement in the future and are currently young and healthy, you may want to consider obtaining life insurance.
The reason you're buying insurance and the amount of coverage you can afford will typically determine whether you get a term or permanent policy.
Married people, particularly those with dependent children, frequently purchase life insurance to pay for their children's education, to replace their income, or to repay a mortgage that is still owed. Permanent life insurance plans can offer a nest egg for a surviving spouse, an inheritance for children, and a tax-deferred cash asset (but they must fulfill specific criteria to qualify for tax benefits). You can also acquire life insurance for crucial personnel of your business, such as a business partner.
Insurance can be purchased for a variety of reasons.
- If you want to cover the life of someone other than yourself, you must show the insurance company that you have an insurable interest (such as a family relationship or a major economic stake) in the person being insured. If you can, you should be able to obtain insurance.
You can also acquire a combination of term and/or permanent plans to meet a variety of life insurance needs, including those that you anticipate changing over time.