How Does Life Insurance Work? The Basics of Life Insurance Explained
Let’s face it, life insurance is something that many people need, but don’t want to talk about. We’ve all seen those GoFundMe pages asking for donations for a person that passed away. It can feel strange planning for the worst-case scenario, especially if you’re young and healthy. Life insurance is a way to help prevent leaving your loved ones with the added stress of financial burdens. Whatever your reason is for thinking about life insurance, this guide will help you get familiarized with some life insurance basics to make your planning and research a little simpler and a little easier.
What is life insurance?
Life insurance is a type of insurance policy that pays out money on a tax-free basis in the event of your death. People usually buy life insurance if they have dependents they want to provide for in case something happens to them, or to cover financial obligations that they may leave behind. Commonly, it’s used for educational expenses, a mortgage or funeral costs.
If you’re shopping around for life insurance, below are some common terms you’ll probably see.
Risk is a very important factor for life insurance companies when they’re considering your application for insurance. If they deem you too much of a risk, they may deny your application or assign you a lower risk class rating. If your application is approved, the risk class that you’re assigned will determine the price of your policy. Risk class is usually broken up into categories such as sub-standard, standard and preferred. Risk class considers health factors such as medical history, current and preexisting conditions, tobacco use, prescription medications and your height and weight.
The term or length of your policy determines the amount of time you will be covered for. Typical term lengths are 10 years, 20 years and 30 years. Some companies will offer other term lengths (like 15 years), but those are less common. If you need insurance for longer than those lengths, you can look at other types of permanent policies which we’ll cover in a later section.
The death benefit is the amount of money the policy will pay in the event of the insured’s death. When selecting the benefit amount, it’s important to consider your and your dependents’ needs. Additionally, the death benefit is tax free to beneficiaries.
The beneficiary is the person(s) who will receive the death benefit once the insured person passes away and a claim is filed by their family with the insurance company. You can name multiple beneficiaries and designate different proportions for different people. For example, you could give your spouse 80% of the death benefit and your child 20% the ratio can be any amount you want: 80/20, 90/10, 50/50, etc.
You can assign primary and contingent beneficiaries to your policy. The primary beneficiaries are the people you name to receive a benefit when you die. If your primary beneficiaries have died at the time your death, your secondary beneficiaries will be paid instead. You can change your beneficiaries at any time.
Cash value is a feature of permanent life insurance policies. Part of the premium you pay in a permanent policy is set aside into a separate cash value account. This account grows over time, based on either a fixed interest rate or a variable or indexed rate based on other investments held by the insurance company. Cash value provides a living benefit (benefits you can use while living) to the policy owner and can be used to cover expenses or as a supplemental retirement fund. Cash value can be accessed as either a policy loan or as a withdrawal. A policy loan allows you to borrow against your cash value, which means that it is not taxable. The interest rates are typically low and if you pay the loan back, it just goes back into your cash value. If you choose to not pay back the loan, the outstanding amount is deducted from your death benefit. If you opt for a policy withdrawal, funds will be deducted from your cash value balance and are taxable income at a cost-basis. Meaning you won’t be taxed until the amount you withdraw exceeds how much you’ve already paid into the policy.
Riders are additional optional features that can added to the policies. Some insurance companies offer certain riders at no additional cost. For example, a rider may pay the premiums for your policy if you’re disabled and can’t work, or it may allow you to use your policy death benefit for long-term care costs.
How much will the policy cost?
Life insurance costs are determined by risk and policy features.
The riskier you are to the insurance company, i.e., the more likely they’ll have to pay a claim, the higher your premiums will be.
The more policy features you have, or the higher the benefits, the more expensive your premiums will be.
Factors considered by the insurance company when calculating the cost of your policy include:
- Health conditions
- Term length
- Death benefit amount
The different types of life insurance
Take a look at the difference between term and permanent life insurance.
Term life is probably the most common type of life insurance people opt for. With a term policy, you have coverage for a set period, usually 10, 20 or 30 years. Once the term period is over, you can either convert it to a permanent policy (if offered by the company), cancel your policy, or have it switch to an annual renewable term, which increases in price every year. Some people don’t like the use-it-or-lose-it nature of term policies. Term coverage is great for covering specific, time-based needs such as a mortgage, other big purchases in life or replacing your income to take care of dependents. Term life insurance is generally the cheapest type of life insurance, and it has a fixed price over the entire term. Term policies usually have an age cap on when you can still apply for a new policy. This maximum age varies between companies.
- Easy to understand.
- Expires after a certain amount of time.
- Not a lot of additional features.
Whole life is a type of permanent life insurance policy, which means it was designed to provide you coverage for your entire life. Whole life insurance is the most expensive type of life insurance because it is designed to cover you for your entire life if you continue to pay your premiums. This essentially ensures that your beneficiaries will be paid. This makes whole life a good tool for leaving behind an inheritance or a charitable gift. Whole life can also be purchased in smaller increments to cover funeral and burial expenses. Whole life also has a cash value component, which can be used as a living benefit, that grows at an interest or dividend rate set by the insurance company. The cash value can be kept by the insured if they choose to cancel the policy.
- Provides lifetime coverage.
- Builds cash value.
- Usually the most expensive.
- May not build cash value quickly.
Universal life is another type of permanent policy. It can be cheaper than whole life because it uses a part of the cash value to pay for the cost of the insurance. This in turn lowers the premium amount. The cash value in universal life grows at a variable or indexed rate that is based on other investments held by the insurance company. However, universal life is not an investment. While universal life can play a part in your retirement income plan, it should be balanced with other financial tools suited to your unique circumstances.
This product also features flexible premiums, meaning you have the option to select how much you want to pay. In order to keep the policy properly funded, the insurance company will suggest minimum and maximum premium levels. Since the policy is partially funded through the cash value, if you pay too little, there is a chance the policy could lapse prematurely. In contrast, you also have the option to overfund the policy in order to build cash value more quickly. Talk with your insurance agent to set up a premium funding level that will balance the overall cost, policy length your cash value goal. Like whole life, you’ll keep the cash value if the policy is cancelled.
Universal life can be viewed as a bad product by some people. But that usually comes from using it in a way it wasn’t intended, bad salespeople making misleading statements, or not setting up the product properly. Universal life is a tool and like any tool, it has situations that it was designed for and situations where it may not make sense.
- Highly customizable.
- Can build cash value more quickly.
- Complicated to understand.
- Coverage may lapse if not set up properly.