Life Insurance

How Does Life Insurance Work?

There are 41 million people in the U.S. who say they need life insurance but do not have it, according to the 2020 Insurance Barometer Report from industry groups LIMRA and Life Happens. This can partially be explained by the tendency of people to overestimate its cost.

Perceptions about affordability and value can deter people from buying the life insurance they need. More than half of respondents in the Insurance Barometer Report said a $250,000 term life insurance policy for a healthy 30-year old would cost $500 a year or more. But the average cost is closer to $160 a year. That’s a pretty big discrepancy in perceived cost versus actual cost.

Here’s a breakdown of what you need to know about life insurance so you can make an educated decision.

What Is Life Insurance?

Life insurance is a contract between you and an insurance company. Essentially, in exchange for your premium payments, the insurance company will pay a lump sum known as a death benefit to your beneficiaries after your death.

Your beneficiaries can use the money for whatever purpose they choose. Often this includes paying everyday bills, paying a mortgage or putting a child through college. Having the safety net of life insurance can ensure that your family can stay in their home and pay for the things that you planned for.

There are two primary types of life insurance: term and permanent life. Permanent life insurance such as whole life insurance or universal life insurance can provide lifetime coverage, while term life insurance provides protection for a certain period.

Main Types of Life Insurance

Term Life Insurance

In addition to being the most affordable type of life insurance, term life insurance is the most popular type of life insurance sold (71% of purchasers) according to the Insurance Barometer Report

Term life insurance provides coverage for a certain amount of time and the premium payments stay the same amount for the duration of the policy. Typical choices are policy lengths are 10, 15, 20, 25 or 30 years.

If you pass away within the term of your policy, your beneficiaries can make a claim and receive the death benefit money, tax-free.

Once the term of the policy expires, you may be able to renew the coverage in increments of one year, known as guaranteed renewability. But each year of renewal will be at a higher rate.

Permanent life insurance

Permanent life insurance provides lifelong coverage. It’s more expensive than term life because it:

• Can last for the duration of your life.
• Usually builds cash value.

The cash value component accumulates on a tax-deferred basis over the life of the policy. It acts as a savings portion of the policy. Typically, you can borrow against the policy’s cash value or make a withdrawal. If you decide to end the policy, you can get the cash value minus any surrender charge.

In some policies the cash value may build slowly over many years, so don’t count on having access to a lot of cash value right away. Your policy illustration will show the projected cash value.

There are several varieties of permanent life insurance:

• Whole life insurance offers a fixed death benefit and cash value component that grows at a guaranteed rate of return. Many whole life insurance policies pay out dividends that can be used to reduce premium payments or can add to your cash value.
• Universal life insurance often offers more flexibility than a whole life insurance policy. You may be able to alter your premium payments and death benefit, within certain limits. With a universal life insurance policy, the cash value will build depending on the policy type. For example, an indexed universal life insurance policy will have cash value tied to an index such as the S&P 500. A variable universal life policy will typically have investment subaccounts that you can choose and manage.
• Burial insurance is a small whole life policy with a small death benefit, often between $5,000 and $25,000. Burial insurance is designed to cover only funeral costs and final expenses.
• Survivorship life insurance or “second to die life insurance”  insures two people under one policy, usually a married couple. When both spouses have passed away, the policy pays out the death benefit to the beneficiaries. Usually, survivorship life insurance is part of a larger financial plan to fund a trust or pay federal estate taxes.

How to Choose a Life Insurance Policy Type

With all of the life insurance options available, it may seem complicated to choose the right one.

Start by deciding between term life and permanent life insurance.

Consider a term life insurance policy if you need life insurance for a specific amount of time. For instance, if you want insurance to cover your working years as possible “income replacement” if you were no longer around.

Term life insurance is also a good choice if your budget is limited. Since term life insurance provides protection for a specific amount of time, and it’s not a cash value life insurance policy, the rates will be lower than permanent life insurance.

As you enter different stages of life, your life insurance needs may change. Many term life insurance policies are convertible to a permanent policy. The options will depend on your policy and insurer. Term life conversion allows you to switch to a permanent policy without re-applying or taking a life insurance medical exam.

On the other hand, a permanent life insurance policy will last for the duration of your life. If building cash value is important to you, look at permanent life insurance options. But if you’re purchasing a permanent policy only to capitalize on the cash value accumulation, depending on the policy, you’re better off putting your money into a savings or investment vehicle, so you’re not paying for the life insurance and charges within a permanent policy.

And cash value isn’t typically intended for beneficiaries. Upon death, any cash value generally reverts back to the life insurance company. Your beneficiaries get the policy’s death benefit, not the death benefit plus cash value. That said, some policy types will offer the death benefit plus cash value, but for a higher price.

How to Choose a Life Insurance Coverage Amount

A good rule of thumb for estimating how much coverage you need is to:

1. Add up all the expenses you want to cover, such as income replacement for your work, a mortgage and children’s college expenses.
2. From that, subtract the amounts that your family could use to cover those expenses, such as savings and existing life insurance. Leave out retirement savings if your spouse will need that later on.

The resulting number is how much life insurance you need. It may look high, especially if you’ve factored in income replacement for many years. Still, life insurance quotes are free, so it doesn’t hurt to price out the coverage you need.

If it turns out to be unaffordable, you can buy what you can afford now to lock in a good rate. You can buy more later, just be aware that several years from now your rate will be based on your older age and any health conditions you’ve developed.

Here is a calculator to help you estimate how much life insurance you will need.

How Much Does Life Insurance Cost?

The cost of life insurance varies significantly depending on several different factors. One of the biggest cost factors will be the type of life insurance you buy. For example, a term life insurance policy is significantly less expensive than a whole life insurance policy for the same amount of coverage.

Here are some of the most common factors affecting life insurance rates:

• Age. The younger you are when you buy a policy the less you’ll pay. That’s because your chance of death is smaller.
• Sex. Females have a life expectancy that is nearly five years longer than males, according to the National Center for Health Statistics. This means that men generally pay more for life insurance than women (except in Montana where insurers must provide gender-neutral life insurance rates).
• Health. Your health has a major impact on your life insurance rates. The insurer will evaluate your past and current medical conditions in order to calculate your life expectancy.
• Lifestyle. Your driving history (such as a DUI conviction), criminal record, and dangerous occupations and hobbies (such as scuba diving) can all result in higher life insurance rates.

How to Get Life Insurance Quotes

According to the Insurance Barometer Report, 15% of people think they can’t afford life insurance. At the same time, many consumers overestimate the cost. The only way to know what you will pay is to get life insurance quotes from a few companies. Quotes are free. An experienced life insurance agent will know what companies tend to give the best prices based on your age, health and desired coverage amount.

Expect to be asked about your age, health, tobacco use, your family health history, driving record, and any dangerous occupations or hobbies.

When you have a quote that you like, you can start a formal application. You answer more questions in detail and apply for a specific policy type, amount of coverage and policy length (if you’re buying term life insurance).

Once you’ve submitted the application, some insurers may require a life insurance medical exam. These exams can take place at your home, work or sometimes a local exam office.

The time it takes to process an application varies significantly among companies and policy type.

• Some insurers offer fast life insurance, including instant approval, to people who qualify, who are generally younger (under age 60) and without medical issues.
• Some insurers use “accelerated underwriting” to skip the medical exam and process applications in a day or a week, depending on the company.
• And some insurers use a traditional process with a medical exam and an approval process that can take over a month.

How to Choose a Beneficiary

A life insurance beneficiary is the person who can claim the death benefit after you pass away.

You can name multiple beneficiaries and decide what percentage they each will receive when you die. Additionally, you should add contingent beneficiaries who will receive the death benefit if your primary beneficiaries have died.

Not everyone names people as beneficiaries. Some people name trusts. By creating a revocable living trust and naming it as the life insurance beneficiary, you can ensure that the money is used according to your wishes. For example, the trust money could be used to take care of children.

If you decide to name a trust the beneficiary of your policy, make sure to work with an attorney to structure the trust correctly. It’s also wise to work with a financial planner so that a trust is part of your larger financial plan.

It’s crucial to update and review your beneficiary selections regularly. For example, life events such as a marriage or a divorce can impact your selection.

To update your beneficiaries, contact your life insurer and submit a change of beneficiary form. Making changes only on a will won’t affect life insurance.

How Does a Beneficiary Make a Claim?

Claims can be paid quickly—in about a week, assuming the insurer has all the documents it needs. Don’t assume a life insurance company will contact you. It’s unlikely they know that your relative died. While some insurers are proactive in monitoring for insured customers who have passed away, they won’t discover a death immediately.

• Death certificate: To start the claim process you’ll need to submit a certified copy of the death certificate. The insurer won’t send it back. Therefore, you may want to request a few certified copies if you need them for multiple purposes.
• Contact the insurance company right away: While you may have a lot on your plate after a loved one passes away, the sooner you contact the insurer, the sooner you can get the money.
• Verify you have met all claim requirements: Once all of the claim paperwork is done, make sure you have all supporting documentation attached. This can include a claim form and death certificate.

Claims are typically paid within 30 days after the insurer receives the necessary documents.

You don’t need an original copy of the life insurance policy to make a claim. You only need to know the name of the insurance company and contact them to initiate the claim.

That’s why it’s important to let your beneficiaries know that you have a policy and tell them the name of the insurer. And insurers are contractually obligated to pay only the people listed on the policy.