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What is Life Insurance and How Does it Work?

Life insurance is a contract between you and an insurance company to provide you with coverage based upon your timely payment of premiums. Life insurance provides a death benefit to your named beneficiary (usually a spouse) upon your death. When you pass away, your beneficiary files a claim with the insurance company to submit proof (a death certificate) of your passing. If there is an agent who usually works with your family, your beneficiary can contact the agent who will help him or her complete the necessary paperwork. Or, your beneficiary can contact the insurance company directly and a claims representative will instruct him or her on what to do. After the insurance company receives all the documents, then your beneficiary will be issued the death benefit payout.

If you name a child as beneficiary, then a custodian of the policy would have to file the claim. This could be someone who you named to manage the money from the policy in case you died while your child is still a minor. If you didn’t name anyone, then a court will appoint someone.

Main Types of Life Insurance

Life insurance can either be temporary or permanent. Temporary insurance is more commonly called term insurance, and policies are issued for a specific number of years, often from 5 to 30. Permanent insurance covers you for your entire life or up to a certain age, usually 100-years-old.

Some of the life insurance 101 basics you need to know are the main differences between term and permanent life insurance.

Term Insurance

Permanent Insurance
 Pays a death benefit to your beneficiary only if you die during the term of an active policy until age 95.  Pays a death benefit to your beneficiary regardless of when you die as long as the policy is in force. 
 In most cases, death benefit and the right to convert to a permanent policy without proof of insurability are the primary features.  Includes both a death benefit and a savings feature.
Policy has no value at the end of the term Policy builds cash or loan value you can borrow against, withdraw, or invest.

Types of Term and Permanent Insurance

Practically all term insurance policies sold to individual consumers are level rate term policies. This type of policy guarantees that your premium will stay the same for a set period of time, which could be the entire term or just a portion. Other less common types of term insurance include annual renewable term and decreasing term coverage. The majority of insurance companies don’t offer these plans to individual insurance shoppers because they are generally not the best fit for families looking for the most protection.

Two of the most popular types of permanent insurance are whole life and universal life. Most whole life policies provide a level premium, so the rate that you pay stays the same for the entire policy. With most life insurance policies, you can get a larger death benefit by passing a medical exam. Other permanent insurance policies available include variable life and variable-universal life.

How Life Insurance Policies Are Issued

Policies are either simplified issue or fully underwritten. Simplified issue policies only require that you answer questions about your health when completing the insurance application. These policies may cost more since the insurance company has less proof about your health. Fully underwritten policies require that you take a medical exam and complete lab work. You usually get a lower premium with these policies if your results show good health.

Factors That Determine Your Premium Rate

A general rule of thumb with life insurance is that the younger and healthier you are, the less you will pay. Age is typically the most important factor in calculating your premium rate. Other factors include:

  • Gender—females typically get lower rates because of longer life expectancy
  • Answers to health questions on the policy application
  • Results from medical exam and lab work
  • Family medical history
  • Marital status
  • Location
  • Lifestyle—smoker/nonsmoker, alcohol consumption, risky hobbies like skydiving

Why Do I Need Life Insurance?

There are three main reasons why many Americans get life insurance:

  1. To pay for burial and final expenses: even a simple funeral can cost thousands of dollars. The National Funeral Directors Association reports that the median price Americans pay for a funeral is $7,181, as of 2014. When you include the price of a vault, something that most cemeteries require, this comes out to a median price of $8,508. About 51% of Americans get life insurance for this reason, according to LIMRA.
  2. To replace income: if you died leaving behind a spouse and young children, it may be hard for them to make ends meet without your income. Money from a life insurance policy can help maintain your family’s standard of living and pay for expenses that go along with raising children. LIMRA reports that 34% of American households get life insurance for this reason.
  3. To pay off a mortgage: a large part of your working adult life is dedicated to paying off the mortgage on your house, which can take 30 or more years. Life insurance can help ease the financial burden your family may face to keep a roof over their head after you’re gone. Money from a policy can help them continue to make monthly payments or pay off the entire balance. LIMRA states that 26% of Americans get life insurance for this reason.

How to Buy Life Insurance

  1. Determine your needs: calculate how much debt you have, your monthly living expenses, and your final expenses. Include any future expenses, such as college tuition. Figure out how long you need replacement income and how much income it would take for your survivors to pay for immediate and future expenses.
  2. Get a quote from different insurance companies: compare rates, policy features, and benefits to make sure you’re getting the best deal
  3. Choose a company with a strong financial rating: companies with the highest ratings offer more guarantee that they will have the finances to pay your claim. You can get financial strength ratings from rating agencies like A.M. Best Company.
  4. Make an appointment with an agent: after you narrow down your search to a specific company, speak with a licensed agent to go over more details about your needs.
  5. Make sure you can afford the premium: double check how much income you have coming in and how much expenses you have going out to make sure the rate you’re getting is affordable.
  6. Read your policy: after you’ve been issued a policy, make sure you read all the fine print. If you don’t like your policy, state laws generally mandate that you have a certain number of days to cancel your policy and receive a refund of any premiums you paid. Depending on the state, this may be within 10 to 30 days after the policy issue date.

Life Insurance for Adults of All Ages

Young and married with small children: young families need the most death benefit from a life policy because the need for income replacement that can cover the expenses for growing children is greater. Also, if a spouse who stays home to take care of the kids were to die, it would be an additional expense for the surviving spouse to pay for child care services. A term plan is typically cheaper to get the most coverage. Longer term policies like the 20-year or 30-year plan can be the most suitable for young families.

Young and married with no children: if both you and your spouse work and household expenses are shared equally, you may not need life insurance. But depending on your lifestyle, it may be hard to maintain the same standard of living if one of you were no longer around. According to a Kiplinger Magazine article, a modest amount of coverage may be enough to meet your needs. Since term policies allow you to get just the basic amount of coverage you need, you can pick a plan with a lower death benefit to get a more affordable rate.

Single-Parent: like young couples with children, single-parents who have younger kids also need a policy that provides a large death benefit. Studies show that most single-parents are women, and the average salary single-mothers earned as of 2014 was $36,780, according to Forbes Magazine. This is far less than the average wage for married couples with children under 18, which is about $107,054 (as of 2013). With less income among the majority of single-parents, it’s more likely that there wouldn’t be enough savings that could be used as income replacement if the parent dies.

Recent empty-nester: so the kids are off to college, but that doesn’t mean your life insurance needs end. You may need to support your children through the college years to help pay for tuition, room and board, books, or even clothing. If your household runs on two incomes and you still have major debts to pay off like a mortgage, you need the protection of income replacement. Depending on your age, you may also have a while to go before you have enough retirement savings.

At this stage in life, a policy that has a death benefit your spouse could use to cover expenses if one of you dies. The policy can also build cash value to supplement your retirement savings may be the most suitable. You could choose to go with a term plan that converts to permanent insurance or go straight for a permanent policy depending on your needs. For example, if you’re 55 and looking to have cash value in a policy by the time you’re 65, then a permanent plan may be best because it could take that long for the policy to build cash value. This usually takes 8 to 10 years.

If you don’t need supplemental income as fast, you could get a 10-year convertible term plan. So by the time you’re 65, you could have a whole life policy, and when you reach 75, you could have cash value in the policy. One thing to keep in mind when converting a term plan is that insurance companies usually only allow you to do this before you turn 65, according to the Texas Department of Insurance.

Three senior couples posing together on a beachRetired senior citizen: if you have the finances to get you through retirement and provide for your spouse if you die, then you don’t need life insurance. If this doesn’t apply, then getting a life policy may be necessary. If you’re under 80, you can still get a term life insurance plan. This is typically the maximum age in which insurance companies provide term coverage, as mentioned by the Texas Department of Insurance. Although the cost would be more expensive because you’re older, premiums are usually lower than a permanent insurance policy, such as whole life.

If you need a policy that can help supplement your retirement savings, then the cash value from a permanent plan may meet your needs. Keep in mind that it does take a while to build cash value. So depending on your age, you may want to weigh the odds of whether or not you will be around long enough to take advantage of this feature. A type of permanent insurance you could also choose is final expense, which is typically offered as a whole life policy. This type of coverage is only meant to cover your burial and funeral expenses, not your long-term financial needs.