How do Life Insurance Policies Work? Worry no more, we have the perfect answer for you here.
Life insurance is a very common asset that figures into many people’s long-term financial planning. Purchasing a life insurance policy is a way to protect your loved ones, providing them with the financial support they may need after you die.
For example, you may purchase life insurance to help your spouse cover mortgage payments or everyday bills or fund your children’s college education.
Perceptions about affordability and value can deter people from buying the life insurance they need. More than half of respondents in the Insurance Barometer Report said a $250,000 term life insurance policy for a healthy 30-year old would cost $500 a year or more.
But the average cost is closer to $160 a year. That’s a pretty big discrepancy in perceived cost versus actual cost.
Here’s a breakdown of what you need to know about life insurance policies so you can make an educated decision.
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What is Life Insurance?
Life insurance is a contract between you and an insurance company. Essentially, in exchange for your premium payments, the insurance company will pay a lump sum known as a death benefit to your beneficiaries after your death.
Your beneficiaries can use the money for whatever purpose they choose. Often this includes paying everyday bills, paying a mortgage or putting a child through college.
Having the safety net of life insurance can ensure that your family can stay in their home and pay for the things that you planned for.
Different Life Insurance Policies
There are two primary types of life insurance: term and permanent life insurance.
Term Life Insurance Policies
Term life insurance lasts a certain number of years, then ends. You choose the term when you take out the policy.
Common terms are 10, 20, or 30 years. The best term life insurance policies balance affordability with long-term financial strength.
Term life insurance, also known as pure life insurance, is a type of life insurance that guarantees payment of a stated death benefit if the covered person dies during a specified term. Once the term expires, the policyholder can either renew it for another term, convert the policy to permanent coverage, or allow the term life insurance policy to terminate.
When you buy a term life insurance policy, the insurance company determines the premiums based on the policy’s value (the payout amount) and your age, gender, and health. In some cases, a medical exam may be required.
The insurance company may also inquire about your driving record, current medications, smoking status, occupation, hobbies, and family history.
If you die during the policy term, the insurer will pay the policy’s face value to your beneficiaries. This cash benefit—which is, in most cases, not taxable—may be used by beneficiaries to settle your healthcare and funeral costs, consumer debt, or mortgage debt, among other things.
However, if the policy expires before your death, there is no payout. You may be able to renew a term policy at its expiration, but the premiums will be recalculated for your age at the time of renewal.
Permanent Life Insurance Policies
Permanent life insurance stays in force for the insured’s entire life unless the policyholder stops paying the premiums or surrenders the policy. It’s typically more expensive than term.
Permanent life insurance is an umbrella term for life insurance policies that do not expire. Typically, permanent life insurance combines a death benefit with a savings portion.
The two primary types of permanent life insurance are whole life and universal life.
- Whole life insurance offers coverage for the full lifetime of the insured, and it savings can grow at a guaranteed rate.
- Universal life insurance also offers a savings element in addition to a death benefit, but it features different types of premium structures and earns based on market performance.
Unlike term life insurance, which promises payment of a specified death benefit for a specific period of years, permanent life insurance lasts the lifetime of the insured (hence, the name), unless nonpayment of premiums causes the policy to lapse.
Permanent life insurance premiums go toward both maintaining the policy’s death benefit and allowing the policy to build cash value.
The policy owner can borrow funds against that cash value or, in some instances, withdraw cash from it outright to help meet needs such as paying for a child’s college education or covering medical expenses.
There is often a waiting period after the purchase of a permanent life policy during which borrowing against the savings portion is not permitted.
This allows sufficient cash to accumulate in the fund. If the amount of the total unpaid interest on a loan, plus the outstanding loan balance exceeds the amount of a policy’s cash value, the insurance policy and all coverage will terminate.
Other types of Life Insurance Policies
The two major life insurance policies(Term and Permanent life insurance) have different classifications/categories. These classifications will be treated in this article.
Term life insurance can be sub-divided into;
Decreasing Term Life Insurance
Decreasing term is renewable term life insurance with coverage decreasing over the life of the policy at a predetermined rate. Decreasing term life insurance is a type of life insurance policy that pays out less over time.
It’s often used to cover the balance of a repayment mortgage, because the total balance of the mortgage decreases over time and will be paid off in full at the end of the term.
The theory behind decreasing term insurance holds that with age, certain liabilities, and the corresponding need for high levels of insurance decreases.
Numerous in-force decreasing term insurance policies take the form of mortgage life insurance, which affixes its benefit to the remaining mortgage of an insured’s home.
Alone, decreasing term insurance may not be sufficient for an individual’s life insurance needs, especially if they have a family with dependents.
Affordable standard term life insurance policies offer the security of a death benefit throughout the life of the contract.
Decreasing term insurance is a more affordable option than whole life or universal life insurance. The death benefit is designed to mirror the amortization schedule of a mortgage or other personal debt not easily covered by personal assets or income, like personal loans or business loans.
Convertible Term Life Insurance
Convertible term life insurance allows policyholders to convert a term policy to permanent insurance.
This is a type of life insurance that allows the policy owner to change a term policy into a whole or universal policy without going through the health qualification process again.
Convertible insurance lets the policy owner convert a term policy that only covers the insured individual for a predetermined number of years into a policy that covers that individual indefinitely, as long as the policyholder continues to pay the insurance premium.
If the policyholder decides to make the conversion on their convertible insurance, the permanent policy will have the same value as the term policy, but the permanent policy will have higher premiums.
Even before conversion, convertible insurance will be more expensive than a term life insurance policy for the same amount of coverage, because there is a built-in cost for the option of being able to make the conversion without a medical exam.
The benefit of convertible insurance is that the policyholder doesn’t have to go through the medical underwriting process again to switch the policy from term to permanent.
This is a valuable feature. If the policyholder’s health has declined since they started the convertible term policy, they will be able to obtain a permanent policy that they otherwise might not qualify for.
Renewable Term Life Insurance
Is a yearly renewable term life policy that provides a quote for the year the policy is purchased. Premiums increase annually and is usually the least expensive term insurance in the beginning.
A renewable term is a clause in a term insurance policy that allows the beneficiary to extend the coverage term for a set period of time without having to re-qualify for new coverage. A renewable term is contingent on premium payments being up to date, as well as a renewal premium being paid by the beneficiary.
In the context of a life insurance contract, a renewable term clause would be beneficial, as future health circumstances are unpredictable.
Although the initial premiums are likely to be higher than those of a life insurance contract without a renewable term clause (the insurance company must be compensated for this increase in risk), this type of insurance is usually in the beneficiary’s best interest.
Renewability is important because, normally, an insurance policyholder will want to renew a policy once the term is up, assuming their life circumstances don’t change drastically, such as if one’s health deteriorates, rendering them uninsurable. Renewability enables a policyholder to keep current coverage (though likely at a much higher premium) without having to re-qualify.
Just as Term life insurance policy has sub-divisions, Permanent life insurance policy also has sub-divisions.
And they are listed below.
Whole Life
Whole life insurance is a type of permanent life insurance that accumulates cash value. Cash value life insurance allows the policyholder to use the cash value for many purposes, such as a source of loans or cash or to pay policy premiums.
Universal Life
A type of permanent life insurance with a cash value component that earns interest, universal life features flexible premiums.
Unlike term and whole life, the premiums can be adjusted over time and can be designed with a level death benefit or an increasing death benefit.
Indexed Universal
This is a type of universal life insurance that lets the policyholder earn a fixed or equity-indexed rate of return on the cash value component.
Variable Universal
With variable universal life insurance, the policyholder is allowed to invest the policy’s cash value in an available separate account. It also has flexible premiums and can be designed with a level death benefit or an increasing death benefit.
How do Life Insurance Policies Work?
A life insurance policy has two main components a death benefit and a premium. Term life insurance has these two components, but permanent or whole life insurance policies also have a cash value component.
Death Benefit
The death benefit or face value is the amount of money the insurance company guarantees to the beneficiaries identified in the policy when the insured dies. The insured might be a parent, and the beneficiaries might be their children, for example.
The insured will choose the desired death benefit amount based on the beneficiaries’ estimated future needs. The insurance company will determine whether there is an insurable interest and if the proposed insured qualifies for the coverage based on the company’s underwriting requirements related to age, health, and any hazardous activities in which the proposed insured participates4.
Premium
Premiums are the money the policyholder pays for insurance. The insurer must pay the death benefit when the insured dies if the policyholder pays the premiums as required, and premiums are determined in part by how likely it is that the insurer will have to pay the policy’s death benefit based on the insured’s life expectancy.
Factors that influence life expectancy include the insured’s age, gender, medical history, occupational hazards, and high-risk hobbies.
Part of the premium also goes toward the insurance company’s operating expenses. Premiums are higher on policies with larger death benefits, individuals who are at higher risk, and permanent policies that accumulate cash value.
Cash Value
The cash value of permanent life insurance serves two purposes. It is a savings account that the policyholder can use during the life of the insured; the cash accumulates on a tax-deferred basis.
Some policies may have restrictions on withdrawals depending on how the money is to be used. For example, the policyholder might take out a loan against the policy’s cash value and have to pay interest on the loan principal.
The policyholder can also use the cash value to pay premiums or purchase additional insurance. The cash value is a living benefit that remains with the insurance company when the insured dies. Any outstanding loans against the cash value will reduce the policy’s death benefit.
Conclusion
Before you apply for life insurance, you should analyze your financial situation and determine how much money would be required to maintain your beneficiaries’ standard of living or meet the need for which you’re purchasing a policy.
For example, if you are the primary caretaker and have children who are 2 and 4 years old, you would want enough insurance to cover your custodial responsibilities until your children are grown up and able to support themselves.
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