What Is Life Insurance & How Does It Work?
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In its simplest form, a life insurance policy is a contract that provides money to be paid to a beneficiary upon the policyholder's death. The policyholder pays monthly premiums to an insurance company in order for the beneficiary to receive any money due under the terms of the policy.
In this article, we'll explain how life insurance works; why policies do not always pay out; and how life insurance can be used as a savings and investment tool in addition to paying a death benefit.
What Is a Life Insurance Policy?
A life insurance policy is a deal between a consumer and the insurance company. The consumer pays money to the life insurance company in the form of monthly premiums. When the consumer dies, the insurance company pays money to that person's beneficiary.
With a life insurance policy, consumers are paying for protection for their loved ones with financial support in the event that they should die suddenly.
Insurance companies invest their policyholders' premiums. The returns those investments earn help keep premiums low relative to the amount of the death benefit. Those investment returns may also be enough to provide a cash value to the consumer, apart from the death benefit, depending on the type of policy they have.
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Different Types of Life Insurance Policies & How They Work
It's important to decide whether you want coverage for a specific period, like while your children are still young, or if you want your life insurance policy to remain active indefinitely or have a savings component. Here are the types of life insurance:
Term life insurance
Term life insurance is only active for a specified term of your choosing, say 10 or 20 years. Young parents may need term life insurance coverage in case they pass on before the children grow up and can support themselves. They pay premiums for a given number of years, and if they die within that period the life insurance company pays out a death benefit to the policyholder's beneficiaries.
If the policyholder doesn't die before the term is up, there's no death benefit and the contract ends but can be renewed at a more expensive price.
Term life insurance premiums are cheaper than other life insurance products because the coverage is only for a specified term. Typically, everything is specified in a term policy: the premium, the death benefit and the length of the term. However, there are some variations:
- Decreasing term. In this type of term life policy, your premiums and the term stay the same, but the coverage amount decreases over time, leaving you with more coverage in the earlier years of the policy than you might otherwise be able to afford. It's a good idea to structure a policy to cover a loan or mortgage to make sure your family has enough money to pay off the debt if you die.
- Convertible term. This type of term life insurance policy can be converted to a permanent life insurance policy. You can also decide when to make the switch. A permanent life insurance policy will be more expensive, but a convertible term policy can be a good way of getting affordable term coverage in the early years.
- Renewable term. A renewable term life policy gives you the option of extending your coverage when the term expires. This would allow you to lengthen your coverage without taking on the full expense of a permanent life insurance policy. Your premiums are likely to increase as you get older.
Permanent life insurance
While term life insurance is designed to provide coverage for a specific period, permanent life insurance remains in effect for as long as you pay your premiums.
Permanent life insurance premiums are significantly more expensive than term life premiums for the same amount of coverage. However, your premiums will be based on your age when you sign up, so unlike renewing term coverage you won't face rising premiums as you grow older.
The following are some examples of permanent life insurance policies:
- Whole life. This type of policy allows you to lock in your premium for as long as the policy is in place. It provides a death benefit, but also has a savings component that provides a cash value you can access through loans or withdrawals. That cash value component grows at a fixed rate. However, any withdrawals of cash value or outstanding loan balance will reduce the amount of the death benefit.
- Universal life. This is a type of permanent life insurance policy that gives you more flexibility to adjust your premiums and/or death benefit over time. For example, paying higher premiums upfront may reduce the long-term cost of the policy. Also, you can lower your premiums by reducing your death benefit. This can be a good way to adjust your policy in later years as your personal savings grow. LIke a whole life policy, a universal policy has a cash value component that grows over time. In a standard universal life policy this growth is at a fixed rate of return, though there are other growth options as described in the two examples that follow.
- Indexed universal. This operates like a standard universal life insurance policy, except that instead of the cash value growing at a fixed rate, its growth will be based on the performance of a market index like the S&P 500. However, the terms of the policy may limit how much that index performance affects your cash value.
- Variable universal. As with an indexed policy, a variable universal life insurance policy uses investments to grow its cash value component. However, a variable policy offers a wider choice of investment options than a single market index. Again though, the policy's cash value may not receive the full amount of growth those investment options earn.
Making the right insurance purchase depends on the financial health of the insurance company. After all, you are giving that company money year after year on the understanding that it will be able to meet its obligation to pay a death benefit when you die.
The insurance company's ability to do this depends on how well they assess risk and manage the premiums they receive. They are required to disclose details about their finances so regulators and the public can see how sound their finances are.
There are a handful of rating agencies that regularly examine the finances of insurance companies and assess how well positioned they are to meet their potential benefit liabilities. Prominent rating agencies are:
- Standard & Poors
- J.D. Powers
Each rating agency uses a different review methodology and ratings system. This can make it confusing to try to compare companies based on their financial strength. However, a company called Ebix has constructed the Comdex system, which issues a number grade based on reports from the different ratings agencies.
The Comdex system depends on an insurance company being reviewed by at least two ratings agencies. It scores companies on a scale of 100.
The following companies were verified by two different sources as having Comdex scores of at least 90. That puts them among the top-rated insurance companies financially.
- Allianz Life
- Banner Life
- Guardian Life
- John Hancock
- Lafayette Life
- Lincoln National
- Mass Mutual
- Met Life
- Minnesota Life
- Mutual of Omaha
- Nationwide Life
- New York Life
- Northwestern Mutual
- Pacific Life
- Penn Mutual
- Principal Life
- Protective Life
- State Farm
- State Life
Term vs. Permanent Life Insurance
While there are a lot of variables that go into choosing a life insurance policy, the big decision is between a term policy and a permanent policy.
Here are some of the big-picture considerations that should go into choosing one or another:
Consider a term life insurance policy if you:
- Have a limited budget
- Are primarily concerned with coverage over the next 10-20 years
- Aren't looking to use your insurance as a savings vehicle
Consider a permanent life insurance policy if you:
- Have enough discretionary income to pay higher premium costs
- Want to lock in your premium rate for life
- Have very long-term dependents
- Are interested in both insurance coverage and a tool for accumulating savings
What Does Life Insurance Cost?
There are several variables involved in life insurance costs, but the table below should give you a ballpark idea of what to expect when purchasing life insurance.
This table is based on the averages of quote information from over a dozen online sources:
Term Life Insurance Monthly Premium for $250,000 in Coverage
Permanent Life Insurance Monthly Premium for $250,000 in Coverage
Female Age 40
Male Age 40
General averages may not be very relevant to your specific situation, but besides giving you a basic feel for what life insurance costs, this table illustrates two important principles of life insurance pricing:
- Men generally pay more for life insurance than women. On average, women have longer life spans. So, the average man is at greater risk of dying than a woman of the same age, resulting in higher premiums.
- Permanent life insurance is more expensive than term life insurance. Since term policies have no cash value and only pay out if the policyholder dies during the term, they are much more affordable. Premiums for permanent life insurance tend to be several times the cost of premiums for term policies with the same coverage amount.
How Much Life Insurance Should You Buy?
If you are looking to provide for a family that's dependent on your income, the amount of life insurance you buy should be based on your family's living expenses.
Figure out those annual living expenses as well as how many years it will take for your kids to become financially independent and/or your spouse to reach retirement age. That should give you a rough idea of how much life insurance coverage you need.
How Do I Qualify for Life Insurance?
There are a few different ways of qualifying for life insurance. Insurance companies assess risk and determine premiums through a process called underwriting. There are three general levels of life insurance underwriting:
- Full underwriting. This is based on a detailed look at your health, including a medical exam and detailed questions about your habits and medical history.
- Simplified issue. This requires you to answer questions about your habits and medical history, but does not involve a medical exam.
- Guaranteed issue. This allows you to buy a policy with no questions asked, but is an expensive way to buy life insurance.
Because it provides a more detailed picture of your risk of dying early, full underwriting generally results in cheaper premiums. The catch is that if this scrutiny reveals health problems, it could make your premiums much more expensive.
What Affects Your Life Insurance Premiums
Life insurance premiums vary a great deal, based on both personal characteristics and the type of policy you get. Here are some of the factors that affect life insurance premiums:
- Medical history
- Current health
- Policy type
- Term length
- Coverage amount
- Cash value accumulation features
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Choosing Your Life Insurance Policy
The type of life insurance you buy matters. Once you've decided on what type of policy and coverage level fit your needs, be sure to compare costs. Premiums for identical policies from different life insurance companies can vary greatly. Even small differences in monthly premiums can add up to a huge amount of money over time.
SmartFinancial can help you find the most affordable life insurance policy by matching you with insurance providers in your area offering competitive rates. For free life insurance quotes, enter your zip code below and answer a few questions. It's that easy!