How Does Life Insurance Work?
If you will have debts to pay off or loved ones to care for if something happens to you, then you probably need to carry some form of life insurance. Life insurance is a legal contract between the policy owner, the insured (who is also often the policy owner), the insurance carrier and the beneficiary. In this arrangement, the policy owner signs a contract giving him or her the legal responsibility to pay a predetermined amount of premium to the life insurance company while the insured person on the policy lives (or else for a predetermined length of time). The life insurance carrier in turn agrees to pay a predetermined amount, known as the death benefit to the beneficiary or beneficiaries on the policy. This is how all life insurance policies work.
What you will learn:
Term vs. Perm
There are two main types of life insurance policies. Term life insurance is the simpler type of the two. With term insurance, the life insurance carrier provides pure death benefit protection upon the death of the insured. Permanent life insurance is more complex in nature than term. With permanent life insurance, part of each premium that is paid goes into a cash value account that is linked to the policy. This cash value grows tax-free and builds up over time. It can be used somewhat like a savings account by the policy owner, who has the right to withdraw money from the cash value in the policy at any time. Because of its simplicity, term insurance is much cheaper than any form of permanent coverage. This means that policy owners can usually afford to pay for a much larger death benefit with fewer dollars than they can get with permanent coverage. But permanent coverage is guaranteed to stay in force for however long the insured lives as long as the premiums are paid. Buying term insurance can be considered “renting” life insurance coverage, while permanent life insurance is considered to be a form of ownership.
Types of Permanent Coverage
Permanent life insurance can be further subdivided into three categories. The first type of permanent coverage is called whole life insurance. This is by far the oldest form of life insurance coverage in existence today. As the name implies, it is designed to last for the insured’s entire life. The policy builds up cash value by paying dividends, which are technically partial refunds of premium paid. Whole life is the most conservative form of permanent insurance.
Universal life insurance is a more flexible form of coverage because the premiums are usually flexible and the policy pays interest into the cash value component over time instead of dividends. The rate of interest paid by the policy is dictated by the current interest rate environment, but there is usually at least a minimum rate of interest that is guaranteed. Many universal policies today pay interest that is linked to the performance of an underlying financial benchmark, such as the Standard and Poor’s 500 Index. This type of product is known as indexed universal life, or IUL.
Variable universal policies represent the final frontier in life insurance products. These policies are just like straight universal policies or IULs in nature, except that their cash values are invested in mutual fund subaccounts that rise and fall in tandem with the stock, bond and real estate markets. It is possible for the policy owner to lose money in this type of policy if the values of the subaccounts decline. Variable universal life insurance policies are generally regarded as one of the most, if not the most complex type of financial product available in the marketplace today.
How Much Life Insurance Do I Need?
Knowing how much life insurance to carry is usually the bedrock of any financial plan for most clients. The answer to this question depends upon several factors, such as the financial condition of the policy owner and the size and ages of his or her family. For example, if you are single and have no debt, then you may need little or no coverage. But if you have three kids under age 12, a spouse who does not work and a large mortgage, then you probably need a large amount of coverage. Most financial planners would recommend that someone in the latter example should purchase a policy with a death benefit equal to at least five to ten times their annual salary. At the very least, the coverage should be enough to pay off the mortgage and any other debts carried by the insured. But in many cases, additional funds will be needed to pay for college educations, special needs expenses, funeral and burial costs and other assorted items. These expenses would also most logically be covered with life insurance.
Life Insurance Beneficiaries
As mentioned previously, the beneficiary of a life insurance policy is the party who receives the death benefit when the insured dies. The beneficiary can be a single person, two more persons, a corporation, a partnership, a trust or any other legal entity that is capable of taking material receipt of the funds. Some beneficiaries opt to receive their entire death benefit in one lump sum, while others choose to receive it over a period of time, such as five years or even their entire life expectancies.
So what are the Best and Worst Types of Life Insurance for Me?
There is no one single right answer to this question. The only concise answer that a financial planner could give you is that it all depends. It depends upon your financial situation and life circumstances as well as your financial goals and objectives. If you are a young parent with small children and your spouse doesn’t work, then a permanent policy is probably not right for you at this point. If you are getting up in years and decide that you want to leave a legacy for your heirs, then a term policy is probably not a good fit, as these policies become increasingly expensive for older policy owners and eventually become prohibitively expensive at some point. Consult with your financial advisor or insurance agent for more information about life insurance and which type is best for you.