Life Insurance

How Does Life Insurance Work?

A life insurance policy provides financial protection for your loved ones and mitigates the loss of your income and expenses when you pass away.

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There are two main types of life insurance policies: term life and whole life insurance.

Term insurance provides protection for a specific period of time before expiring or renewing at a higher price. While a specific number of years is commonly used to set the coverage duration, some term insurance policies can also designate a maximum age. For example, a term policy could set a maximum age of 75, meaning once you turn 75 years old, your coverage would be up for renewal. If the insured person passes away prior to the end of the term, the beneficiaries receive a death benefit, which is a lump sum of money that is generally tax-free. The death benefit can be used for final expenses, medical bills, or any other purpose that the beneficiary chooses.

Whole life insurance also provides financial protection at death and may also have a cash value component, which can be accessed by the insured during their lifetime as a living benefit. This cash value grows tax-deferred. However, if the policyholder makes a withdrawal from the cash value of their policy, the gains are taxable at that time.

How Does Buying Life Insurance Work?

You can become eligible to purchase life insurance as young as 14 years old in some states. While few begin to plan for their future that early in life, the lower the age when the policy is purchased, the lower the rate will generally be.

Term insurance is a popular choice for younger policyholders as it’s more affordable than whole life insurance. Its shorter coverage duration also makes it a better option for temporary needs for increased coverage. For example, if you buy a home and have a mortgage, you could purchase a term life policy to provide increased financial protection just for the lifetime of that mortgage. This means if you were to die before paying off the remainder the mortgage, your term life policy’s death benefit could cover the rest of it.

However, term insurance policies may have limited livings benefits in comparison to whole life insurance, which has cash value accumulation and generally more options for living benefits. Whole life policies may be a good option to help you plan for both your future and that of your beneficiary, as it lasts your entire lifetime and is guaranteed a death benefit so long as you pay your premiums. You would not have to renew your policy at higher rates if you maintain your whole life coverage. Another perk of whole life insurance is that you can withdraw or borrow from your cash value if you need funds for an emergency.

Choosing the Best Policy and Amount For You

Here are some considerations to make when determining the type of life insurance policy that fits your needs.

Can you afford to fund the policy?

Think about how much money can you afford to put aside for life insurance coverage for the life of the policy. This is crucial as there is no life insurance policy that will provide protection if the policy lapses due to insufficient funding. When you purchase a life insurance policy, you’re making a financial commitment, so make sure it is an affordable option for you now and later.

How much life insurance do I need?

One rule of thumb used to determine the amount of insurance needed is to multiply your annual salary by 10. For example, if you earn $50,000 a year, a good estimate of how much insurance you may need would be a $500,000 policy. However, a more careful calculation will need to be made to take other variables into account, including your outstanding debts, number of financial dependents, and goals.

How many dependents do you have?

Those with dependents will have different life insurance coverage needs than those without dependents. However, even those without dependents can plan for the future. In addition, dependents are not the only ones who may need a policyholder’s death benefit. For example, those providing care for parents or other relatives may choose to name them as beneficiaries.

Do you need a cash value option?

A whole life insurance policy accumulates value in addition to providing financial security for your dependents. Your premiums build up value over the life of your policy, so this can be used as a form of income once you retire. If this is important to you, seek out plans that offer a cash value component.

Do you need a customized plan?

With life insurance, you can add on additional coverages to better customize your policy. However, sometimes these add-ons — known as riders — come with an additional fee. The types of riders you can choose from will vary based on your life insurance provider, but common riders include accidental death benefits and family income benefits.

How Much Does Life Insurance Cost?

There are many factors that can impact the cost of life insurance, including:

  • Health: If you have pre-existing health issues or use tobacco products, expect a higher rate.
  • Job: The more hazardous your job, the more expensive your insurance premium will be. For example, an aircraft pilot’s insurance premium will generally be higher than an accountant’s.  
  • Hobbies: An avid skydiver can expect a significantly higher premium than a person who plays slow-pitch softball.
  • Coverage amount: The larger your policy, the higher your premium will be.
  • Type of policy: Term life insurance tends to be more affordable than whole life insurance, but over time becomes an expensive option, as premiums increase with every policy renewal.

Choosing Your Beneficiary

Once you’ve decided on the type of life insurance policy that best fits your needs, the next step is choosing a beneficiary. Unless you live in a common property state or want to name a minor as a beneficiary, there are few restrictions on who you may choose. Here are some common types of beneficiaries:

  • Primary beneficiary: This designation means they are the first to receive their payout. You may designate more than one primary beneficiary.
  • Contingent beneficiary: These beneficiaries are assigned in the event that the primary beneficiary passes away prior to the disbursement of the benefits.
  • Entity beneficiary: These are nonperson entities that are usually estates, charities, organizations, or trusts. It could be a favorite charitable organization, or a trust for a minor.
  • Minors: Most insurers will caution against naming a minor as a beneficiary because it can become complicated upon the death of the insured. You can name a minor’s legal guardian as the beneficiary or designate a custodian to clarify your wishes for the beneficiary. You can also create a trust for the minor and designate the trust as your beneficiary.
  • Common property states: If you live in one of the “common property states” — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin — your spouse must be a beneficiary. If you want to remove your spouse as a beneficiary, they must officially waive their rights before you can choose another one.

How Do Life Insurance Benefits Work?

Life insurance death benefits financially protect your beneficiaries from the loss of your income and expenses when you die. The death benefits are paid out to the person (or persons) named by the deceased within the insurance policy once the policyholder passes.

The payout process is usually a smooth one, so long as the beneficiary has the necessary paperwork and files the claim in a timely matter. Payouts are processed within 60 days in most cases. The beneficiary can also usually choose how they want to receive the payout, whether as a lump sum, in installments, or a handful of other options.

What Does Life Insurance Exclude?

Although life insurance usually covers nearly all deaths regardless of circumstances, there are some situations where it may not. Here are a few examples of what may be excluded from a life insurance policy.

  • Suicide: Suicide isn’t always excluded, but most insurance companies will not pay out the death benefit if the suicide occurred within 2 years of the policy’s purchase.
  • Dangerous activity: If the policyholder dies in what is deemed a dangerous activity, their insurer may not pay out the death benefits. Examples of activities that are often viewed as dangerous include rock climbing, scuba diving, and hang gliding, though what’s considered dangerous can vary greatly depending on the policy’s language.
  • Illegal activity: If the policyholder dies while engaged in illegal activity, such as a bank robbery, the payout of death benefits is almost always excluded.
  • Aviation: If the policyholder dies in a private plane crash, it’s likely the death benefit payout will be denied. However, most insurance companies will pay out the benefits if the policyholder dies in a commercial plane crash.
  • Misstatement of age: If you lie about your age on your policy, the insurance company might not pay out your death benefit, or the death benefit may be changed to reflect your correct age and any change in premium associated with the age correction.
  • Material misrepresentation: If you knowingly lied about information within your life insurance policy to ensure you’d be approved, the insurer might deny the payout.

How Does Life Insurance Pay Out?

When the policy owner passes away, the life insurance policy pays out the death benefits to the designated beneficiaries. The beneficiary must file the proper paperwork, usually including a claim sheet to begin the process of the claim.

1. Document collection

There are several important documents the beneficiary should collect to engage the payout. The key forms to have on hand are:

  • The certified death certificate. This is crucial to prevent fraud.
  • The insurance policy. This details the benefit amount, the names of the beneficiaries, and the policy number.  
  • The claims form, also known as a “request for benefits.” This document is usually what gets the claim process started and includes information such as cause of death, your relationship to the deceased, and how you’d like to receive your payout.

2. Contact the policy provider

Once the necessary documents are compiled, the next step is to reach out to the insurance company to file your claim. Although there is typically no time limit to do so, the sooner you file the claim, the sooner the payout will arrive.

3. Wait for claim approval

The claims approval timeframe can range from a few days to a couple of months. This is why it’s best to start the claims process as soon as possible.

Types of Payouts

Each payout option is different, so it’s important to choose which one works best for you.

  • Lump sum: As the name indicates, this is when the benefits are paid out all at once via a single payment.  A lump sum is generally tax-free.
  • Annuities and installments: An annuity pays out over a set period of time in installments and depending on how it is set up, can also be used as guaranteed income in retirement.
  • Other options: The insurer may have other benefit payment options available, such as putting the payout into a savings account. Ask about your choices if neither a lump sum nor installments sounds right for you.

How Living Benefits Work

In life insurance, living benefits allow the policy owner to access cash value and other benefits while they’re still alive. Living benefits can be available for both term life and permanent life insurance policies. However, keep in mind that specific benefits vary based on the individual policy purchased.

Common Living Benefits for Term Life Insurance Policies

  • Accelerated death benefits: An accelerated death benefit (ADB) lets the owner of the policy receive a percentage of their payout prior to death. This is used by terminally-ill patients who have been determined to have less than 2 years to live. The benefit is that they can offset their current costs of healthcare with this payout.
  • Return of premium: With this benefit, all the premiums paid in by the policyholder are returned to them at the end of their specific term so long as they are still alive.
  • Disability waiver of premium: This is a benefit that saves you money by allowing you to waive premium payments if you suffer a long-term disability.

Common Living Benefits for Whole Life Insurance Policies

  • Cash value withdrawal: This allows you to access a portion of the cash value within your life insurance policy. You will be taxed on any amount of the cash withdrawn that comes from a gain, such as interest earned on your premiums. Since you may have to pay taxes when you withdraw cash, this option is best suited for an emergency.
  • Policy loan: This is allowing you to take out a loan on your policy. You’ll be charged interest, which is set by the insurer.
  • Policy surrender: This is when you cancel your policy and access the cash value in a one-time lump sum. An example of when to use this option is if you have multiple life insurance policies and are comfortable canceling one to access funds quickly.
  • Long-term care benefits: This benefit lets you access funds to help cover long-term care expenses that your health insurance doesn’t cover or may exceed your means. This option is best suited for retirees or older policyholders who require long-term care.