What is life insurance and how does it work? You may have heard that buying life insurance coverage is a good idea. However, you’d like to know how exactly it works first!
Don’t worry, you are not alone. According to LIMRA ‘s 2017 Life Insurance Awareness Month, the most important factor for Americans when buying life insurance is that it is easy to understand(83 percent.)
The simplest explanation is that if you agree to pay your premiums to a life insurance company then your beneficiaries receive a death benefit when you die. Most claims for a benefit will require a death certificate. The insurer pays the names beneficiaries in order and percentage as listed on the application.
Having this contract in place gives you peace of mind. You can choose the coverage amount and number of years for your plan.
There are two types of life insurance. Term life insurance and permanent life insurance. Permanent is long term(lifetime) coverage and has higher premiums.
How does term life insurance work?
Term life is the most inexpensive type of coverage. It’s commonly referred to as temporary coverage. You stop paying premiums on term after the agreed upon time frame.
Many term plans come with the option to either convert coverage or renew the term. Renewing the term means you will be offered a price for another set of the original term length.
Converting your coverage means you are moving from a term to a permanent plan.
Neither a renewal or conversion requires any medical underwriting.
Example: Let’s say you buy a 20 year term at age 23. Here are your two options:
- Turn all or some of your coverage into permanent(lifetime) coverage at any point during the 20 year term.
- Renew your policy another 20 years based on the rate for your new age of 43.
How does whole life insurance work?
Whole life is the most common type of permanent coverage. Often times consumers tell me they want this plan because someone they know said it was a good idea.
I don’t recommend permanent coverage for most people. If you are set on permanent coverage, be sure to explore the different options.
Of all the permanent plans, whole life is my least favorite. The reason being is because it’s the least flexible. Payments cannot be stopped and must be paid for a lifetime. You can choose a 20 pay or single pay option. This just means you are paying the plan up sooner.
Whole life requires a higher premium paid than term life and accrues a guaranteed and non-guaranteed cash value.
Lot’s of people are mislead by the allure of investing not just whole life but all cash value life insurance. They rarely understand the concept, fees and believe they will gain lots of cash.
In general it takes a good 5 years before a cash value plan will see any growth. The cash inside can be taken out but you do pay an interest rate. The money can and should be paid back to maintain the death benefit. After all, keeping the coverage in place should remain the priority of the plan.
I’ve seen many people deplete their policy only to see it lapse and have to start from scratch.
How does universal life work?
Universal life insurance is a permanent plan that offers more flexibility. If a plan is funded well enough to maintain the death benefit than you can stop making payments. This shouldn’t be done unless you have intentions to resume payments and monitor the plan.
People rarely review the cash value life insurance plans they purchase. Insurance carriers send annual statements that will show the amount of cash accumulation.
Like whole life coverage, you can take money out of a universal life plan. This is still subject to an interest rate.
There are several types of universal plans on the market. The most common are:
- Universal Life(Traditional)
- Guaranteed Universal Life
- Indexed Universal Life
- Variable Universal Life
My favorite type of permanent coverage is Guaranteed(No Lapse) Universal Life. This is a plan that works well for people seeking affordable, lifetime coverage. I prefer this type over final expense which is typically offered as whole life insurance.
Is Cash Value A Good Idea?
I recommend anyone considering a permanent life insurance policy, have a conversation with a financial adviser beforehand.
A fee only financial planner can offer unbiased advice on whether or not a cash value plan works well in your insurance portfolio. There may be some alternative investment products to consider.
This is where the phrase”Buy term and invest the rest comes from!” As a reminder, life insurance should never be thought of as an investment. In fact many state laws prohibit agents from promoting them as such.
Term life insurance is the best plan for many consumers.
Contractual Agreement
How do life insurance policies work? When you buy a life insurance policy you are applying for a contract. It’s a promise to pay your beneficiary when you pass away.
The contract is solidified in the state where you are present during the application. Upon an approval for coverage, you will get the contract to review for acceptance.
Nowadays, this is commonly sent via email. This helps prevent delays in securing coverage. You can still print a copy and read through it on paper!
Once you have reviewed and accepted coverage with your signature, the policy will go into force. After this, most still allow for a 30 day free look period. This is the time you have to discontinue your plan for a refund of premiums paid.
You do not need to provide a reason. After the 30 days you can still discontinue your policy.
Term is commonly referred to as pay as you with no cancellation penalty. Cash value life insurance often has a surrender charge when you let it go.
Conclusion
Understanding how life insurance works gives you the confidence to get it in place! There are more details that go into life insurance but these are the basics that you need to get started.
Once you start shopping around for coverage, you can get more in depth information from the company. Working with an independent broker is usually the best route.
Brokers will have an array of companies that you can choose from. This means your chances of getting the best price are higher than if you go direct to one company.
