September 9, 2018

How Does a Life Insurance Policy Work?

Read more about Life Insurance

Life insurance provides a cash payout when the insured dies. Read on to learn who needs it and why. But be careful too. Don't make any of these mistakes.

© CreditDonkey

What Is Life Insurance

In simple terms, a life insurance policy provides a payout to your beneficiary at your death.

It goes like this: You choose your coverage amount, you pay a monthly premium, and upon your passing, the insurance company will pay the amount to your beneficiary. This amount is free from probate and is not taxed.

As long as you pay the monthly premiums, the insurance company will uphold the contract. But you're not obligated to pay either. If you stop paying, the policy will just lapse with no death benefit payout.

We'll go over the types of insurance and why people get them.

Types of Life Insurance: Term vs. Whole

There are two major types of life insurance: permanent and temporary. The two types serve different purposes.

  • Term Insurance
    Term insurance provides life insurance for a specific term (typically 10, 15, 20, or 30 years). If you die within the term, the insurance company will provide a payout. If you don't die, then the policy just ends.

    Policies can be renewed at the end of the term, but the premiums will be higher (as you're now older). Some policies can be converted to permanent insurance.

  • Whole Life Insurance
    Whole life is a type of permanent insurance. These policies are designed to remain in force for your entire life, as long as you keep on paying the premiums.

    There is also cash value accumulation. It's like a savings account that you can borrow against. And you'll be paid the cash value amount if you surrender the policy.

    Whole life is a lot more expensive. Initial premium payments can be as much as 10x higher than term premiums. Whole life only makes sense when coverage is needed for the insured's entire life.

Read more about all the different types of life insurance to see which is best for you.

Because whole life insurance is expensive, many whole life policies lapse during the first five years, completely negating the purpose of buying whole life insurance. Buying whole life insurance you don't need or that you will allow to lapse is an expensive mistake.

Which Is Better?

This depends on your unique situation.

Term vs. whole is like the difference between renting an apartment and buying a home. Renting costs less on an annual basis but provides no refund when you move out. Buying has a high mortgage payment, but it's also an investment and generates equity.

Which is the better financial decision? Let's break it down simply.

  • Term Life Insurance
    Best if you want the cheapest option and only need coverage for a specific period of time. For example: just until your children graduate college or your house is paid off.

  • Permanent Life Insurance
    Best if you need lifetime coverage, want flexibility to borrow, and can afford the premium. This is best for those with more complex needs, such as if you need to pay estate taxes or have a special-needs child.

Read more about the differences between term and whole life insurance.

Life insurance agents make a living by earning commissions on their sales. Term policies earn a smaller commission than whole life policies. If your agent recommends whole life insurance for temporary needs, use a different agent.

Why Do People Buy Life Insurance?

© CreditDonkey

The main reason to buy life insurance is to provide financial security to loved ones. But it's not the only motivation. There are three major reasons people buy life insurance:

  1. Provide for Their Families
    Life insurance provides a way to take care of your family after your death. When a spouse dies without life insurance, the family can plummet into a desperate financial situation.
    Life can insurance be used to:
    • Pay your funeral costs
    • Pay bills associated with your final illness
    • Pay off your debts, including your mortgage
    • Replace the income that you provided to your family
    • Provide funds to put your children through college
    • Help your spouse with funds for retirement
    • Serve as inheritance to your children
    • Provide funds to care for a special-needs child
    • Pay estate taxes

  2. Leave a Legacy
    Another reason people buy life insurance is to leave something to a cause they care about.

    • Provide funds to a charity you support.

    • Establish a scholarship fund in your name.

    • Fund a park or other lasting legacy to benefit your community.

  3. Fund a Buy/Sell Business Agreement
    It's smart for business owners to buy life insurance. If you have a business partnership, things can get messy if a partner dies and his/her half goes to the spouse. Life insurance can:

    • Provide funds that your business partner can use to purchase your share of the business from your estate.

    • Provide funds for your business to hire someone to provide the expertise you contributed so that your business will survive your death (key man insurance).

What kind do you need

The choice between term and whole insurance comes down to the question of whether you need temporary or permanent coverage.

It's important to think about what you need now and what you need in the future. You should only buy the coverage you need so that you're not wasting money.

Here's a break down of the common things life insurance is used to help pay for, so that you can have a better idea of which policy you should choose.

  • Funeral Costs
    Though it sounds like it, this does not require permanent insurance. Many people have savings or pre-pay for their funeral so there is no expense at the time of their death. Or term insurance can provide enough funds for funeral expenses.

  • Final Illness Medical bills
    These medical bills are based on how much health insurance you have and whether it covers your expenses. If you have good health insurance, this is not a permanent need.

  • Debts Including Mortgages
    This need is temporary. You can take out a term insurance policy that lasts until your mortgage is paid off. Or you may not even need insurance. If your retirement income is enough to pay the mortgage after your death, life insurance is not needed for this purpose.

  • Income Replacement
    This is temporary. You can get a term policy that lasts until your spouse retires or your kids are grown. If you have young children, your coverage may need to be as high as 15x your annual income. If you have a child with special needs, it can be even higher.

  • Income Replacement During Retirement
    First, know whether you will continue to get retirement income after your death. If it's from investment income, it will continue after your death. If it's from a pension, that depends on whether you elected survivor's benefits for your spouse.

    In most cases, this is a temporary need. If your spouse can't get survivor's benefits from your pension, consider using insurance to provide financial security for your spouse.

  • Care for a Special-Needs Child
    You want to be covered as long as the child lives. Add twenty years to the physician's life expectancy estimate to be on the safe side. If your child could outlive you, then you'd want permanent insurance to have life-long coverage.

  • College Funds
    You only need temporary insurance until your children complete college.

  • Estate Taxes
    You'd want permanent insurance to ensure that the coverage lasts your whole life. This way, your heirs will have the funds to pay your estate taxes after your death.

  • Legacy Needs
    This requires permanent insurance. To fulfill your desire to leave a legacy, the life insurance must be in force when you die.

  • Business Needs
    In most cases, you just need temporary insurance. The need for business-related insurance ends when you sell the business or retire.

How can insurance companies pay a large death benefit in exchange for small premiums?

Life insurance works because of the law of large numbers. Most insured people will not die, so the company won't have to pay out. The insurance company can statistically estimate how many clients will die in a given year.

So it can calculate how much each person must pay to ensure they collect enough to pay the claims. The insurance company also invests the money to earn returns.

3 Important Questions to Ask Yourself

  1. How to recognize when you need life insurance?
    If someone depends on your income or services you provide (such as taking care of the home and children), you need life insurance.

  2. How much insurance do you need?
    Add up all the reasons you are buying insurance. If your children are young, you may need as much as 15x your annual income. If your children are older, 7x your annual income may be enough unless they're headed to private universities.

    Read our detailed article on how to calculate how much insurance you need.

  3. Which type of policy do you need?
    For most people, term insurance is enough to cover temporary needs. Permanent insurance is mostly for special cases where you need life-long coverage. Only buy permanent insurance for permanent needs.

3 Life Insurance Mistakes to Avoid

  1. Not Buying Enough Life Insurance
    Many young parents don't buy life insurance, assuming that it's too expensive. Or what they buy isn't enough. Think about what you want for your family. Do you want to cover daily living expenses, pay off debt, and send the kids to college? Make sure you get enough coverage.

  2. Buying the Wrong Type of Insurance Most people do not need permanent insurance. Some are convinced they should buy it to accumulate cash for their retirement or to pay for their children's college expenses. Permanent insurance is much more expensive than term, so most families can't afford the coverage they need. It is more important to have enough insurance than it is to have lifelong coverage.

  3. Not Periodically Reviewing Your Beneficiaries
    It's important to review your beneficiary designation from time to time, especially when there is a birth, death, marriage, separation, or divorce in the family. Failure to update your policy frequently causes these agonizing mistakes:

    • The ex-spouse gets the life insurance
    • Younger children are excluded because they were born later and never added
    • A new spouse is not added to the policy

Bottom Line

If you have anyone who depends on your income or services, you need life insurance. Your loss could be a huge financial burden. Life insurance will help to relieve that.

Term life insurance is simple and cheap and provides a payout should you die within the term. A permanent life insurance policy has lifelong coverage and has an additional cash value benefit.

Think carefully about what kind of coverage you need and for how long.

Write to Jeanine G at Follow us on Twitter and Facebook for our latest posts.

Read Next:

What is Life Insurance

Types of Life Insurance

Why Life Insurance

Life Insurance

Quotacy Review

Quotacy lets you get multiple life insurance quotes online in one place. It doesn't cost any money to use, but is it legit? Read this review for the pros and cons.
Leave a comment about How Does a Life Insurance Policy Work?
Email (won't be published)

Online Term Life Insurance

A good online life insurance policy can protect your family in minutes. Take a look at the most trustworthy companies to buy from.

About CreditDonkey
CreditDonkey is a life insurance comparison website. We publish data-driven analysis to help you save money & make savvy decisions.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed on this page are those of the author's alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.

†Advertiser Disclosure: Many of the offers that appear on this site are from companies from which CreditDonkey receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). CreditDonkey does not include all companies or all offers that may be available in the marketplace.

*See the card issuer's online application for details about terms and conditions. Reasonable efforts are made to maintain accurate information. However, all information is presented without warranty. When you click on the "Apply Now" button you can review the terms and conditions on the card issuer's website.

CreditDonkey does not know your individual circumstances and provides information for general educational purposes only. CreditDonkey is not a substitute for, and should not be used as, professional legal, credit or financial advice. You should consult your own professional advisors for such advice.

About Us | Reviews | Deals | Tips | Privacy | Terms | Contact Us
© 2021 CreditDonkey