How Does Life Insurance Work?
Not sure if you need to buy life insurance? No matter how much you plan, at some point the unexpected and unavoidable happens.
It’s not a matter of if, but when.
An accidental death, diagnosis of terminal illness or the sudden loss of a bread-winning loved one can send even the most stable family into a tailspin of despair.
The shocking truth is that the average American does not have enough life insurance coverage. In fact, studies show that more than half of the working US population lives without individual life insurance. However, the bad news doesn’t stop there. In the group that does have life insurance, only 60 percent have adequate coverage.
This means that the families of the majority of Americans, including the 40 percent who do not have enough coverage, are at risk if a sudden and unfortunate circumstance occurs.
Are you one of the uninsured or underinsured majority? Do you worry about what would become of your family if something were to happen to you? Do you think you don’t need or can’t afford a quality life insurance policy? Think again.
If you’ve ever asked yourself, how does life insurance work? We show you how and more importantly, we show you why you should care.
What is life insurance?
Life insurance is a contract between an insured individual and an insurer (insurance company), in which the insurer promises to pay the proceeds of the policy to a single beneficiary (or multiple beneficiaries) in the event of the insured’s death.
Some life insurance policies are set up to pay out if the insured becomes critically or terminally ill, while others build cash value that can be withdrawn in the future for things such as retirement or a child’s college education.
The agreement has a face value (also called the monetary value or death benefit), and a premium (payable by the insured individual).
The price of the premium and level of insurability are generally determined by the insured’s age, medical history, gender, occupation and other influential factors. The higher the level of risk associated with the premature death of the policyholder, the higher the subsequent premium.
Because of this, the following types of people usually pay more for their life insurance policies:
- Older individuals
- People with medical conditions (such as heart disease, diabetes, high blood pressure, cancer or mental illness)
- Participants in “dangerous” sports (such as rock climbing, hand gliding or sky diving).
While most life insurance claims are paid without incident, they can also be denied. For instance, suicide is not usually covered by the average life insurance policy, and if the issuer discovers fraud on the part of the insured or the claimant of the policy, they can refuse to disburse the death benefit.
Who needs life insurance?
Ask any insurance broker who needs a life insurance policy and they would most likely say, “Everyone”. However, in reality, if you have no dependents, life insurance doesn’t offer too much benefit.
For the purpose of this overview, here are some specific types of people for whom having life insurance coverage is critical.
Parents with minor children who are dependent on their income.
Spouses with a wife, husband or significant other who is dependent on their income.
Caregivers with elderly or disabled parents who depend on their support.
Business owners who want to ensure that their business does not suffer financially due to their passing.
Individuals with minimal assets whose current savings and investment plans (pension, 401K, etc.) are not enough to take care of their family’s needs in the event of their death.
Along with providing for relatives such as a spouse, child or parent, you can buy life insurance to help take care of obligations such as:
- Non-relatives: Providing for an individual who is not related to you.
- Taxes: Ensuring that all the required taxes are covered in the event of your death if you have a large personal estate.
- Debts: Paying off debts such as credit cards, mortgages and other installment payments.
- Everyday expenses: Providing for your family to buy items like groceries, pay utility bills, etc.
- Final expenses: Paying final expense costs such as funeral home bills, burial or cremation.
- Charitable donation: Making the beneficiary of your policy a charity of your choice.
Types of Life Insurance
There are two main types of life insurance products offered by most brokers, known as term (valid for a specified period of time) and permanent (valid until the death of the insured).
The best type of policy for your needs largely depends on your specific circumstances and how much you can afford to spend for premium payment.
Here are brief explanations of the different life insurance solutions to help you compare and decide which one to choose.
Known as the most basic form of life insurance, term life policies are designed to:
- Protect the insured for a period of between 1 and 30 years.
- Offer high level coverage, per dollar in premiums paid.
- Be the least expensive type of coverage.
- Have no cash value.
- Not accrue interest.
- Not be borrowed against.
- Not return any of the premiums paid to the insured if they outlive the policy term.
As another type of term life insurance, and sometimes offered as a “college savings plan”, an endowment life insurance policy is designed to:
- Pay a lump sum of money to the insured upon maturity (at the end of a specified term).
- Be payable to the beneficiary of the policy if the insured dies before the end of the term.
- Have higher cash value and premiums than whole life policies.
- Offer the lowest death protection per dollar in premiums paid.
Term life and endowment life policies are good options for young and healthy individuals, who have modest budgets available for making premium payments.
Several products fall under the umbrella of a group of coverages known as permanent life insurance. Unlike term plans, permanent products remain valid until the insured’s life ends. These types of policies also have a cash value and can be borrowed against (tax free).
Whole life insurance, which is known as the simplest cash value policy, has insurance and investment components and is designed to:
- Build wealth through tax-deferred savings.
- Offer a lower rate of return than other investment products.
- Have fixed and inflexible premiums.
- Have charges associated with surrendering the policy.
Universal life policies, which offer flexible death benefits and premiums, are designed to:
- Be calculated based on current interest rate assumptions.
- Have higher premiums if interest rates fall.
- Reduce death benefits if interest rates go down.
Variable life policies, which are considered as securities contracts and are regulated by the laws regarding Federal Securities, are design to:
- Determine death benefit based on the performance of the investment portion of the policy.
- Not have guaranteed minimum cash values.
Variable-universal policies, which combine the flexibility of universal plans with the control over investment of variable plans, are designed to:
- Tie the amount of the death benefit to how well the policy investments perform during its life.
- Have a guaranteed minimum death benefit payable.
Permanent life policies are good for individuals who want to build cash value savings, protect their assets (as with estate planning) and can afford to pay higher policy premiums.
How much coverage is enough?
Once you figure out which type of life insurance is best for you, the next thing to determine is how much coverage you need for the policy to make sense for your needs.
Insurance experts recommend coverage that values anywhere between 5 to 10 times what you earn each year. However, your personal finances and circumstances will ultimately decide how much coverage you get.
As you calculate the coverage you need, take the following factors into consideration:
- Current savings
- Social security
- Property assets
- Retirement accounts
- Cash balances
Along with these, assess your projected final costs and the living expenses that
your family will have to cover after you are gone.
If in doubt, consult with a licensed and professional life insurance advisor who will guide you in figuring out the right amount of coverage for your needs.
An important part of planning for the future includes ensuring that your loved ones can maintain their lifestyle, even if you are not able to earn an income.
Not having life insurance and not having adequate coverage can potentially devastate your family and put them at a serious financial disadvantage upon your death.
If the unexpected were to happen today, would your loved ones be spared from disaster?
The information outlined above is a starting point to securing the financial health and future of your family or business. The next step is finding an experienced and reputable insurance agency to guide you through the process of buying the best life insurance product for your needs.
Do you need affordable life insurance to protect your interests in case the unimaginable happens? Speak with one of our helpful agents to explore your options and get a free life insurance quote today.