We buy insurance for our cars, homes, and property. Insurance covers are meant to cover us from the losses if the insured things are damaged, lost, or stolen. Life is beyond our control, and we cannot attach any amount of money to an individual’s life. So, what exactly is life insurance? Is it practical to get an insurance cover for one’s life?
Life insurance is often misunderstood purely because its concept is different from all the other insurance policies. Here, you rely on the cover to give your loved one’s solid financial protection when you leave. In essence, you are insuring your dependents from the lost financial power when something terrible happens to you.
In this piece, we will break down what life insurance is all about to help you understand what you are signing up for when you decide to buy one.
What is Life Insurance?
This is a contract between an insurance company and an individual or entity. The individual in the contract deposits premium payments and the insurance company will pay a lump sum called the death benefit to your beneficiaries.
There are a few variations to the kinds of life insurance available, and these will be mentioned further below. However, it is vital to understand the key parties and terms in a typical life insurance policy.
Most life insurance policies identify the following:
- The insurer – This is the insurance company you are getting into a contract with. Only certain companies provide life insurance as the government heavily regulates this space.
- The policyholder – This is the entity that owns or holds the policy. It could be an individual, family trust or business. The policy can ensure the holder or another person.
- The insured – This is the person whose life is insured.
- The death benefit – This is the total amount the insurer will pay when the insured passes away.
- The beneficiaries – These are the entities that will receive the death benefits. It can go out to an individual or be shared among a group of people depending on the policyholder’s policy specifications and instructions.
- The term – This is the period that the insurer agrees to pay a death benefit. It varies from policy to policy.
- The cash value – Life insurance policies have a cash value that accrues over time. This value can be cashed out or borrowed against. Some life insurance policies have no cash value.
Who Needs Life Insurance?
Choosing to take life insurance or not is a decision you have to make. The law does not require you to take it, but it would be best to have it if your situation dictates it. Some people consider it an additional cost, and the big question is that is it worth it?
Most families depend on the income of a working adult. Losing this income can spell trouble for the family, especially if young members need money for education, upkeep, rent, and mortgage payments. Life is unpredictable, and you cannot predict when you will lose someone.
This is one of the main reasons why you should take life insurance. Most people live in homes purchased through mortgages, and these payments total to huge sums every month.
If the working adult paying the mortgage passes away, the remaining family members might find it challenging to keep up with these payments, leave alone find another place to stay if they cannot pay.
This explains why most mortgage lenders advise their clients to take up a life insurance policy. But what if you are not buying a home, or already own one? Why should you take this policy?
One life event that can prompt you to take up life insurance is when you get married. One perk of marriage is knowing that your partner can provide support and companionship for life.
However, many women lose their partners and vice versa, meaning that people are left with the financial burden of a mortgage, children’s upkeep, and other living expenses to handle on their own.
To avoid such situations, many newlyweds are requested to take up life insurance. When you get a baby, the responsibility multiplies as the little person relies on you for a good life. Here, taking life insurance is also prudent.
How Much Coverage Should You Take?
Life insurance has no cap, and the more you pay, the more your beneficiaries will get when you pass away. However, it does not make sense to pay a lot until you remain with very little to lead the comfortable life you want here on earth. This way, try to assess your current situation and use this to establish how much cover you should take.
If you want to cover the mortgage, working out how much you need should be straightforward. This is because the payout should be sufficient to clear the mortgage balance and secure the home for your dependents.
If you want to give your family a regular income after death, look at how much you provide currently and use this to inform the life insurance cover you take. Other things to look at are your age and whether you want to leave the family members with inheritance and some money to cater for the funeral costs.
Combine all these factors and come up with a suitable amount. A life insurance advisor can help with this as you need to strike a balance between leaving something substantial for your dependents and enjoying your money as you live.
Types of Life Insurance
Today, you will find various forms of life insurance policies sold by various companies. However, there are two primary forms of life insurance, and all the others fall in either category.
These principal forms of life insurance are – term and whole life.
Term Life Insurance
This is the simplest form of life insurance. It pays out benefits if the insured person dies within the term of the policy. Terms range from one to thirty years. Once the term elapses, the policyholder can either renew it for another term or convert it to permanent coverage.
How Does It Work?
When you go to buy term life insurance, the company determines the premiums based on the payout amount. Other things that also come into play include your age, gender, and medical condition. In some instances, the company might require you to undergo an independent medical assessment from one of their doctors.
The company might also be interested in your driving record, current medications, drug abuse status and family history.
The payout to your beneficiaries when you pass on is not taxable in most cases and can be used to settle healthcare, funeral, and mortgage costs, among others. If the policy terminates, in that the period ends while you are still alive, there won’t be a payout.
When you opt to renew a policy whose term is about to end, the insurance company will have to calculate new premiums based on your current health, age, and current medications. In simple terms, the insurance company will take the measures they took when you initially applied for the policy and come up with new terms for it.
Term insurance has no value other than the benefits paid out to beneficiaries when you pass on. It has no savings aspect as it will be seen with whole life insurance policies.
Looking at this policy’s restrictions, it is one of the cheapest life insurance covers you will find today. For instance, a healthy person in their mid-thirties can get a 20-year life insurance cover with a face value of $250,000 for about $20 or $30 per month.
A whole life equivalent will cost about ten times more in premiums. The overall risk here is lower to the insurer since most policies expire without paying the death benefit. This lower risk allows insurers to charge low premiums. Other things that affect the rate of premiums are interest rates and the company’s financial status and state regulations.
Types of Term Life Insurance
There are a few variations of term life insurance policies. They include:
Level term policy
Here, the insurance provides cover for a specified period between ten and thirty years. The death benefits and premiums are fixed from the word go. However, insurance costs do not stay constant over the long run, say ten years, and companies must account for this. However, they do not pass this cost in the form of increased premiums. To make up for this, the policy often costs more than the yearly renewable term life insurance.
A yearly renewable term policy
This policy has no specified term and can be renewed after every year. You do not have to give evidence of insurability for the renewal to be accepted. The premiums, however, change every year as your status change to account for age, and changing health status. This way, premiums can become expensive as you age, making it unattractive for many.
Decreasing Term Policies
This cover has a death benefit that decreases every year based on the agreement. However, the policyholder pays a fixed premium for the entirety of the policy. This cover is mostly used when there is a mortgage in the picture to match the coverage with the home loan’s declining principal.
Note that insurance companies have various variations to these life insurance policies and check with your specific company to see that the terms are right for you.
What is Group Term Life Insurance?
This is a select type of term insurance issued to a large group of people. It is mostly given by companies that take a life insurance cover for their employees. Here, the company is the joint group that gets the contract and then issues coverage to benefit employees.
Today, most companies provide a base amount as group coverage at no cost to their employees and give them the ability to purchase supplemental coverage for their employee’s spouses and children. It is comparatively inexpensive compared to individual life insurance due to the number of people covered under it.
How Does It Work?
Approximately 85% of companies offer group life insurance as a benefit to employees for free. They are listed as term insurance and given to employees who meet specific criteria, such as being a permanent employee or a few days after they are hired. It can also be adjusted to meet special life events according to the policy specifications.
The standard amount of cover is equivalent to the employee’s annual salary. Employers mostly pay the premiums for basic coverage. The employee can opt to pay for additional coverage that requires higher premiums.
Note that if your employer offers term life insurance, you might not be allowed to take it with you when you change jobs.
The Good and Bad of Group Term Life Insurance
Group term life insurance can be good or bad, depending on the company taking it. It can be cheap, especially for younger participants who may not be required to undergo a lot of scrutiny like their elder counterparts.
Insurance companies are flexible with the terms of these policies depending on the company’s requirements taking the contract, and all these specifications are outlined in the agreement.
However, individuals should be keen to check whether group life insurance coverage is enough as some of them are meager. Here, you might be required to combine it with an additional cover to protect your loved ones sufficiently.
Most employers limit cover based on factors such as base salary, role, kind of employment, and tenure and always check and supplement it if necessary. Besides, group term life insurance is also contingent upon employment, and if you change jobs, you will be left vulnerable.
Permanent Life Insurance
This is the general term for life insurance policies that do not expire. Their key distinction from term insurance policies is that they have a death benefit and savings portion.
How Does Permanent Life Insurance Work?
Just as the name suggests, these policies are not tied to a specific period. They last the entire lifetime of the insured. One of the main reasons why this policy may lapse is the nonpayment of premiums. The premiums paid to go toward maintaining the death benefits to the beneficiaries and building cash value.
The policyholder can borrow funds against the cash value or withdraw funds to help meet specific needs. Most policies have a waiting period against which borrowing against the savings is not permitted to help the cover build up sufficient cash value.
One favorable feature of this cover is that it allows one to grow cash value on a tax-deferred basis. Here, the policyholder pays no taxes on earnings as long as the policy remains active.
If you meet specific premium payment requirements, you can withdraw money from the policy without paying taxes. Mostly, withdrawals up to the total amount of premiums paid can be taken without paying for taxes. Note; Most term insurance policies give you the option to convert to permanent life insurance before the term expires.
Types of Permanent Life Insurance
Whole Life Insurance
This is the base type of permanent life insurance. It provides coverage for the insured’s life and contains a savings component that allows you to accumulate cash value.
This is also referred to as traditional life insurance, and most of the other policies are variations of it. While this is the benchmark policy, it is not the same as permanent life insurance which is the umbrella term for all the other policies we will discuss below.
How Does It Work?
Since whole life insurance is the base type, it does not work any different from permanent life insurance. It guarantees a death benefit to beneficiaries in exchange for level and regularly paid premium payments.
It also has a savings portion, called the cash value, alongside the death benefit. In the savings portion, interest accumulates based on a tax-deferred benefit.
To build more cash value, a policyholder can pay more than the specified premiums. Dividends can also be reinvested into the cash value and earn interest. The cash value is a living benefit to the policyholder and can also serve as a source of equity. Unpaid loans reduce the death benefit by the outstanding amount.
Universal Life Insurance
This is a form of permanent life insurance with an investment savings element and low premiums similar to those of term life insurance. Most UL policies have a flexible premium option. Others require a single lumpsum premium of scheduled fixed ones.
How Does It Work?
One main feature that distinguishes universal life insurance is that it offers more flexibility than a whole life cover. Policyholders can change their premiums and death benefits. UL insurance premiums are made up of two parts, i.e. a cost of insurance amount and a saving component called cash value.
The COI is the minimum amount of premium payment needed to keep the policy active. It is an amount that takes into consideration several other things. It includes charges for mortality, policy administration, and other expenses required to keep the policy active. It varies from policy to policy based on age, insurability, and risk amount.
Additional premiums above the COI accumulate in the cash value section of the policy. With time, the COI increases but, in some cases, the accumulated cash value will cover the increase in COI, which lets you pay a constant amount.
One benefit of this cover is the cash value. It earns interest based on the current market rates, and as it accumulates, holders can access a portion of it without affecting the death benefit. However, those who make withdrawals will have to pay taxes from the excess cash value of the UL plan.
The flexible premiums are an upside of this policy, and holders can remit more than the COI if they wish to boost the cash value of the policy. If there is enough cash value, they can skip premium payments and face no sanctions.
Variable Universal Life Insurance
This is a Universal Life Insurance policy with additional features. It has flexible premium payments in exchange for a death benefit and cash value portion.
This policy has a maximum cap and minimum floor associated with the savings aspect. It has investment subaccounts that let you invest the money in the cash value component.
The subaccounts work in the same way as mutual funds. The ROI depends on market rates, and the fluctuations can result in significant returns or losses. The name variable is derived from how its cash value is exposed to a fluctuating investment market.
Term vs Permanent Life Insurance
Suppose you are looking to choose between term and permanent life insurance policies. In that case, you need to understand the similarities and differences as they will state what is suitable for you or not. Here, we will highlight some of the key points that define a life insurance policy to help you pick between term and permanent life coverage. They include:
Length of coverage
Term life insurance covers you a fixed period, whereas permanent insurance is designed for the rest of your life as long as you keep it active by meeting the specified requirements.
Cost of premiums
Term life insurance has lower premiums than permanent life cover due to the nature of the policies. However, term insurance premiums rise after every renewal, but permanent life cover can have the same premiums for the rest of your life.
Most permanent life insurance policies have a savings aspect called the cash value. It allows you to access the funds in case of an emergency or even borrow a loan against it. The longer you pay the premiums, the more the cash value grows.
Term insurance does not have a savings component, and the only benefit is a payout to your beneficiaries when you pass on.
Term life insurance policies can be converted to permanent policies. The reverse is not possible.
Both term and permanent life insurance policies guarantee a death benefit when the insured passes on, and the policy is still active.
How to Choose the Best Life Insurance Policy
Picking the right life insurance policy requires you to decide on various matters such as the type, company, and cost. It is hard to find the right balance, but you should be well equipped to get one that suits you perfectly with the tips below.
Assess Your Needs
The first step to getting the right life insurance policy is by determining what you need. What do you expect from the coverage?
Do you have a young family that you want to be covered? Do you need an avenue to build sufficient cash value for the long term? These are some of the questions you need to ask yourself before you start shopping for a specific policy. There is no perfect life insurance policy in the market as it all depends on what suits your situation well.
Compare and Contrast
Do not settle for a life insurance policy before looking at what several companies offer. Today, the internet has made it easy to check out how these life insurance policies fare, and you can use various policy comparison tools to find the best one.
Leverage the power of online reviews posted on various websites today to look at how different companies rank in terms of different features such as customer service, the application process, and user experience, among others.
Establish the Cost
One way of determining the life insurance you need is by looking at how much you need. If you want to secure your family’s financial well-being, then review various factors to help you figure out the right amount. How much money will sustain them for a specified time?
However, you need to balance leaving a fortune for your family and living comfortably while you are still alive. This is because a life insurance cover with a tremendous value might force you to pay higher premiums, which will reduce the amount of money you have currently.
When picking a life insurance policy, one major thing that you need to establish is whether you will go for a term or permanent insurance. Here, we will highlight a few scenarios that will help you point the right policy and what works for you.
Consider term insurance if you need the policy for a specific time. It allows you to align the term of the policy to your time-sensitive needs. For instance, if you have young children and want to secure their education by keeping some funds to pay for their college fees, a 20-year time life insurance policy might be the most suitable choice for you.
Another instance where you might need term life insurance if you need cover but have limited funds. Permanent policies can be expensive due to the additional benefits they have, but term insurance can guarantee you a payout to your beneficiaries if something happens for you within the specified term. In a nutshell, term life insurance gives you some sort of cover at a lower cost.
Permanent life insurance is the costly option that guarantees your beneficiaries some cover without any restrictions on time. It also comes out as a great option if you need to accumulate a savings element that will grow without being taxed. It can be used as collateral for a mortgage or loan, but note that this comes at an extra cost.
Answer: Life insurance policies are not perfect and will exclude certain things. There are a couple of exclusions that come into play, and they vary from policy to policy. For instance, you might be denied payout on a policy when the insured commits suicide or dies within two years of taking the policy.
Additionally, the policy might be rendered invalid if you lied about your health status. Ensure that you know the terms and conditions of your life insurance policy from the word go to understand what you are signing up for to avoid any upsets later.
Answer: Luckily, you can check on numerous insurance company ratings when assessing various providers to bring out the best one. However, the wealth of ratings across the internet can be overwhelming to the point that it becomes hard to draw a meaningful conclusion.
This way, it helps to know some of the top sources of ratings that can inform your decision. Example of third-party ratings can be trusted include those from A.M Best and Moody. You can also check out ratings from Better Business Bureau and J.D Power. Pay extra attention to recurring complaints and how they were addressed.
Answer: It all depends on the terms of the specific life insurance policy you buy. Some will make you wait for four or five years before it becomes active. However, the average waiting period is between one and two years.
Some of the essential things you need to understand regarding life insurance policies have been mentioned. You should be in a better place to pick the right policy from the wealth of options out there. Remember that there is no perfect policy out there as it all depends on what suits your situation.
This way, what works for someone else might not work for you. Take your time and assess the options using various life insurance policy comparison tools out there to point out the perfect one.