You probably already know that life insurance is a way to continue providing for your loved ones once you're gone, but you may still find yourself asking, "how does life insurance work?" In short, a life insurance policy is a contract between the insured and an insurance company. For a fee, the insurance company agrees to pay a sum of money to a designated recipient upon the death of the insured.
Want to know more? We delve into the details below. Keep reading to learn how to choose life insurance that will work best for you.
How Do Life Insurance Policies Work?
So, how does life insurance work? It's actually pretty straightforward!
In exchange for a monthly fee, called a premium, the insurance policy pays out a guaranteed sum of money, or death benefit, upon the death of the insured.
Depending on the type of insurance policy purchased, there may also be a savings account component, called a cash value. This account can increase over time.
In the US, the death benefit and cash value are not typically taxable.
The death benefit and cash value go to a beneficiary designated by the insurance policyholder -- who is usually also the insured.
How costly is a life insurance policy? That monthly premium is calculated based on a number of factors, including the insured’s age, health, life expectancy, and the type of plan purchased.
The death benefit is similarly calculated based on the insured’s age, gender, and health.
The type of policy, term or permanent, determines how long the policy will last.
What Is a Life Insurance Beneficiary?
The beneficiary of a life insurance policy is the person or entity who receives the insurance policy's payout -- that's the death benefit and cash value -- upon the death of the insured. As mentioned, it can be a person, like a spouse or a child, or it can be an entity, such as a charity.
When you buy a policy, you name a primary beneficiary and a number of contingent beneficiaries. The primary beneficiary is first in line to receive the policy death benefit. If they cannot be located for any reason, the listed contingent beneficiaries receive the benefit. And if no beneficiaries can be located, the death benefit typically goes into your estate.
What Are The Types of Life Insurance?
Two primary types of life insurance can be purchased: term and permanent. As the names imply, term insurance lasts a set amount of time and permanent never expires. Simple enough, but how does term life insurance work? What about permanent options? Let's take a look.
How Does Term Life Insurance Work?
We’ll start by breaking down the key features of a term life insurance policy before delving into the subtypes:
Term life insurance, which is sometimes called pure life insurance, lasts for a specific duration, usually 1 to 20 years.
It only pays out if the death of the insured occurs during the term of the policy -- hence the name.
Once a term ends, the policyholder can renew the policy, terminate it, or, possibly, convert it to a whole life policy. How does whole life insurance work? We cover that below!
If you decide to renew, the monthly premium will be recalculated to reflect the insured’s current age and health.
Term life insurance comes in three types, level, decreasing, and yearly renewable term (YRT). The terms “level” and “decreasing” refer specifically to the amount paid out. Perhaps unsurprisingly, level term life insurance policies tend to be the most popular option.
In a decreasing term policy, the payout amount for the policy decreases a set amount each year of the term.
For a level term policy, the death benefit amount remains the same throughout the term. Premiums tend to be higher for this type of term policy than the others.
In yearly renewable term policies, there is no term period. Rather, the monthly premium is recalculated at each annual renewal. While this may be an attractive option at first, the cost can become prohibitive as the insured ages.
How Does Permanent Life Insurance Work?
Permanent life insurance contrasts with term in that it lasts the entire life of the insured.
So long as the premium is paid, permanent life insurance does not expire.
Permanent life insurance tends to have a higher monthly premium than term insurance.
In addition to a lump sum death benefit, permanent life usually has savings and investment options, called a cash value, that can increase the final payout amount. These investments are generally tax-deferred.
You are generally able to dip into the savings and interest you have accumulated through a permanent life insurance plan while you are still living.
There are two types of permanent life insurance: whole life and universal life.
How Does Whole Life Insurance Work?
With a whole life insurance policy, your monthly premiums and the interest you collect on the plan's savings will stay the same throughout the life of the policy. You will never be expected to pay more every month, but neither will you see an increase in the growth rate of the policy's cash value. If you're looking for something steady, a whole life insurance policy may be the right choice for you.
How Does Universal Life Insurance Work?
Flexibility is what sets universal life insurance policies apart from whole life policies. In many ways, they are the same, but with a universal policy, the monthly premium and interest rate can change. You may pay more or less each month, and you may find your death benefit and cash value increasing or decreasing based on the investment.
Some universal life insurance policies also let you pay the monthly premium out of the policy's cash value, so you don't have to pay out-of-pocket if money is available in the policy.
What Is Supplemental Life Insurance?
Supplemental life insurance is an add-on policy, often offered through an employer, that extends the coverage of an existing policy. Burial insurance is an example of supplemental life insurance intended to cover the costs of funeral and burial.
Supplemental life insurance policies offer lower monthly premiums at the cost of smaller death benefits, but they also generally aren’t standalone.
Choosing Life Insurance
Want to know how to compare life insurance policies effectively? Be sure to consider the following while you're shopping around:
What is your current financial situation? Your budget determines what sort of premium you are able to pay. If you are young, have a limited budget, and need a larger death benefit, a permanent plan may be better for you because of the savings that can be accrued.
How long do you want to be covered? If you need financial protection only for a limited time, while your children are young or for the length of your mortgage, for example, a term life plan may be better for you. If you need insurance for as long as you live, check out permanent coverage.
How much will your beneficiaries need? What do you want your death benefit to fund? Is it income replacement, or just covering burial costs? Will the policy you’re looking at cover it?
How old are you and what is your health? Factors like age and whether or not you smoke can affect your premium.
How stable is the company you’re considering buying from? A permanent life insurance policy is only as permanent as the company you’re buying from. Check the company’s financial rating before committing.
What do the quotes look like? Don’t just go with the first affordable policy you find. Compare the company rating, premium costs, and offered policies on multiple insurance companies before you commit to one!
When Should I Get Life Insurance?
Do you have any dependents, like children, who rely on your income? Or perhaps someone who shares a debt with you? Maybe you and your spouse have a mortgage, or you are a student whose parents have co-signed on a loan for college. These are good reasons to have a life insurance policy.
If you are thinking about buying life insurance, also remember that premiums will always be lower if you are younger. So, even if you’re young and healthy, a life insurance policy isn’t a bad idea!
There’s a lot to learn about life insurance, but a simple guide like this one can illuminate quite a bit! Life insurance isn’t always as expensive as you’d expect, and it doesn’t need to be that tough to crack into, either. Now that you know how life insurance works, get to researching individual companies and plans to find a policy that works well for you.