Mortality is a difficult topic. Young people refuse to acknowledge it. Retirees hope they’ve planned properly for it. Somewhere in the middle of those life phases is where the conversation about life insurance needs to happen. Unfortunately, much of what you hear about life insurance is inaccurate and it’s important to sort fiction from facts before you make any decisions. So, here we’ll answer the common question, “What is life insurance?” and explain how it works.
What is life insurance?
Like most insurance policies, life insurance is a legal contract between two parties – the policyholder and the insurance company. When a life insurance policyholder agrees to pay premiums, then the insurance companies agree to pay what’s called a “death benefit” if the policyholder dies while the policy is in effect.
3 Basic Life Insurance Policy Types
There are three primary categories of life insurance.
Term Life Insurance
Term life insurance policies pay a death benefit but expire after a certain period (ie. a term).
Whole Life Insurance
Whole life insurance is your traditional life insurance policy. This policy builds cash value as you pay premiums.
Universal Life Insurance
A portion of your premium payments goes into an interest-bearing savings account with a universal life insurance policy. You can choose to use that money or apply it to the policy to pay a lower premium.
Other Types of Life Insurance Policies
Each type of life insurance policy has caveats that cause policyholders to lean one way or another when choosing a life insurance policy. These caveats could be investment options, medical exclusions, or even affordability. Luckily, each type of life insurance serves as an umbrella, housing different policies and riders that address various needs. There’s literally a plan for every budget and every condition. Some popular policies include:
Variable Universal Life Insurance
Unlike standard universal life insurance, variable universal life (VUL) offers flexible premiums, and the cash value portion can be invested in stocks, bonds, and mutual funds. It can also be taken as cash if you prefer.
Indexed Life Insurance
The cash value of an indexed universal life insurance policy is invested into what’s known as an “index fund” that tracks the performance of a selected stock index. Nasdaq and the S&P 500 are examples of stock indexes.
Final Expense Insurance
There are two types of final expense insurance. Guaranteed issue life insurance does not require a medical exam or questionnaire. Simplified issue life insurance requires a medical questionnaire. Neither accumulates cash value.
Return of Premium Rider
A return of premium rider attached to your term life insurance policy helps you recover the premiums you paid into your term policy if you outlive it.
How does life insurance work?
Insurance companies are investment firms. They use the funds generated from insurance premiums to make investments that ensure they can pay out death benefits when the time comes. That involves a certain amount of risk on their part. To mitigate that risk, insurance companies have guidelines and qualifying requirements for certain policies.
Health is one of the primary issues. If you’re in poor health, life insurance is more difficult to get (but not impossible). As we mentioned above, there’s always an option, but the price of that option will be higher, and the death benefit will be lower. Age is another issue. Older policyholders pay more expensive premiums because their mortality risk is higher.
The death benefit is paid out to a beneficiary of your choosing. Parents will typically designate their spouse or children. In cases of accidental death, the benefit may be doubled. If the cause of death is suicide, that may nullify the policy.
Life Insurance FAQs
Do I need life insurance?
Everyone needs some form of basic life insurance. Even people with no family members to take care of still need to cover the costs of funerals and interment. At the very least, you’ll want to have a term life policy that will cover those expenses. Individuals with spouses and children need significantly more.
How much life insurance should I have?
Policies range from $5,000 to multi-million dollar policies. Many experts use the DIME Method to help decide how much life insurance one should have.
- Debt (D) – Add up all your debt and financial obligations
- Income (I) – Factor in how much your income plays a role in your family’s finances. A general rule of thumb is to multiply your income by 10 – 15x.
- Mortgage (M) – Consider what will happen to your home after you pass. If you want your family to retain your property, then you will need to add in your mortgage payments or invest in a mortgage life insurance policy.
- Education (E) – If you wanted to pay for your children’s college education, then consider the fact that your death benefit could do that. So, factor in this cost.
Lastly, don’t forget to factor in whatever your funeral costs would be.
Should I get term life insurance or whole life insurance?
Whichever policy you decide to get depends on your current financial situation and your long-term goals. Term life insurance is often considered an expense. You don’t build any value or get any returns unless you pass before it expires. On the other hand, whole life insurance is an investment because it builds cash value. It can be used as a tool to build wealth while you are still living.
However, whole life insurance is very expensive and may not be affordable for a young adult. In that case, term life would offer significant, affordable coverage, especially if you have children. You could also apply for a return of premium rider. Though it tacks on an extra expense, it will help you get some of your money back once your policy expires and your children are out of the house.
Other Important Life Insurance Terminology
Our brokers at Principled Life are sympathetic to shoppers who don’t know much about life insurance. However, it will be helpful and less stressful for you if you familiarize yourself with some basic insurance jargon.
If you’re planning on shopping for life insurance, here is some terminology that you’ll hear and read when trying to find the right policy. These are the most common terms you’ll hear, some of which may already be familiar to you:
- Cash value: Whole life and universal life carry a cash value. The cash value builds with each premium payment made and can be accessed via loans or partial withdrawals. The money is tax-deferred, so you don’t pay taxes on it until you withdraw it.
- Convertibility: This is a term associated with certain term life insurance policies that offer the option of converting them to whole life policies, thus making them “permanent policies” that accumulate a cash value.
- Dividend: Some insurance companies pay out dividends to policyholders if they have a surplus available after paying their expenses and reserving funds for claims and benefits. The dividends can be added to the cash value portion of the policy or taken as a payout.
- Beneficiary: The beneficiary of a life insurance policy is the person or persons who receive the death benefit if you pass away while the policy is in effect. Beneficiaries are not required to be family members. You can designate anyone you like.
- Rider: A rider is an add-on to your policy that you can purchase for a fee. Examples of life insurance riders include guaranteed insurability, accidental death, family income benefit, accelerated death benefit, child term rider, and long-term care (LTC).
If you have any questions about life insurance, premiums, benefits, or would like a life insurance quote, call Principled Life today. One of our experienced life insurance advisors will be more than happy to answer your questions, shop for the best quotes, and get you insured over the phone.
