Life Insurance
Life insurance is a type of insurance designed to pay a sum of money to a beneficiary if the insured person dies. These policies were originally created so that if the main income earner of a household dies, the payout from the policy could be used to support his or her family. Over the last 50 years, life insurance policies have evolved in both form and function, and now often include an investment component and the ability to use the policy’s cash value during the insured’s lifetime.
How Does Life Insurance Work?
A life insurance policy is a contract between you and an insurance company. You make one or more premium payments to the insurance company, and in return, the insurer agrees to provide a payout, or “death benefit” after you die. If anyone depends on you financially, an insurance policy can be an important safety net to ensure that they are taken care of after you’re gone.
Parties to the Contract
There are typically four parties involved with any life insurance policy.
- Policy Owner. This is the person who is responsible for paying the premiums on the policy and is the legal owner of the policy.
- Insurer. This is the insurance company, the entity the policy owner pays in exchange for life insurance coverage.
- Insured. This is the individual whose life is actually being insured. If this person dies, the Insurer will pay out the death benefit.
- Beneficiary. This is the person who receives the death benefit from the insurer when the insured dies. The policy owner can usually change the beneficiary at any time. There can be more than one beneficiary on a policy.
In some cases, the policy owner and Insured may be the same person while the beneficiary is someone else. For example, a husband could purchase a life insurance policy for himself and list his wife as the beneficiary, or a mother might purchase life insurance for herself and list her child or children as beneficiaries.
The policy owner and beneficiary may be the same person with insurance covering someone else. This is common in large companies that take out life insurance policies on high-value employees. If the employee dies, the company receives a death benefit to help offset the loss of value from the employee.
All four parties can also be different. For example, a husband may take out a life insurance policy on his spouse with the children listed as beneficiaries.
How much does life insurance cost?
To establish how much they will charge you in premiums, the life insurance company will evaluate you as a risk, looking at factors such as your personal and family medical history, your overall health, and whether or not you smoke. Smoking is the quickest way to increase the cost of your premiums. In some cases, the insurer may even decline to offer you life insurance, for example if you are past a certain age or have severe health issues.
By purchasing group life insurance, usually through your employer, you may be able to skip the evaluation process. That’s because, with group insurance, the insurance company decides on an average cost for the entire group and charges each individual the same premium amount for the same death benefit.
Types of Life Insurance
There are several types of life insurance, each with different benefits and cost structures.
Term Life Insurance
Term life insurance is typically the least expensive type of life insurance. A term life insurance policy provides coverage for a specific period of time, usually 5, 10, or 20 years, then the policy expires. Term insurance policies are most commonly used by a head-of-household to insure themselves until they retire, with a spouse or other family members listed as beneficiaries. This provides financial security for a family when the main income provider dies.
However, term life insurance can also be used to insure the life of a stay-at-home parent, providing money to cover childcare, home maintenance or cooking services if that parent dies. The premiums for a term life policy will be fairly low for young, healthy people, but if the insured is older when the policy starts, their premiums will be higher. Some policies must be renewed each year. These typically start with a lower premium and increase that premium each year as the insured ages..
Permanent Life Insurance
While term life insurance covers you for a certain period of time, permanent life insurance can protect you and your family for your entire life, as long as you pay the premiums. It typically includes a cash value component and may allow you to pull some of that money out during your lifetime. Some types of permanent life insurance include those below:
Whole life offers level premiums, a guaranteed death benefit, and guaranteed cash value growth.
Universal life offers more flexibility than whole life, with the ability to adjust the amount of premiums you pay and your death benefit, as your needs change over time. The cash value of a universal life policy is typically tied to market interest rates.
Indexed universal life is similar to universal life, but its cash value growth is tied to the performance of a market index, such as the S&P 500 Index.
Variable universal life offers similar flexibility as universal and indexed universal life but differs in how the cash value can grow. In this case, the cash value is based on the performance of the investment options you choose. The insurer may offer a variety of stock, bond, or index-based investment options you can choose from. Unless you choose an investment option that is guaranteed, there is no guaranteed growth of the cash value with variable universal life; however, your investments have the ability to grow more than whole, universal, or indexed universal life, if the underlying investment options perform well.
Riders on a permanent life policy
Some permanent life insurance policies offer riders, or optional features or protections, usually for a slight increase in premiums. Those riders may allow you to:
- Accelerate the death benefit and use it to pay critical illness or long-term care expenses, or to pay for other costs if the insured is terminally ill.
- Guarantee that your policy will remain in force, regardless of how the market, index, or underlying investment options perform.
- Protect against market downturns or guarantee a certain credited amount on the cash value of your policy.
- Waive the policy’s monthly charges if the insured becomes disabled.
The flexibility of a policy’s cash value
If you opt for a permanent life insurance policy, you may have access to the policy’s cash value at some point. It’s best to talk to your financial professional and accountant about how much you can take out and if you’ll need to pay it back, as well as the tax consequences of those actions.
If structured properly, you may be able to take loans or withdrawals from the cash value tax free. In those cases, you could use those funds to:
- Supplement your retirement income. For example, you may want to pull cash value out of your life insurance policy in a year when the market is down, so as not to lock in market losses in your other retirement investment accounts.
- Pay for college education expenses. Some people purchase permanent life insurance policies when their children are little, allow the cash value to grow as the children grow, and use it for financial protection in case they die during that critical time before their children are on their own. If they haven’t needed the policy at the point when their children are in college, they can pull out some of the cash value to help pay tuition and other expenses.
- Pay for large, unexpected expenses. For example, if you suddenly need a new roof on your house and your homeowner’s insurance won’t cover the cost, or you need an expensive emergency medical procedure, you could potentially pull some of the cash value out of your policy to pay those costs.
Keep in mind that there may be restrictions on the amount of cash value you can take or you may need to repay loans to avoid paying taxes on the money withdrawn. Talk to your financial professional before taking cash value from your policy.
Challenge Questions
- List all the different types of Life Insurance mentioned above.
- How might someone use the cash value in a Life insurance policy?
- Why would someone want to include a rider with their life insurance policy?
- Who are the four parties involved in a life insurance contract?