Life insurance, once primarily designed to assist with burial costs and support widows and orphans, has evolved into a versatile financial product. Currently, just over half of Americans have some form of life insurance coverage, according to the latest ownership data from LIMRA, an insurance research organization.
What is Life Insurance?
Life insurance is a contractual agreement between you and an insurance company. In exchange for your premium payments, the insurance company agrees to pay a sum of money, known as the life insurance death benefit, to your designated beneficiaries when you pass away. Beneficiaries can include your spouse, children, or any other individuals or entities you choose.
Typically, life insurance covers both natural and accidental deaths. Some policies, offer “living benefits,” allowing you to receive a portion of the death benefit while you are still alive if you are diagnosed with a covered chronic, critical, or terminal illness.
There are two primary types of life insurance: term and permanent.
- Term life insurance provides coverage for a fixed period.
- Permanent life insurance policies, on the other hand, offer coverage for your entire life.
Generally, term life insurance carries a lower initial cost compared to permanent life insurance. However, permanent life policies, such as whole life insurance, build cash value over time and remain in effect as long as you continue paying premiums.
Common Life Insurance Terminology:
- Premiums: These are the payments you make to the insurance company. For term policies, premiums cover the cost of insurance and administrative expenses. With permanent policies, a portion of your premiums contributes to building cash value, which accrues interest over time.
- Beneficiaries: These are the individuals or entities who will receive the death benefit upon your passing. Beneficiaries are often spouses, children, or parents, but you can select anyone or any organization.
- Death Benefit: This refers to the total amount of money the beneficiaries will receive when the insured person dies. You determine the face value of the death benefit when you purchase a policy, and in most instances, your beneficiaries will receive that amount when you die.
- Riders: These are additional features you can add to a life insurance policy to customize the coverage. Riders can cover premium payments if you become unable to work or add coverage for a child to your policy.
How Does Life Insurance Work?
Life insurance provides coverage for the life of the insured individual. The policyholder, may be a different person or entity than the insured, makes premium payments to an insurance company. In return, the insurer pays a sum of money to the beneficiaries listed on the policy after the insured individual dies.
How Term Life Insurance Works
Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. If the insured person dies during this time, the policy pays the beneficiaries the stated amount. If the policyholder outlives the policy term, the policy expires without a payout. Term life is a popular option because of its simplicity and affordability. It’s a useful solution for individuals who need coverage for a defined period, like during the years they’re raising children or paying off a mortgage. Most term policies are convertible, allowing you to upgrade to a permanent life insurance policy if your needs change.
Why Buy Term Life Insurance?
You might want term life insurance:
- To provide funds for a child’s college education in the event of your death.
- To cover significant debts, such as a mortgage, to prevent these burdens from falling on your spouse or family.
- To replace your income if you die during your working years when others depend on your financial support.
- To protect your business interests, such as funding buy/sell agreements or providing coverage for key individuals.
How Permanent Life Insurance Works
Permanent life insurance policies generally remain in effect for your entire life, assuming you continue to pay the premiums. Whole life insurance is the most well-known type of permanent insurance, but other options include universal life, indexed universal life, and variable life.
Permanent life insurance policies accumulate cash value over time. As you pay your premiums, a portion is added to the policy’s cash value, which earns interest at a fixed or variable rate depending on the specific type of policy. Once a sufficient cash value has accumulated, you can access it while you are still alive. For example, you might borrow against it, make withdrawals, or use the interest payments to cover your premiums. You can also cash in the policy if you no longer need coverage. These choices can create intricate tax implications, so it’s important to consult with a fee-based life insurance advisor before tapping into your cash value.
Whole Life Insurance
Whole-life policies offer guaranteed payouts, predictable cash value gains, and fixed premiums, which can be attractive. However, these features typically come with a higher cost compared to term life policies. It’s generally not advisable to view whole life insurance as an investment vehicle. Consider it a life insurance type with a cash value component, and explore other investment options for potentially better returns.
Why Buy Whole Life Insurance?
Whole life insurance can be beneficial if:
- You wish to cover final expenses, such as funeral costs, to alleviate the financial burden on loved ones.
- You want to leave an inheritance and avoid having it become part of your estate.
- You desire to build an investment to assist with expenses while you are still alive.
Universal Life Insurance
Universal life insurance also offers permanent coverage, but it provides greater flexibility than whole life. The premiums are adjustable, enabling you to make larger or smaller payments based on your financial situation or the policy’s performance. Depending on your financial performance, you might be able to reduce or stop payments altogether, using the cash value to cover costs. Conversely, you may need to increase your payments if the cash value does not perform as expected.
Other Permanent Life Insurance Options
- Indexed Universal Life (IUL). This is a type of universal life insurance that allows you to allocate your cash value to index funds selected by the insurer. IUL policies are more complex than standard universal life policies, often including caps on returns and complex fee structures.
- Variable Universal Life. Offers more flexibility than IUL and is more complex. It allows policyholders to direct their cash value investments to subaccounts to increase returns, but these investments come with potentially greater risk.
- Variable Life. Another permanent life insurance option, similar in concept to variable universal life, but it’s an alternative to whole life with a fixed payout. Policyholders can use subaccounts to grow the cash value of the policy. Both variable universal life and variable life carry increased risk and are considered securities by the federal government, similar to stocks and bonds.
How Life Insurance Claims Work
To receive the death benefit after you die requires that your beneficiaries file a claim with your life insurance company. They will typically need to provide a copy of your death certificate and complete a claim form, available online, through the mail, or by phone. Once the claim is approved, the life insurance company may pay the death benefit in a lump sum or in installments.
Who Needs Life Insurance?
Primarily, life insurance’s purpose is to replace your income in the event of your death. If you have a spouse, children, or anyone financially dependent on you, the policy’s payout can help ease their financial burdens. Even if no one relies on your income, there will still be expenses associated with your death, such as burial and final costs. When considering the amount of life insurance coverage to purchase, evaluate your beneficiaries and their financial needs.
How Much Life Insurance Do You Need?
The amount of life insurance you need depends on the specific goals you have in mind. If you only need to cover funeral and burial expenses, the amount you need will be less than if your aim is to replace lost income and provide for your family’s long-term financial security. Considering these factors will help you arrive at a coverage amount that closely matches your individual financial and family situation.
How Much Does Life Insurance Cost?
The cost of life insurance varies depending on the type of coverage you choose as well as your personal factors. Factors such as age, health, and lifestyle all affect the cost of coverage. For example, a $500,000 whole life policy for a healthy, non-smoking 30-year-old woman would average around $3,861 annually. In contrast, a 20-year term life policy with the same coverage would cost approximately $187 per year, on average.
Frequently Asked Questions
- Do I Need a Medical Exam to Get Life Insurance? Many life insurance applications require a medical exam. The insurer will check your weight, blood pressure, cholesterol, and other health factors to determine your overall health. Some providers will offer life insurance without a medical exam, but you’ll typically pay more for the policy. Coverage limits may also be lower with no-exam policies.
- Can I Get Life Insurance Through Work? If you don’t need a large amount of coverage, check whether your employer offers group life insurance as an employee benefit. Employer-sponsored life insurance can often cover basic end-of-life expenses and may match some or all of your annual salary. Basic coverage often does not require a medical exam and may even be free.
- How Should I Choose My Beneficiaries? Think carefully about who relies on you financially, who might need to manage your funeral expenses, and to whom you’d like to leave an inheritance. Keep in mind that if you intend to leave money to minors, you may need to appoint a guardian or set up a trust.
- When Does Life Insurance Pay Out? Life insurance generally pays the death benefit if you die of natural causes (such as a heart attack or disease) or in an accidental death (such as a car crash). Most life insurance policies also cover suicide after a waiting period of one or two years. However, a policy typically won’t pay out if you die committing a crime, including driving drunk or using illegal drugs. Some policies also exclude deaths due to high-risk activities, war, or terrorism. If you’ve lied about anything on your life insurance application, the insurer may refuse to pay the death benefit to your beneficiaries.
