Life insurance is a contract between an individual (the policyholder) and an insurance company, where the insurance company promises to pay a designated beneficiary a sum of money upon the death of the insured person. Here’s a detailed breakdown of how life insurance works:
Key Components
- Policyholder: The person who owns the life insurance policy and is responsible for paying premiums.
- Insured: The person whose life is covered by the policy. In many cases, the policyholder and the insured are the same person.
- Beneficiary: The person(s) or entity (e.g., trust) designated to receive the death benefit when the insured person dies.
- Premium: The payment made by the policyholder to the insurance company to keep the policy active. Premiums can be paid monthly, quarterly, annually, or as a lump sum.
- Death Benefit: The amount of money paid to the beneficiary upon the death of the insured person.
- Term: The period during which the policy is in effect. This can be a specific number of years (term life insurance) or for the lifetime of the insured (whole life or universal life insurance).
Types of Life Insurance
- Term Life Insurance:
- Provides coverage for a specified term (e.g., 10, 20, 30 years).
- Pays a death benefit only if the insured dies during the term.
- Generally has lower premiums compared to permanent life insurance.
- Does not accumulate cash value.
- Permanent Life Insurance:
- Provides coverage for the insured’s entire life as long as premiums are paid.
- Includes whole life, universal life, and variable life insurance.
- Accumulates cash value, which can be borrowed against or withdrawn.
- Generally has higher premiums than term life insurance.
How It Works
- Application and Underwriting:
- The policyholder applies for coverage, providing personal and health information.
- The insurance company evaluates the risk of insuring the individual through a process called underwriting. This may include a medical exam and review of medical history.
- Based on the risk assessment, the insurance company determines the premium amount.
- Premium Payments:
- The policyholder pays premiums as agreed in the policy. This can be monthly, quarterly, annually, or as a lump sum.
- If the policyholder stops paying premiums, the policy may lapse, and coverage will end.
- Accumulation (for Permanent Policies):
- Permanent life insurance policies accumulate cash value over time. This is a portion of the premium that is set aside and grows tax-deferred.
- The policyholder can borrow against or withdraw from the cash value, but this may reduce the death benefit.
- Death Benefit:
- When the insured person dies, the beneficiary files a claim with the insurance company, providing a death certificate.
- The insurance company reviews the claim and, if everything is in order, pays out the death benefit to the beneficiary.
- The death benefit is generally not subject to income tax.
Considerations
- Cost: Premiums vary based on the insured’s age, health, lifestyle, and the amount of coverage.
- Coverage Needs: The amount of life insurance needed depends on factors like debt, income replacement, future expenses (e.g., education), and the financial needs of dependents.
- Policy Terms: Understanding the terms and conditions, including exclusions and limitations, is crucial.
- Riders: Additional benefits or coverage options can be added to a policy, such as accidental death benefit, waiver of premium, and critical illness coverage.
Example
- Term Life Insurance: A 30-year-old non-smoking male buys a 20-year term life insurance policy with a $500,000 death benefit. He pays an annual premium of $300. If he dies within the 20-year term, the beneficiary receives $500,000. If he survives the term, the policy ends, and there is no payout.
- Whole Life Insurance: A 30-year-old non-smoking female buys a whole life insurance policy with a $500,000 death benefit. She pays an annual premium of $2,500. Part of her premium goes towards the death benefit, and part goes into a cash value account. Over time, the cash value grows, and she can borrow against it. When she dies, her beneficiary receives the $500,000 death benefit.
Understanding these aspects of life insurance can help individuals choose the right policy to meet their financial protection needs.
