How Does Life Insurance Work

Life insurance’s primary function is to provide enough money for your loved ones after you are gone. In spite of its importance, only 59% of Americans have life insurance, and roughly half of those are underinsured. 

This is due to the fact that nine million households only have group life insurance. This is often insufficient. Those with only group life insurance have a $225k average coverage gap, according to LIMRA

The other factor? Most people are don’t understand life insurance well enough to buy it. 

Though there is some confusion over the names, there are two main categories of insurance policies: permanent and temporary. Premiums for each type are normally paid monthly, and all policies have a death benefit.

As opposed to permanent life insurance, you can purchase term life insurance for a fixed period of time. A term life insurance policy is typically cheaper than a permanent life insurance policy. On the other hand, permanent life insurance will build cash value over time and won’t expire if you pay your premiums on time. Also, term life policies are essentially worthless if you outlive the contract.

 

Since we’ve already discussed the differences between term life and permanent life, let’s take a closer look at how life insurance works. But, if you need a refresher, please feel free to revisit the previous chapter. 

 

Life Insurance Basics: Terminology, Coverage Needs, and Cost

 

Policies differ greatly when it comes to life insurance. Families, high-risk buyers, couples, and many other groups have life insurance available to them. Despite all their differences, most policies share similar characteristics. Below are some basic life insurance concepts that will help you better understand how it works.

 

Life insurance terminology. 

 

  • Premium. The premium is the amount of money you pay to your insurance company. Your term life insurance policy will cover these costs and any administrative fees. The cash-value account of a permanent policy will also allow you to pay money into it.
  • Beneficiaries. A beneficiary is a person who receives money when a deceased person passes away. Your choice of life insurance beneficiaries is an essential part of planning the impact of the policy. You can choose anyone as a beneficiary, but most often spouses, children, or parents are often the best candidates.
  • Death benefit. In life insurance, death benefit refers to what will be paid to the beneficiaries if the insured person dies. In some cases, the amount of this coverage is a fixed amount when you buy a policy. The cash account of your permanent life insurance policy can also grow and you can select certain options to increase the payout.
  • Riders. Maybe you’d like your premiums covered if you become unable to work, or perhaps you want to include a child under your policy. These features and others can be added to your policy by purchasing an additional rider.

 

Who needs life insurance?

 

As with other types of insurance, life insurance was intended to solve a financial problem. In this case, a life insurance policy is vital since your income will disappear when you pass away. As a consequence, your spouse, children or anyone financially dependent on you will be left without support.

 

You will still have funeral costs even if no one will depend on your income. Your spouse, children, or other family members will be responsible for paying the burial costs and other expenses related to your passing. Considering your beneficiaries’ needs can help you decide how much coverage you’ll need.

 

Life insurance may not be necessary if a policy would damage your finances or put your dependents in financial jeopardy. But, it will be required if your death will cause your loved ones a financial burden immediately or for a long period of time.

 

Generally speaking, you may want or need life insurance coverage if:

 

  • The income you earn is crucial to the survival of others, in particular your dependents.
  • In your family, you’re the sole wage earner, such as single parents.
  • You’re a stay-at-home mom or dad who performs most of the housekeeping and childcare responsibilities.
  • You support your aging parents financially.
  • You provide for your spouse financially despite being an empty-nester or not having children.

 

If you decide that life insurance is best for you, you will need to determine how much coverage you need and whether a permanent life or term life policy will be best. For more information about your options, speak with a trusted insurance agent.

 

How much life insurance do you need?

 

What you need in terms of life insurance will vary depending on your goals and financial situation. As a general rule of thumb, unless you’re trying to replace lost income, you won’t need as much money for end-of-life expenses.

 

To estimate the amount of life insurance you need, you can use a life insurance calculator.

If you’re considering a permanent policy, speak to a financial advisor who works on a fee-only basis. You can get advice from the advisor on whether a life insurance policy is appropriate for your situation.

 

How is life insurance priced?

 

Life insurance rates are largely determined by your health. The better a person’s health is, the lower their life insurance rates will be. In addition, young buyers usually have a lower death rate, so their life insurance is often cheaper.

 

In most cases, women live longer and nonsmokers live longer. This is also true for those people without any severe medical problems. Life insurance is usually more affordable for people in these groups.

 

An insurance medical examination is required for many applications. Insurers will measure your weight, blood pressure, and cholesterol, among other things, as part of their overall risk assessment.

 

A few providers offer life insurance without a medical exam, but premiums tend to be higher. You also may end up with less coverage than you expected, as some large insurers limit coverage to $50,000 for no-exam policies.

 

It might be better for you to check with your employer to see if they offer life insurance as a perk. In addition to covering some or all of your annual salary, employee life insurance can cover basic end-of-life expenses. A fundamental policy usually does not require an exam. It might even be free.

 

What Exactly Does Life Insurance Cover?

 

That’s a terrific question. First, let’s answer a more basic question: Who is covered by life insurance?

 

Simply put, it covers whoever or whatever is your beneficiary. Most likely, that’s someone you care about, like your spouse, children, or a favorite nonprofit organization. If you pass away with term life insurance coverage in place, your beneficiaries will receive a payout, which is called a death benefit.

 

With that out of the way, let’s circle back to the original question: What exactly does term life insurance cover? 

 

You’ll find it covers any expenses your loved one wants or needs it to. This includes both short-term expenses, like funeral costs, and long-term expenses, such as paying off a mortgage. Remember,  your insurance policy is a contract that you sign with a life insurance company. In case you die before that contract expires, your beneficiaries will receive a death benefit payout corresponding to the level of coverage you bought.

 

Term insurance needs calculators are helpful when determining if you’ll need a certain amount of coverage. Moreover, you might consider how much your loved ones will have to spend and what sort of legacy you want to leave them. 

 

Keeping all of this in mind, here are seven expenses most people purchase life insurance to cover:

 

    • End-of-life-expenses. Life insurance policies are commonly used to pay for end-of-life financial obligations like funeral costs and burial expenses. In case you weren’t aware, the average funeral can cost $10,000. Life insurance ensures that your family won’t have to cover this bill. 
    • Day-to-day bills. Take a moment to consider the costs of running your household. There may be a mortgage or rent to pay. You also have to budget for food, utilities, health insurance, car payments, insurance, clothes, school supplies, and fees for extracurricular activities. If your beneficiaries inherit a life insurance policy, they’ll have a larger financial reserve for these daily expenses. 
  • The mortgage. A home is usually a family’s greatest asset and can provide long-term financial stability. An insurance policy would protect your family’s ability to pay the mortgage if you were to die and your income was no longer available.
    • Cosigned debts. Even though your mortgage is likely your biggest debt, it may not be your only one. Also on the table are credit cards, auto loans, personal loans, and student loans. There is no repayment requirement for federal student loans when a borrower dies (or the parent in case of Parent PLUS loans). The responsibility to repay cosigned debts won’t go away when you pass away, whether it’s with a spouse, family member, or anyone else. Due to the joint responsibility for the debts, cosigners could have financial hardship if they have to make payments alone. If you had life insurance, your beneficiaries would be able to pay off those debts after you’ve passed, as well as protect their credit score. 
    • Child care and other dependent expenses. According to the federal government, a middle-income family spends $12,980 per child each year. In addition, college can add thousands of dollars more to this cost. As such, being insured is a great idea when you have children. An insurance policy that provides a lump sum payout can be used to cover anything from daycare and summer camps to college tuition. Moreover, it can help pay for the costs of raising children with special needs. A wheelchair or feeding tube may be needed, for example.
    • Medical expenses or long-term care. The death benefit of most life insurance policies can be accelerated if the policyholder suffers from a terminal illness. You might be able to use that money to pay for long-term care and medical expenses when you’re unable to work. Not only is this stressful, it can also be expensive without help. If funds are tapped by the accelerated death benefit rider, then the overall death benefit will be reduced.
  • Leaving a legacy. It’s common for people to leave money to their partners and children so that they won’t have to deal with financial problems in the future. They can use this money to cover college tuition or for a down payment on their first home. Or, you may want to leave your favorite charity some money after you pass away. A life insurance policy could be used to establish such a legacy if you’re no longer alive. In addition to covering your family’s immediate needs, you can also take out a policy that provides for longer-term financial objectives.

 

What Type of Life Insurance Should You Buy?

 

At this point, you’re well aware of the two main types of life insurance: 

 

  • Term life insurance, which provides basic coverage for a set amount of time.
  • Permanent life insurance, which lasts your entire life and contains an investment component.

But, which type of insurance should you purchase?

Term life insurance.

Life insurance policies covered by term policies expire after a predetermined number of years. In addition to being the most affordable type of life insurance, term life insurance is also the simplest form of coverage.

How term life insurance works: In case of death, your beneficiaries receive the death benefit of your term life insurance. However, the insurance company will not pay you or your beneficiaries if you outlive the term.

Permanent life insurance.

Instead of paying a set number of premiums for a set period of time, you pay them for life. As a result, this establishes a death benefit for your beneficiaries.

The cash value component of permanent life insurance often earns interest and increases in value as your premiums are paid. If the accumulated cash value increases steadily, you may even receive dividends on the funds. Alternatively, you can use the cash value as collateral to take out a loan or withdraw cash. However, this could reduce your beneficiaries’ death benefits.

How whole life insurance works: Typically, whole life insurance offers a fixed interest rate which grows the cash value at a set rate. 

Among the other options for permanent life insurance are:

  • Universal life insurance has a cash value determined by a stock index offered by the insurer. Market underperformance results in a lower cash value and higher premiums.
  • Variable life insurance gives you the option to choose your investments but also has fixed premiums. You may not notice a difference in coverage if your assets do not exceed the value of the death benefit.
  • Variable universal life insurance combines the adjustable rates of universal life insurance with the diversified assets of variable life insurance. You may see a change in premiums if the investments perform well or poorly.

Life insurance riders.

Riders, which complement your coverage, allow you to customize it. Here are some examples:

  • Accelerated death benefit rider. An accelerated death benefit rider lets you collect your death benefit early if you need end-of-life care due to a terminal or critical illness. It’s included by default in many policies.
  • Long-term care rider. If you become ill and can no longer do any two of these six activities, a hybrid policy will pay for the cost of assisted living should you need it. These activities are eating, bathing, getting dressed, walking, using the toilet, and maintaining continence. Long-term care riders take money from the death benefit of your policy if they are used.
  • Term conversion rider. Despite the expiration of your life insurance policy, you may still require life insurance coverage. It’s common for term policies to be converted into permanent policies at no additional cost using the same details you offered when you first applied — often without additional underwriting.

 

How Much Does Life Insurance Cost?

 

A person’s life insurance premium is dependent on the amount of coverage they need, as well as their likelihood of dying during the term of the policy. So, if your health, hobbies, or age makes you more likely to die, your premium may be higher. Overall, healthier people and those with a less risky lifestyle pay less for life insurance.

It may be easier to purchase life insurance at a lower cost if you’re in poor health or enjoy hobbies like skydiving.

Can I get better life insurance rates if I lie about my health?

To save money on premiums, you might consider lying about your health (or other matters relating to your life insurance application). Your policy is contestable for the first two years after it is issued; any claim made after your death can be contested by your beneficiaries. 

You may be left with only a refund of your premiums if your insurer determines that you misrepresented your health. It is possible for your insurance company to refuse to pay out your death benefit even after this two-year period has passed.

Can You Make Life Insurance More Affordable?

 

As opposed to lying to an insurance company regarding your health, you can secure a more affordable life insurance policy by: 

  • The earlier, the better. It’s more expensive to purchase life insurance as you age, so if you purchase when you’re younger and healthier, you’re likely to save money over time. The reason is that you can lock in your rates when you’re 25 and in tiptop shape. That means whatever you pay when you’re an elder will also be the same.
  • Choose the right level of coverage. If you’re unable to pay the premiums and end up missing payments, a more expensive policy doesn’t make sense. Choose a policy that fits your budget instead.
  • Compare quotes from different companies. Your risk is evaluated differently by every insurer. For instance, some companies may charge more for marijuana users, while others are more tolerant. Always compare life insurance quotes from different providers before committing. 
  • Get healthy before you apply. You’ll pay much higher premiums if you are assigned nicotine or tobacco rates when you apply. You’ll need to show that you’ve been tobacco-free for at least two years in order to lower your rates, and if you want the lowest premiums, it must be at least five years. Furthermore, if your body mass index (BMI) is 25 or higher, you’re considered overweight by the CDC. It’s common for life insurance companies to calculate premium rates using BMI. So shedding some pounds prior to applying could result in a more favorable rate. 

Don’t wait to get coverage even if you aren’t in great health now. A rate revision can be requested after one or two years. As part of this process, you must go through underwriting again to prove to your insurer that your health has improved. And, to put your mind at ease, the company will not come back with a higher premium.  

How to Apply for Life Insurance 

 

It’s fairly easy to fill out a life insurance application. To get a quote, you first need to speak with a licensed agent or broker. After that, you can apply for a life insurance policy in just five easy steps.

  • Fill out the application and complete the phone interview. You fill out the application and subsequently take a phone interview. The information you provide here will include your health, family history, hobbies, and insurance needs. During the application process, you’ll also designate the beneficiaries for your policy.
  • Take the medical exam. The paramedical examination is similar to the medical exam you get from your doctor unless you qualify for instant decision life insurance or no-medical exam life insurance. You may need to provide blood or urine samples to confirm your health information.
  • Wait for the attending physician’s statement. An insurer may request that you submit an attending physician’s statement (APS), which lists the medical conditions you’re receiving treatment for and your prognosis if you have any serious or chronic illnesses.
  • Go through underwriting. Your premium amounts will be based on information provided in the application, such as driving history, credit score, and medical information in the Medical Information Bureau. An underwriter uses this information to assess the risk of insuring you. 
  • Pay your first premium. The policy will not go into effect until your first premium is paid. To prevent a lapse, you should set up a payment plan for your premiums. For the initial payment or to schedule recurring payments, your agent or broker may require your payment information.

How long does it take for life insurance coverage to kick in?

When you sign and pay your first life insurance premium, your policy becomes effective. The effective date is the day you sign your final policy documents and kick off your coverage. You decide when your coverage goes into effect after the insurer approves your application and sends over the paperwork. The time between when you sign your life insurance paperwork and having to reapply is typically about six months.

Beneficiary Choices for Life Insurance

 

You must designate a beneficiary when purchasing life insurance. In the event of your passing, this is who you want to receive your death benefit. 

 

You can name anyone as your beneficiary, but the most common suggestions are:

 

There is an option to name a single beneficiary or a primary beneficiary, as well as one or more contingent beneficiaries. If your primary beneficiary is deceased, a contingent beneficiary will receive death benefits from your life insurance policy.

How to File a Life Insurance Claim

Life insurance policies do not pay out death benefits automatically. Beneficiaries must submit a claim to their life insurance company first. It may be possible to do this online or by submitting a paper claim depending upon the insurer’s policies. In order to process a claim and payout, the company usually requires supporting documentation, mainly a copy of the policy, the claims form, and the death certificate.  

You can follow these steps to make this process easier:

  • Find the life insurance policy.
  • Learn who the beneficiaries are, how their death benefits are divided, the total coverage amount, and how the death benefits are received by the beneficiaries.
  • Request a claim form from the life insurance company.
  • Request a copy of the death certificate from the county or municipality, or from the hospital or nursing home where the insured died.
  • Contact your life insurance provider and file a claim.

The insurance company will pay beneficiaries the death benefit once they have reviewed the information and confirmed that their premiums are current. Payment is usually made within 30-60 days after a claim is filed by most insurance companies.

Beneficiaries should file claims with all insurance companies with whom they may be eligible. There are also people who have both a group policy offered by their employer and a plan they have purchased individually. 

As the policyholder, you can facilitate the process as smoothly as possible by informing your spouse, children, or other beneficiaries where your life insurance documents are located. If you have any beneficiary or trustee of your estate who is an adult, we suggest sharing a copy of your policy with them as a precaution.

Immediately after filing a claim, make sure you find out which business issued the policy, or which agent sold it if you don’t have a copy of the policy. It should be on file with the company or agent.

If you are unable to locate the policy, you may be able to get assistance from the National Association of Insurance Commissioners. Through its policy locator service, you can request information about life insurance policies from participating insurance companies. Similar services are available in some states. For more information about this, contact the insurance commissioner in your state.

Why are payments delayed?

 

Delays in payment can occur for a variety of reasons. In the event the insured dies within the first two years from the date of issue, beneficiaries may face delays of six to twelve months. The reason? The aforementioned one- to two-year contestability period.

 

A death certificate listing homicide may also delay payments. An insurance agent may communicate with the detective assigned to the case to exclude the beneficiary from being a suspect. Until suspicions surrounding the beneficiary’s involvement are cleared, the payout is held. In the event of charges, the insurance company may withhold the payout until either the charges have been dropped or the beneficiary has been cleared.

The following situations can lead to payout delays:

  • It was determined that the insured died as a result of illegal activity, such as driving under the influence.
  • During the application process, the insured party lied.
  • There was no mention of health problems or risky hobbies or activities like skydiving.

Life Insurance Payout Options

 

Again. if a life insurance policy has a death benefit, it must be claimed by the beneficiary. Upon receiving a death certificate and the completed claim form, most insurance companies process claims within a few days or weeks. In the event that a policy was recently purchased, and if the insurer believes there a fraud committed when it was issued, this could cause a delay.

 

Upon receipt of a death benefits claim, beneficiaries can elect how their benefit will be paid. You can usually receive proceeds from a sale in one of the following ways:

 

  • Lump-sum fixed amount: Those who choose this option receive the total death benefit payment all at once. Despite its popularity, investments in this category can pose some risks if the money is not mismanaged. Due to the Federal Deposit Insurance Corporation’s coverage which only extends up to $250,000, if the payout exceeds this limit, additional deposits may need to be made.
  • Specific income payout: You can choose to pay your beneficiaries in monthly installments over a certain period. This way the income doesn’t evaporate too quickly. As an example, a $600,000 death benefit might be paid out to your beneficiaries in $30,000 a year for the next 20 years. Taxes on the interest earned on the balance must be paid since the life insurance company holds the money in an interest-bearing account.
  • Retained asset account: Insurance companies may offer retained asset accounts as an interest-bearing option for policy proceeds. Beneficiaries are given a checkbook to access their funds, and any interest earned must be reported to the IRS. In addition, the insurance company guarantees the proceeds of the account, no matter whether the balance exceeds FDIC-mandated limits.
  • Annuity: This is a life income payout that ensures recipients receive payments for the rest of their lives. Insurers determine the amount they pay based on the age of the beneficiary when filing a claim and the amount of the death benefit. When your beneficiary passes away, any remaining death benefits will go back to the insurance company — unless they choose to receive an annuity for a set timeframe. Any remaining funds will go to the specified beneficiaries.

 

Putting It All Together

 

Life insurance policies assure both policyholders and their loved ones that financial troubles will be preventable in the event of their death. You don’t have to become an expert, But, you can at least feel slightly more confident about purchasing life insurance coverage if you understand how the process works, from buying it to filing a claim to receiving a payout.

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