How Does Life Insurance Work? Our Experts Reveal The Industry Secrets
You’ve obviously heard about life insurance before, but do you really know how it works.
The bottom line is that life insurance protects your loved ones when you pass.
I’ll go into that more in this guide.
I’ll also talk about the many different types of coverage, costs, how to buy, tax incentives, and most importantly- how to choose the best policy.
What Is Life Insurance
Life insurance is a contract between you and the life insurance company. You promise to pay your premiums and the life insurance company promises to pay out your benefits when you pass.
The promises apply only if you’re honest on your life insurance application and disclose any health issues or lifestyle habits that increase your risk of premature death.
How it works
All life insurance policies provide a ‘death benefit.’ You don’t reap any benefits from monies paid, but your beneficiaries do.
Let’s say you name your two children as your beneficiaries and you pay the life insurance premiums for 5 years before you pass.
When your children submit a claim and your death certificate, the life insurance company pays them the death benefit or policy amount. This is all contingent on you paying your premiums.
Whether you pay your premiums monthly, quarterly, or annually, you must pay them. Most insurance companies cancel policies when the insured doesn’t pay the premiums.
Some policies have level premiums (remain the same for the life of the policy) and others have variable premiums that change with your age or other factors.
Whole life insurance policies also grow a cash value.
Think of the cash value as a savings account for you, instead of a benefit for your beneficiaries.
Your cash accumulates tax-deferred and each policy offers different uses for the money.
A few examples include using the funds to pay future premiums or borrowing from the funds for large expenses.
Any remaining loans decrease the death benefit when you die.
Who Needs Life Insurance
Anyone who has people depending on them for income or financial support needs life insurance.
This could mean people from all walks of life, but the most common include:
Parents with young children
Whether you work or not, if you have children, they rely on you for income and caregiving.
If you pass, someone has to take care of the kids physically, emotionally, and financially.
Your life insurance proceeds will take care of the financial end so that your family members can focus on their physical and emotional needs.
Single income earning families
Single income families face two issues. If the income-earner dies, his/her spouse needs money to survive until he/she finds work.
If the non-income earner passes away and you have children, you’ll need proper childcare, along with the many other duties stay-at-home parents provide, which costs money.
People with existing debt
If you don’t have enough money saved to cover your existing debts, your life insurance funds may cover it.
A mortgage is the most common liability, think about what would happen if you passed and your loved one could not afford the house payments. Life insurance can help bridge that gap.
Elderly people to cover their end of life expenses
The average funeral costs $10,000 or more.
If you don’t have enough saved for your loved ones to pay for your funeral, Final Expense insurance may help cover the costs at affordable premiums.
Families with valuable estates
Estate taxes eat up 40% or more of an estate when it’s worth too much.
If you fall within this category, life insurance helps offset the estate taxes, leaving your beneficiaries with the assets you want them to have.
Married couples with a pension may opt for a lump sum payout.
They may use the higher payout to buy a life insurance policy so if one spouse dies, the other has life insurance benefits to cover them.
What is covered?
Most life insurance policies cover expected and unexpected deaths, including accidents.
However, there are a few exceptions.
Some insurance policies have a waiting period of 1 – 3 years. Read your policy’s fine print before choosing. Waiting periods limit coverage should you die within that time.
Most policies have ‘graded benefits.’ The insurance company pays back the premiums you paid up until your death plus a percentage, such as 10% of the policy amount.
Natural deaths cover a large number of issues including old age, cancer, heart attack, stroke, and respiratory issues.
Life insurance covers death by most diseases, as long as you’re honest on your application and provide information about any pre-existing conditions.
Accidental deaths cover car accidents, falls, or freak accidents that you couldn’t prevent or control.
Most life insurance policies cover violent deaths unless the beneficiary or someone that benefits from the policy commits the murder.
Most life insurance companies cover airplane accident deaths, but some exclude pilots, co-pilots, or other flight crew members.
Criminal related accidents
If the death is related to a crime, whether physical, violent, alcohol, or drug-related, most insurance companies will not pay the benefits.
On average, you should carry life insurance that’s 10 – 15 times your income.
However, this doesn’t apply to every situation. Determine your coverage gap to find your right coverage amount.
Your coverage gap is the difference between your financial obligations and financial resources, here is how to calculate it:
Determine your financial resources
Add your annual after-tax income and your liquid assets such as stocks, bonds, checking, savings, and retirement accounts.
Determine your financial obligations or expenses
Predicting your future expenses requires some forecasting.
Figure $15,000 per child annually until 18 (or older depending on your preferences) plus college costs, and end of life expenses (use an average $10,000 funeral expenses).
Add your current debt or the liabilities you’ll leave behind, such as a mortgage, car payment, or student loans.
Determine how much of a financial cushion you’d like to leave behind
Add in any additional amount of money you’d like to leave behind for your family, whether for medical expenses, vacations, or other personal expenses.
The difference between your financial resources (income and assets) and your obligations determine your coverage amount or at least a starting point.
Basic life insurance covers your death and pays your beneficiaries a set amount.
Riders help enhance the coverage and can make it more affordable in certain situations.
Accelerated death benefit
If you become ill, you can ‘accelerate’ your death benefits and use the funds for current medical expenses.
Some insurance companies allow this only after a terminal illness diagnosis and all insurance companies deduct the amount you use from the death benefit.
Family income benefit
The family income benefit pays your family in installments rather than one lump sum. Many people choose this for their children or spouses if they know that they won’t manage well.
Long term care
Helps cover the cost of any assistance you may need if you can’t take care of yourself.
This doesn’t cover healthcare, but rather daily assistance in grooming, eating, cooking, and getting around. It’s like long-term care insurance, but at a lower cost.
Waiver of premium
If you become disabled or unable to work, the waiver of premium rider eliminates your premium but keeps your policy in effect.
If you become disabled due to illness or accident, the disability income rider pays you a monthly income.
Types Of Coverage
Term Life Insurance
Term life insurance covers you for a set period or term. If you pass within the term, your beneficiaries receive a payout. If you outlive the policy, your benefits expire.
You may renew it at a higher premium, convert it to a whole life policy, or buy a new policy, but all at higher rates since you’re older.
Whole Life Insurance
Whole life insurance lasts your entire life or for as long as you pay the premiums.
Whole life insurance premiums cost more because they cover your death benefit (like a term policy) but also grow a cash balance.
You may borrow from the cash value or use it to pay your future premiums. However, if you borrow, you must repay the funds with interest.
Any funds not repaid get deducted from life insurance policy’s death benefit.
Universal Life Insurance
Universal life insurance also lasts your entire life and works like whole life insurance. It has a death benefit and cash value. However, unlike whole life insurance, universal life has flexible premiums.
Your insurance company sets a minimum premium you must pay. This covers the death benefit plus administrative costs.
The IRS sets a maximum amount you may contribute, and you can pay any amount in between the two.
Many people pay as much as they can early in the policy and then let the cash accumulation cover their premiums when they’re older.
Final Expense Insurance
This type of policy only covers your final expenses which include your funeral, burial, final medical expenses, and sometimes a few months of living expenses for your loved ones.
Most final expense insurance policies offer a coverage amount of $50,000 or less and are most suited for seniors over 50.
You can get final expense insurance in either ‘guaranteed issue’ (no medical exam or medical questions) or ‘simplified issue’ (no medical exam, but you must answer medical questions).
Guaranteed Issue Insurance
Guaranteed issue life insurance provides certain coverage no matter your medical history.
Insurance companies give coverage to anyone but at a higher premium and lower coverage amount.
Most guaranteed issue policies have a 2-year waiting period and are identified as final expense insurance policies for seniors aged 50 – 80.
How Much Does It Cost?
Almost 85% of consumers assume life insurance is too expensive, so they don’t buy it.
If you’re among them, you may not realize you control the costs to an extent. The coverage type and amount play a huge role in the cost. However, there are other factors that influence rates.
What influences rates?
Buying life insurance when you’re young saves you a lot of money. If you buy a level premium policy, your rates don’t change as you age.
Some policies have graduated premiums though and those increase as you age.
Men pay higher insurance rates than women because women have a longer life expectancy than men.
Most insurance policies require a medical exam or at least honest answers to medical questions.
They’ll record your height, weight, blood pressure, and cholesterol among other factors.
Underwriters use these metrics to determine your premiums based on your riskiness of contracting specific illnesses.
If you smoke, drink, or take part in risky activities, insurance companies charge more.
Family medical history
You can’t help your family history, but it affects your insurance rates. If you have a family history of major medical issues, you may pay higher premiums to account for the higher risk.
Cost comparison for men
Life insurance rates for men vary considerably as they age. Let’s take a look at a $1 million policy for a healthy non-smoker male.
At age 25, he’d pay $58 per month for a 10-year term policy, $92 per month for a 30-year term policy, and $1,031 per month for a whole life policy.
The same male would pay $176 per month for a 10-year term policy, $336 per month for a 30-year term policy, and $2,592 per month for a whole life policy if he waited until age 45.
Costs comparison for women
Women’s life insurance rates are lower than men’s because of their longer life expectancy.
A healthy non-smoking woman buying a $1 million policy would pay the following rates.
At age 25, she’d pay $48 per month for a 10-year term policy, $76 per month for a 30-year term policy, and $911 per month for a whole life policy.
The same female would pay $141 per month for a 10-year term policy, $273 per month for a 30-year term policy, and $2,501 for a whole life policy if she waited until age 45.
Does life insurance cover suicide?
Most life insurance policies don’t cover suicide for the first two years of the policy. The two-year period may restart if you miss premiums or there is a policy lapse.
What happens if you don’t die?
Term life insurance policies aren’t a savings plan. If you outlive the term, you forfeit the plan unless the insurance company offers renewal or lets you convert the policy to a whole life policy.
How does life insurance work for beneficiaries?
When you pass, your beneficiaries must file a claim with your insurance company. Some offer a simple online process, but others require a call.
Your beneficiaries must provide your death certificate and any other documents the insurance company requires.
After the insurance company approves the claim, they’ll pay the amount in a lump sum to the beneficiaries.
Can you sell a life insurance policy?
Selling your life insurance policy is called a life settlement. Most life settlement companies pay an amount between the cash surrender value of your policy and the full death benefit.
The buyer takes over the policy and starts paying the premiums, they later collect the payment when you pass.
How to Buy Life Insurance
When you buy a life insurance policy, you buy it for the long-term (sometimes your entire life). So give careful consideration to the premiums, coverage, and fine print before you buy a policy.
Choosing a suitable policy
Decide between a term and whole life policy. If you choose whole life, you must choose standard, universal, variable, or guaranteed insurance. If you choose a term life policy, you’ll need to choose a term (length of time).
Qualifying for a policy
Next, you must qualify for the policy.
After you complete an application, many companies require a medical exam, and all insurance companies place you in a category based on your qualifying factors, such as your health and lifestyle habits.
Choose your coverage amount
Once you know your customized premiums, you can choose the coverage amount based on what you can afford and the amount of coverage you need.
What happens if you miss a payment?
Most insurance companies offer a grace period of 30 days. If you don’t make your payment beyond the extra 30 days provided, your policy lapses.
You may apply for reinstatement, but you must bring the account to current including any late fees.
Most insurance companies allow reinstatement for three to five years after the policy lapse. But, if you wait more than a month or two, you may have to requalify for the policy which includes undergoing another medical exam.
Life Insurance & Tax
Most beneficiaries don’t pay taxes on life insurance payouts if they take the payout immediately.
However, if they choose to wait and the money earns interest, they may owe taxes on the interest.
What happens if the policy is left to your estate
If you leave your life insurance proceeds to your estate, your beneficiaries may pay higher taxes because the life insurance proceeds increase the estate’s value.
Once the estate hits a certain threshold ($11.58 million in 2020), the IRS charges estate taxes, which cost up to 40% of the estate’s value.
If you want to avoid adding the life insurance policy to the estate, you must transfer the policy to someone else. In other words, you transfer it to a new owner.
Once you transfer it, the new owner pays the premiums, not you.
You may also place the insurance policy in an irrevocable trust, but you can’t be the trustee – it must be someone else.
Once the policy is in trust, you aren’t the owner and its value doesn’t affect your estate.
Is Life Insurance Worth It?
Life insurance is worth it if there is anyone who depends on you and will suffer financially when you pass.
Even if you don’t have dependent children or a spouse, leaving money behind to cover your final expenses, and to manage your final liabilities helps your loved ones as they settle your estate.
Look for affordable life insurance with the necessary coverage to make the most of your current and future financial life.