The Truth On How a Life Insurance Policy Works
Written by Daniel Ray, Life Insurance Expert |
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Fact Checked by
Lisamarie Monaco |
Editorial Disclosure
If you are wondering how a life insurance policy works, this article is perfect for you!
Many people don’t know that when they purchase life insurance, they are actually purchasing an investment. Better yet, the proceeds of your policy can be used for any purpose you wish! The next time someone asks you what a life insurance policy is and what it does, share this blog post with them to help them learn more about how this type of financial product works.
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What is life insurance
A life insurance policy is a contract between a policyholder and a legal entity, in which a specified sum of money is paid to your next of kin or nominee in the event of your passing before the policy’s term concludes.
All that’s required is to buy the policy, which you can pay for in monthly installments or as a lump sum. The money will also be paid out if you are diagnosed with a terminal illness and have less than 12 months to live.
The main purpose of a life insurance policy is basically to offer financial support to your family or beloveds after you pass on. This monetary benefit can help your family settle debts, pay for their daily expenses, cater to your kids’ school fees, and generally help them maintain a certain standard of living.
Types of life insurance policy
There are two main types of Life insurance i.e., permanent and term life insurance.
A permanent life insurance policy as the name implies is a type of life policy that offers you protection for the rest of your life. The key difference between permanent and term life insurance policies is the cash value.
Permanent life insurance includes a cash value feature, ensuring the policy lasts as long as the policyholder is alive and premiums are paid. You are entitled to the financial benefits accrued under the policy by the insurer.
A portion of your premiums is invested, allowing the cash value to grow tax-free over time. The total death benefits are payable from the start of your policy, but it takes several years for the cash value to accumulate to a significant amount.
Permanent life insurance is further categorized into Universal and Whole life insurance. Universal life insurance is usually relatively cheaper but the cash value, death benefits, and premiums growth rate are unpredictable making it a bit complex.
Whole life insurance, on the other hand, is way simpler as the premium, remains constant for as long as the agreement is valid, the cash value continues to increase at a stipulated rate, and the death payouts are assured.
As for the term life insurance policy, the coverage has a specific time period ranging from 10 to 30 years. This is also known as pure life insurance coverage because, unlike permanent life insurance, it does not offer any cash value.
How term life policy works
As stated earlier, a term life policy is set for a specific period of time that is normally selected when the policyholder purchases the policy. The common policy periods are 10, 20, and 30-year terms.
If you pass on during the policy coverage period, the insurer will pay out the benefits to your beneficiaries as stated in the policy. No payment is made when you are a life.
One of the things that makes term life more appealing in relation to Permanent life policy is the fact that the payouts are more and the investment is relatively low. It also offers a temporary and an alternative option to the expensive permanent life cover.
How permanent life covers works
Permanent life cover is valid for life provided you faithfully pay your premiums. The most popular permanent cover is whole life followed by universal and lastly variable life cover.
The beauty of permanent life policy is that they grow in cash value as time as time goes. A proportion of the premiums is set aside for the cash account, which is then invested so as to earn interest.
It is advisable to purchase permanent life insurance when you are young and inexpensive to insure as the policy tends to grow faster during its early stages. Whole life policy, unlike universal cover whose growth fluctuates depending on the market forces, has a constant growth rate.
Note that it takes a number of years to grow a significant cash value so it is more of a long-term investment.
Another thing with permanent life insurance is that you can access the cash value while you are still alive. You can choose to withdraw some amount or use the interest or even borrow to pay for the premiums later in life.
You can also choose to trade the policy for its current market value at a cost.
Whole life insurance
Whole life insurance cover with its constant premiums, possible cash value, and the guaranteed payout may appear pretty attractive, but as you’ve guessed it – it comes at a price.
The premiums for a whole life cover are way expensive compared to term life insurance cover. For instance, a $500,000 whole life cover for a 30-year-old woman goes for approximately $3750 per year.
The same cover for a term life policy with a term length of 30 years will cost you around $300 per year.
Universal life policy
Universal life policy has both lifetime cover and flexibility. It enables you to make either large or small payments based on your capabilities or investment performance.
If things are looking good, you may opt to stop payments, however, if the performance is poor, you may have to pay a little extra to cater for the shortfall.
So, it generally depends on the insurer’s investment performance. Any wrong moves by the insurer will cost you more than what you had planned for.
How are life insurances priced
One of the main things that are considered when calculating your life insurance premium is your health. Young and Healthy individuals have a lower probability of dying soon and therefore, life insurance companies usually charge them a lower rate.
Individuals without chronic medical issues live longer, non-smokers, women, people who keep fit, and so on are highly likely to live longer. The people who fall under this category usually receive preferential pricing.
Most life insurance companies have medical examinations as part of the registration process. Your cholesterol level, weight, blood pressure, and blood sugars are some of the factors that are examined in an effort to establish your general health.
There are some companies that don’t require a medical examination, however, their premiums are relatively higher. They may also offer limited coverage than what you expect, with some companies offering a maximum of $50,000 for a no medical exam policy.
FAQs
The cost of premiums is determined by factors such as the insured’s age, health, lifestyle, the type and amount of coverage, and the duration of the policy. Smokers or individuals with health issues generally pay higher premiums.
Term life insurance provides coverage for a specific period (like 10, 20, or 30 years) and pays out only if the insured dies during this term. Whole life insurance covers the insured’s entire lifetime, accumulating cash value over time.
Upon the insured’s death, the designated beneficiary receives the death benefit, which can be used for any purpose, such as paying off debts, covering living expenses, or funeral costs.
If the insured outlives a term life policy, the coverage ends, and there is no payout. Some policies offer a renewal option or conversion to whole life insurance.
You can borrow against the cash value of a whole life insurance policy but not a term life policy. Loans must be paid back with interest, or the loan amount will be deducted from the death benefit.
Riders are additional benefits that can be added to a policy, like critical illness coverage, waiver of premium, or accidental death benefits, often at an extra cost.
In term insurance, if there is no claim during the policy term, the premiums paid are not returned unless the policy is a “return of premium” type.
To claim the death benefit, beneficiaries must submit a claim form and the deceased’s death certificate to the insurance company. The insurer will then process the claim and disburse the funds.
Generally, life insurance death benefits are not taxable income for beneficiaries. However, any interest received on the payout may be taxable.
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Conclusion
It’s not easy to find the right life insurance policy. There are so many different types of policies, coverage amounts, and premiums that it can be overwhelming. We know how important this decision is for you as a family member or business owner, which is why we have made things easier by providing an online quote form with all our available plans listed in one place! You can use this information to compare rates and get your questions answered before deciding on the best plan for you. Have any friends or relatives been thinking about getting their own policy? Share this post with them now!
