Life insurance is an integral part of estate planning. It can be purchased at any age, although eligibility and pricing can vary significantly. Life insurance might seem complicated, but it's not. In this article, I'll explain to you what life insurance is in the most basic terms. In addition, I'll answer all your questions on how does life insurance work? By the end of this article you'll know how to get the best type of life insurance possible for you and your family.
What Is Life Insurance?
Life insurance is an “if, then” exchange contract between you and an insurance company. Typically, you pay a life insurance company a monthly premium to insure your life. If you die before your insurance policy runs out, the insurance policy pays out a “death benefit amount” (face value) to your beneficiaries.
The beneficiaries are decided by you. And you can change them whenever you want, as often as you like. Although your beneficiaries don't have to be notified that you chose them, it's a good idea to keep them informed. This makes it much easier for them to file a claim if you happen to pass away while the policy is active. Learn more about how long it takes to receive a life insurance payout and how to file a claim.
In addition, if there is any cash value in the policy when you die, the insurance company will keep it.
If you have a dependent who relies on your income to live, you should probably get life insurance. In addition, if you have outstanding liabilities that won't get paid if you die, then you probably need life insurance. And, if you will feel horrible leaving your loved ones, then you should also probably get life insurance.
Life insurance is an act of kindness. You are getting life insurance to protect the people you care about the most from your untimely death.
For reference, I have two children and a stay at home wife. I'm also semi-retired in that I haven't had a day job since 2012. We live entirely off our investment income. However, I do have a $1 million term life insurance policy that I took out in 2014 that expires in 2024. In retrospect, I wish I took out a 30-year term life insurance policy instead.
How Does Life Insurance Work?
Here are the basic life insurance terms and descriptions you should be aware of. Study them closely. The definition that causes the most confusion is “Cash Value.” Cash Value is used when taking out a Whole Life Insurance policy versus a more common Term Life Insurance policy.
Life Insurance Basics
- Policy – An insurance agreement and contract in written form.
- Premium – Money you pay to an insurance company for your insurance coverage.
- Carrier – An insurance company.
- Beneficiary – The person (or people) that will receive a lump sum payment in the event of your death.
- Death Benefit – The contracted lump sum payment available to your beneficiaries in the event of your death.
- Face Value – The value of the policy received upon death or if the policy matures before you die.
- Cash Value – The amount of accrued cash available inside a policy for whole life products.
- In Force – Active, i.e., an “In Force” policy is a currently active insurance contract.
- Quote – An estimate from an insurance company that may not precisely reflect your actual premium.
- Underwriting – The process of determining how much you will pay in premiums for your coverage.
- Medically Underwritten – Underwriting that considers specific information about your health and usually requires you to take a medical exam.
Two Main Types Of Life Insurance
There are two main types of life insurance policies you should be aware of: 1) Term Life Insurance and 2) Whole Life Insurance. I'll then highlight several other types of life insurance policies which are sub-categories of term life and whole life.
Let's look at them in more detail.
1) Term Life Insurance
Term life insurance is the most common type of life insurance. You pay premiums in exchange for coverage in the form of a death benefit available to your beneficiaries if you died.
How does life insurance work with a term policy? Think about term life insurance like renting an apartment. Once you're done paying rent, you no longer get shelter. You also don't build any equity in the apartment.
Term life insurance is the most popular because it is straightforward and more affordable. It does its job insuring your life, and nothing more.
In addition, term life insurance is simple because you pick an amount of coverage and term. Amounts are typically between $50,000 – $3 million. And terms are usually between 10 to 30 years. The longer the term you choose and the higher the coverage, the higher the annual premiums will be.
The most common term to pick is a duration that will cover your kids through college and when your mortgage will be fully paid off. For example, if you have a 1-year-old, you may want to get a 25-year term life insurance policy. If you just took out a 30-year mortgage, you may want to get a 30-year term life insurance policy.
You could choose a term that provides coverage until your mortgage or other debts are paid off, or your kids are on their own, for example.
When the term expires, your coverage expires. You could renew coverage at a higher premium, convert to a permanent policy, or consider whether you still need coverage.
Check out PolicyGenius, the #1 marketplace where you can get real term life insurance quotes all in one place. They help you see what's out there so you can make the best life insurance decision for you and your family.
2) Whole Life Insurance
The second main type of life insurance is whole life insurance. It's also known as permanent life insurance. So how does life insurance work with whole life? Whole life insurance policies do not expire — they last as long as you pay the required premiums. Whole life insurance lasts your whole life, which can be helpful if you want longer than a 30-year policy.
Why would you want longer than a 30-year policy? One reason may if you have a child with special needs who will always depend on you for support. If this is the case, getting a while life insurance policy is crucial.
My neighbor has a daughter with cerebral palsy. She is unable to walk or talk. Thus, she needs full-time care that costs them over $10,000 a month. When my neighbors die, their daughter will depend on their whole life insurance policy to take care of her. God bless them all.
Whole life insurance policies are also a form of forced savings because your premiums also fund a cash value that grows slowly over time. This cash value is one reason permanent coverage costs more than term life coverage.
Similarities To An Amortizing Mortgage
Think about a whole life insurance policy like an amortizing mortgage that pays down principal and interest. At the end of your amortizing mortgage term, you will have built up a large cash value in terms of home equity. A term life insurance policy is just paying the interest on the principal.
The cash value in your policy is attractive because it is a tax-deferred savings account from which you can withdraw or borrow funds later in life. The cash value is often indexed, which should grow in value over time. Just note that any withdrawals and outstanding loans are subtracted from the death benefit.
Permanent life insurance is an umbrella term. It covers several kinds of life insurance policies such as whole life, universal life, variable life, and variable universal life insurance.
Related: Best Mortgage Lender For First-Time Buyers
Universal Life Insurance
How does life insurance work as a universal policy? Universal life insurance is a type of whole life insurance policy. But with universal life insurance, you can change your premium and death benefit amount without taking out a new policy.
Universal life insurance (often shortened to UL) is a type of cash value life insurance, sold primarily in the United States. Under the terms of the policy, the excess of premium payments above the current cost of insurance is credited to the cash value of the policy, which is credited each month with interest.
The policy is debited each month by a cost of insurance (COI) charge as well as any other policy charges and fees drawn from the cash value, even if no premium payment is made that month. Interest credited to the account is determined by the insurer but has a contractual minimum rate (often 2%).
When an earnings rate is pegged to a financial index such as a stock, bond or other interest rate index, the policy is an “Indexed universal life” contract. Such policies offer the advantage of guaranteed level premiums throughout the insured's lifetime at a substantially lower premium cost than an equivalent whole life policy at first.
The cost of insurance always increases, as is found on the cost index table (usually p. 3 of a contract). That not only allows for easy comparison of costs between carriers but also works well in irrevocable life insurance trusts (ILITs) since cash is of no consequence.
However, you need to be careful to monitor the policy. If interest rates end up being lower than expected when you initially bought the policy, you may have to pay additional premiums to keep the policy from lapsing.
Variable Universal Life Insurance
Variable universal life insurance (often shortened to VUL) is a type of life insurance that builds a cash value. How does life insurance work with VUL? In a VUL, the cash value can be invested in a wide variety of separate accounts, similar to mutual funds. And the choice of which of the available separate accounts to use is entirely up to the contract owner.
The ‘variable' component in the name refers to this ability to invest in separate accounts whose values vary. They vary because they are invested in stock and/or bond markets. The ‘universal' component in the name refers to the flexibility the owner has in making premium payments. The premiums can vary from nothing in a given month up to the maximums defined by the Internal Revenue Code for life insurance.
This flexibility is in contrast to whole life insurance that has fixed premium payments that typically cannot be missed without lapsing the policy (although one may exercise an Automatic Premium Loan feature, or surrender dividends to pay a Whole Life premium).
VUL Is A Type Of Permanent Coverage
Variable universal life is a type of permanent life insurance, because the death benefit will be paid if the insured dies any time as long as there is sufficient cash value to pay the costs of insurance in the policy. With most if not all VULs, unlike whole life, there is no endowment age (the age at which the cash value equals the death benefit amount, which for whole life is typically 100). This is yet another key advantage of VUL over Whole Life.
With a typical whole life policy, the death benefit is limited to the face amount specified in the policy, and at endowment age, the face amount is all that is paid out. Thus with either death or endowment, the insurance company keeps any cash value built up over the years. However, some participating whole life policies offer riders which specify that any dividends paid on the policy be used to purchase “paid up additions” to the policy which increase both the cash value and the death benefit over time.
Simplified Issue Life Insurance
How does life insurance work if you don't want to take a blood or urine test? Simplified Issue Life Insurance usually is a term life insurance policy where no medical exam is required. The policy amount of simplified issue life insurance is typically under $1 million. Although, some carriers offer $1 million policies to eligible applicants without any known pre-existing medical conditions.
For reference, a medical exam typically involves bloodwork and a urine sample which are sent to a lab for analysis. The exam may also include a weight check, BMI measurement, and blood pressure screening. If you're healthy and also hate needles, opting for a simplified issue life insurance policy is a great option.
The application process for simplified issue policies is simple and straightforward. You’re good to go after filling out a health questionnaire instead (if you have no serious health problems).
Best Way To Shop For Life Insurance
In the old days, people had to call up individual life insurance companies one by one for quotes and go through a tedious application process.
Today, you can still go to each carrier one by one and apply online. However, this is still not that efficient.
Instead, the much more efficient way to shop for life insurance is to apply on PolicyGenius. They are the #1 insurance marketplace where you can get free life insurance quotes all in one place from the top carriers. From there, you can compare and contrast different type of policies and choose the on that best fits your needs.
Below is a sample of quotes for a 10-year $500,000 term life insurance policy.
I've met the founders of PolicyGenius multiple times since they first started the company. They are both ex-McKinsey consultants and Harvard Business School graduates. They're doing a fantastic job and have grown their business tremendously, saving consumers thousands of dollars.
How Much Life Insurance Coverage Do I Need?
Determining how much life insurance you need is both subjective and objective. Only you can figure out how much life insurance coverage will provide the level of peace of mind you desire.
To objectively determine how much life insurance coverage you need, you must calculate your liabilities, assess your children's and your partner's needs, and figure out what type of future liability you might take on.
In other words, properly forecasting the present and the future are paramount.
My mistake in 2014 when I took out $1 million policy for 10 years was not properly forecasting I would have two kids by 2020. I figured we'd have one child, but I thought having a second child at age 42 was such a low probability.
What I also failed to forecast was that after age 40, insurance companies tend to hike insurance premiums for men. This was at least my case. Because I went to treat my snoring and sleep apnea, my insurance premium skyrocketed. Therefore, if you want to get the best insurance rate, be careful seeing the doctor for non-life threatening illnesses before you apply.
In general, you want to get life insurance younger so you can lock in a cheaper rate.
How Long Should My Term Last?
The term of your life insurance policy should las as long as the following:
- The lifetime of your mortgage
- The duration of time you plan to take care of your kids
If you’ve just taken out a 30-year mortgage, consider a 30-year policy to be sure you’re covered while you still owe money on the house. I personally do not recommend anybody take out a 30-year fixed mortgage over an adjustable rate mortgage. You're going to end up paying way more in mortgage interest with a 30-year mortgage as a result. Go with an adjustable rate mortgage instead to save.
If you expect all your kids to be financially independent in 25 years, a 25-year policy may be just what you need. Just know that not everything will go according to plan in this brutally competitive world. I have three neighbors who all have 30+-year-old sons still living at home with them.
The best age to get life insurance is around age 30. After age 30, life tends to get a lot more complicated with family, health, and your occupation. I would lock in a 30-year term life insurance policy at age 30. You can always cancel if you don't need it later.
Medical Exams For Life Insurance
How does life insurance work with medical exams? If you're getting a life insurance policy that's less than $1 million, there's a decent chance you might not need a medical exam. However, most of the largest life insurance companies will require you to take a medical exam.
Here's what the exam will entail:
- A height and weight check
- Blood draw
- Urine test (so don't do drugs within 60 days before the exam)
- Blood pressure and cholesterol checks
The exam is very basic. But, it does discourage a lot of people from applying, including me, due to need to draw a vial of blood. If you really hate needles, you can ask your insurance agent to specifically look for policies where no medical exam is needed.
Based on your medical records, and exam results if applicable, an insurance underwriter will then determine your premiums based on your risk of dying.
There is a possible downside to getting a no-exam policy. Insurance companies might expect the worst and charge you higher premiums over the life of your policy.
Therefore, if you feel you are in incredible shape, or you know you're in incredible shape after getting a thorough physical from your doctor, you should get a medical exam with your new potential life insurer.
Factors Determining Your Life Insurance Premium
How does life insurance work in regards to pricing? One way to save on your life insurance premium is to first know what goes into calculating your life insurance premium. Once you know, you can then make positive changes in your life to help lower your premium.
Life insurance companies base your premiums on the following:
- Credit score
- Family’s health history
Now that you know the most important factors that determine your life insurance pricing, you should do the following to save:
- Drive Safely: Not only will you save on your auto insurance premiums, you'll also save on your life insurance premiums.
- Lose Weight and Exercise: Don't be like the majority of Americans who are overweight! There are millions of starving people in the world. Eat better and exercise.
- Boost Your Credit Score: People with lower credit scores tend to file more claims. Therefore, try to get to an excellent credit score of 800 or higher to save.
- Get Life Insurance Younger: The younger you get life insurance, the cheaper the premium. Forecast your beautiful future and lock in a low life insurance premium before your life gets messy.
- Quit Using Tobacco & Drugs: Smoking, vaping, and doing drugs are not looked positively upon in the life insurance world. With COVID-19, any substance that negatively affects the respiratory part of your body will probably really jack up your premiums.
- Live a safer lifestyle. Before applying for life insurance, it's a good idea to stop sky-diving, scuba-diving, and skateboarding 50 mph down hills.
- Have a safer occupation. This one might be unavoidable. You do the work that you do. Just know that if you are roofer, you may pay a higher premium than a desk worker.
Don't Lie On Your Application
When applying for life insurance, you should always tell the truth to the best of your ability. There is a contestability period where a life insurer could deny your claim for lying or withholding information.
The period is two years in most states and one year in others. It begins as soon as a policy goes into effect.
If you die within the contestability period, the life insurance company can investigate whether you gave accurate information on your life insurance application. The company can deny paying the death benefit if you lied — even if the cause of death has nothing to do with misrepresentation on your application.
Don't lie or withhold information to get lower rates and then hoping you'll live through the contestability period. You put your loved ones at risk.
Why You Need Life Insurance Beyond Your Children And Debt
If a policyholder were to die, life insurance is most commonly used for the following:
- Daily Living Expenses
- Mortgage/Rent Payments
- Retirement Savings
- Education Savings
- Personal Debts
- Small Business Obligations
- Estate Taxes
- Final Expenses (funeral expenses)
- Charitable Giving
Another great thing about life insurance is that the benefits should be tax-free. Please double check with your insurance carrier just in case.
Below are even more reasons why you might want to get life insurance.
If you have already exhausted your Roth IRA, IRA, and 401(k) plans or can no longer contribute for some reason, then putting money into your life insurance cash value can give you another tax-advantaged option.
Money withdrawn from your indexed universal or whole life policy is considered a loan. And is thus not taxed like regular income.
Of course, there are fees (like the cost of insurance) to consider when using life insurance as an investment vehicle. You need to do your research and talk to experts to make informed decisions.
If you don't get life insurance, make sure you build enough passive income streams to support your loved ones. If you don't, not only will they be mourning your loss, you will throw them in disarray trying to make enough money to survive.
Long-Term Care Support
Long-term care is extremely expensive. We're talking $10,000 – $20,000 a month, depending on the level of care. Long-term care also is needed for about two years on average. Consider long-term care insurance.
Life insurance policies often have long-term care riders. These riders offer access to the face value (death benefit) of the policy before you die if you need the money for a qualifying event. (These riders are sometimes called Chronic Illness or Living Benefit Riders.)
Nursing home expenses and chronic illness expenses are two examples of events that may allow access to funds. These funds are pulled from the death benefit.
Life Insurance Is A Must
Unless you plan to always be alone and never progress in life, getting life insurance is a smart move. The younger you can get life insurance, the cheaper the premiums.
Living a wonderful life is all about planning for the future. With life insurance, not only will you have better peace of mind, you'll also be able to protect your loved ones in case of an untimely death.
The best way to get affordable life insurance is to check out PolicyGenius, the #1 life insurance marketplace. You can get real term life insurance quotes all in one place for free. They help you see what's out there so you can make the best life insurance decision for you and your family.