Life Insurance: What It Is, How It Works, & How To Buy a Policy

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Life insurance is an agreement between an individual and an insurance company, in which the insurer promises to pay a designated beneficiary a sum of money upon the insured individual’s death. The amount paid out to the beneficiary is typically determined by the amount of coverage purchased by the insured person.

In this article, we will discuss the importance of insurance, including why it is essential to consider when planning for the future. Additionally, we will explore the various types of insurance policies available and the factors that determine the cost of coverage.

Meanwhile, by the end of this article, you will have a better understanding of why insurance is crucial, what types of policies are available, and how to determine the appropriate coverage for your needs.

What is Life Insurance?

Life insurance is a financial product designed to provide a lump sum payment to your designated beneficiaries in the event of your death. This payment can be used to cover expenses such as funeral costs, outstanding debts, and ongoing living expenses for your loved ones.

There are several types of life insurance policies available, each with its own unique features and benefits. The most common types of insurance policies are term insurance, whole life insurance, universal life insurance, and variable life insurance.

Term life insurance provides coverage for a specific period of time, typically between one and 30 years. If the policyholder passes away during the term of the policy, the beneficiaries receive a death benefit. Term life insurance policies are generally less expensive than other types of life insurance and are a good choice for those who need coverage for a specific period of time.

Whole life insurance is a type of permanent life insurance that provides coverage for the entire life of the policyholder. In addition to the death benefit, whole life insurance policies also have a cash value component that grows over time. This cash value can be used to borrow against or withdraw from the policy.

Universal life insurance is another type of permanent life insurance that provides flexibility in both the premium payments and death benefit. The policyholder can adjust the premium payments and death benefit as their needs change over time. Like whole life insurance, universal life insurance policies also have a cash value component.

Variable life insurance is a type of permanent insurance that allows the policyholder to invest the cash value component in various investment options, such as stocks and bonds. The death benefit and cash value of the policy can fluctuate based on the performance of these investments.

When choosing a insurance policy, it’s important to consider your financial goals and needs, as well as your budget. A financial advisor or insurance agent can help you determine which type of insurance policy is best for you.

How Life Insurance Works

Life insurance is a contract between an individual and an insurance company in which the individual pays a premium in exchange for a payout to beneficiaries upon the insured individual’s death. The payout is typically tax-free and can be used by beneficiaries to cover expenses such as funeral costs, outstanding debts, or to supplement their income.

Factors affecting insurance premiums include age, health, gender, occupation, and lifestyle habits. Age is a significant factor in determining the cost of insurance premiums, as older individuals are generally considered to be at a higher risk of death. Health is also a crucial factor, as individuals with pre-existing medical conditions may face higher premiums, or may be denied coverage altogether.

Gender is another factor that can influence insurance premiums, as women are generally considered to have a longer life expectancy than men, which can result in lower premiums. Occupation can also play a role in determining life insurance premiums, as individuals who work in high-risk jobs such as mining or construction may face higher premiums.

Lastly, lifestyle habits can affect insurance premiums, with individuals who smoke, drink excessively, or participate in high-risk activities such as skydiving or rock climbing facing higher premiums. It’s important to note that insurance premiums can vary significantly based on these factors, so it’s essential to shop around and compare policies before making a decision.

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Who Needs Life Insurance?

You need insurance if you need to provide security for a spouse, children, or other family members in the event of your death. Life insurance death benefits, depending on the policy amount, can help beneficiaries pay off a mortgage, cover college tuition, or help fund retirement. Permanent insurance also features a cash value component that builds over time.

What Affects Your Life Insurance Premiums?

■ Age (life insurance is less expensive)

■ Gender (female tends to be less expensive)

■ Smoking (smoking increases premiums)

■ Health (poor health can raise premiums)

■ Lifestyle (risky activities can increase premiums)

■ Family medical history (chronic illness in relatives can raise premiums)

■ Driving record (good drivers save on premiums)

Benefits of Life Insurance?

■ Payouts are tax-free. Life insurance death benefits are paid as a lump sum and are not subject to federal income tax because they are not considered income for beneficiaries.

■ Dependents don’t have to worry about living expenses. Most policy calculators recommend a multiple of your gross income equal to seven to 10 years that can cover major expenses like mortgages and college tuition without the surviving spouse or children having to take out loans.

■ Final expenses can be covered. Funeral expenses can be significant and can be avoided with a burial policy or with standard term or permanent life policies.

■ Policies can supplement retirement savings. Permanent life policies such as whole, universal, and variable insurance can offer cash value in addition to death benefits, which can augment other savings in retirement.

Avoiding Taxes

The death benefit of a insurance policy is usually tax-free. Wealthy individuals sometimes buy permanent insurance within a trust to pay estate taxes. This strategy helps to preserve the value of the estate for their heirs.

Tax avoidance is a law-abiding strategy for minimizing one’s tax liability and should not be confused with tax evasion, which is illegal.

Who Needs Life Insurance?

Life insurance provides financial support to surviving dependents or other beneficiaries after the death of an insured policyholder. Here are some examples of people who may need insurance:

■ Parents with minor children. If a parent dies, the loss of their income or caregiving skills could create a financial hardship. Life insurance can make sure the kids will have the financial resources they need until they can support themselves.

■ Parents with special-needs adult children. For children who require lifelong care and will never be self-sufficient, insurance can make sure their needs will be met after their parents pass away. The death benefit can be used to fund a special needs trust that a fiduciary will manage for the adult child’s benefit.

■ Adults who own property together. Married or not, if the death of one adult would mean that the other could no longer afford loan payments, upkeep, and taxes on the property, insurance may be a good idea. One example would be an engaged couple who take out a joint mortgage to buy their first house.

■ Seniors who want to leave money to adult children who provide their care. Many adult children sacrifice time at work to care for an elderly parent who needs help. This help may also include direct financial support. Life insurance can help reimburse the adult child’s costs when the parent passes away.

■ Young adults whose parents incurred private student loan debt or cosigned a loan for them. Young adults without dependents rarely need insurance, but if a parent will be on the hook for a child’s debt after their death, the child may want to carry enough insurance to pay off that debt.

■ Children or young adults who want to lock in low rates. The younger and healthier you are, the lower your insurance premiums. A 20-something adult might buy a policy even without having dependents if there is an expectation to have them in the future.

■ Stay-at-home spouses. Stay-at-home spouses should have insurance as they have significant economic value based on the work they do in the home. According to Salary.com, the economic value of a stay-at-home parent would have been equivalent to an annual salary of $162,581 in 2018.

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■ Wealthy families who expect to owe estate taxes. Life insurance can provide funds to cover the taxes and keep the full value of the estate intact.

■ Families who cant afford burial and funeral expenses. A small life insurance policy can provide funds to honor a loved one’s passing.

■ Businesses with key employees. If the death of a key employee, such as a CEO, would create a severe financial hardship for a firm, that firm may have an insurable interest that will allow it to purchase a insurance policy on that employee.

■ Married pensioners. Instead of choosing between a pension payout that offers a spousal benefit and one that doesn’t, pensioners can choose to accept their full pension and use some of the money to buy life insurance to benefit their spouse. This strategy is called pension maximization.

■ Those with preexisting conditions. Such as cancer, diabetes, or smoking. Note, however, that some insurers may deny coverage for such individuals, or else charge very high rates.

Considerations Before Buying Life Insurance

Research Policy Options and Company Reviews

Because insurance policies are a major expense and commitment, it’s critical to do proper due diligence to make sure the company you choose has a solid track record and financial strength, given that your heirs may not receive any death benefit for many decades into the future. Investopedia has evaluated scores of companies that offer all different types of insurance and rated the best in numerous categories.

Consider How Much Death Benefit You Need

Life insurance can be a prudent financial tool to hedge your bets and provide protection for your loved ones in case of death should you die while the policy is in force. However, there are situations in which it makes less sense—such as buying too much or insuring those whose income doesn’t need to be replaced. So it’s important to consider the following.

What expenses couldn’t be met if you died? If your spouse has a high income and you don’t have any children, maybe it’s not warranted. It is still essential to consider the impact of your potential death on a spouse and consider how much financial support they would need to grieve without worrying about returning to work before they’re ready. However, if both spouses’ income is necessary to maintain a desired lifestyle or meet financial commitments, then both spouses may need separate life insurance coverage.

Know Why You’re Buying Life Insurance

If you’re buying a policy on another family member’s life, it’s important to ask—what are you trying to insure? Children and seniors really don’t have any meaningful income to replace, but burial expenses may need to be covered in the event of their death. Beyond burial expenses, a parent may also want to protect their child’s future insurability by purchasing a moderate-sized policy when they are young. Doing so allows that parent to ensure that their child can financially protect their future family. Parents are only allowed to purchase insurance for their children up to 25% of the in-force policy on their own lives.

Could investing the money that would be paid in premiums for permanent insurance throughout a policy earn a better return over time? As a hedge against uncertainty, consistent saving and investing—for example, self-insuring—might make more sense in some cases if a significant income doesn’t need to be replaced or if policy investment returns on cash value are overly conservative.

Qualifying for Life Insurance

Insurers evaluate each insurance applicant on a case-by-case basis, and with hundreds of insurers to choose from, almost anyone can find an affordable policy that at least partially meets their needs. In 2018 there were 841 insurance and annuity companies in the United States, according to the Insurance Information Institute.

On top of that, many insurance companies sell multiple types and sizes of policies, and some specialize in meeting specific needs, such as policies for people with chronic health conditions. There are also brokers who specialize in insurance and know what different companies offer. Applicants can work with a broker free of charge to find the insurance they need. This means that almost anyone can get some type of insurance policy if they look hard enough and are willing to pay a high enough price or accept a perhaps less-than-ideal death benefit.

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Insurance is not just for the healthy and wealthy, and because the insurance industry is much broader than many consumers realize, getting insurance may be possible and affordable even if previous applications have been denied or quotes have been unaffordable.

In general, the younger and healthier you are, the easier it will be to qualify for insurance, and the older and less healthy you are, the harder it will be. Certain lifestyle choices, such as using tobacco or engaging in risky hobbies such as skydiving, also make it harder to qualify or lead to higher rates.

How to Buy a Life Insurance Policy

Buying a life insurance policy is an important financial decision that requires careful consideration. To make the process easier, follow these steps:

A. Assessing your life insurance needs

The first step is to determine how much coverage you need. Consider factors such as your age, income, debts, and the financial needs of your dependents in case of your untimely death.

B. Choosing the right type of life insurance

There are two main types of life insurance: term insurance and permanent life insurance. Term life insurance provides coverage for a specific period, while permanent insurance offers coverage for your entire life. Choose the type that best fits your needs and budget.

C. Finding a reputable life insurance company

Research insurance companies and check their financial strength ratings. Choose a company with a strong reputation, high customer satisfaction ratings, and a history of paying out claims.

D. Comparing life insurance quotes

Get quotes from several different companies to compare rates and coverage. Consider factors such as the length of the policy, the death benefit, and any riders or additional coverage options.

E. Applying for a life insurance policy

Once you’ve chosen a policy and company, complete the application process. Be prepared to provide personal and financial information, and answer questions about your health and lifestyle.

F. Undergoing a medical exam

Many life insurance policies require a medical exam to determine your health and potential risk. The exam will typically include a physical exam, blood work, and a urine test.

G. Receiving your life insurance policy

After the application process and medical exam are complete, the insurance company will review your application and determine whether to offer you coverage. If approved, you’ll receive your policy and begin making premium payments. It’s important to review your policy carefully and ask any questions you may have.

Conclusion

In conclusion, life insurance is a type of financial protection that pays a lump sum of money to the beneficiaries of the policyholder in the event of their death. It provides peace of mind knowing that loved ones will be taken care of financially in the event of an unexpected tragedy.

Purchasing a life insurance policy is an important decision that should not be taken lightly. It can be difficult to think about the possibility of passing away, but it’s important to consider the financial impact that it could have on those left behind. Having a insurance policy can provide financial security for loved ones and can help cover expenses such as funeral costs, outstanding debts, and ongoing living expenses.

It’s important to choose a policy that suits your needs and budget. There are various types of life insurance policies available, such as term life insurance and whole life insurance, each with their own pros and cons. It’s recommended that you speak with a financial advisor or insurance agent to determine the best type of policy for your situation.

In conclusion, if you have loved ones that depend on you financially, it’s important to consider purchasing a life insurance policy. The right policy can provide peace of mind knowing that your loved ones will be taken care of in the event of your unexpected passing.


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