How Does Life Insurance Work

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Understanding how life insurance works is one of the ways to decide if you should buy life insurance. The basic concept of how life insurance works is that an individual buys a life insurance policy from a life insurance company. He or she names a policy beneficiary. If the insured person makes premium payments on time to keep the policy in force, his or her beneficiary receives a payout after the named individual dies.

The reason for buying life insurance is even more understandable. Life insurance protects loved ones in the event an insured dies and can’t continue to provide financial support. The primary types of life insurance include 1) term (or temporary) life insurance, 2) whole (or permanent) life insurance, and 3) universal life insurance.

How Does Life Insurance Work: Term Life

Term life insurance is sometimes called temporary or pure life insurance. Term life is usually a no-frills policy that pays out a death benefit when the insured dies to the beneficiary. Term policies can a short duration—usually between 10 to 30 years—but some are as short as a one-year term.

Term life doesn’t pay out money to the insured in most instances when he or she is alive. Instead, the policyholder’s beneficiary receives a lump sum or installment death benefit payment. Unlike other types of life insurance, the term life insured doesn’t receive dividends or return of premium capital from the insurance company.

Term life insurance insures against the policyholder’s loss of life. He or she doesn’t die, the life insurance company keeps the paid in premium payments. However, because most term life policies cost less, the insured pays lower policy premiums and probably wants to continue paying them. In some cases, a term life insurance policy is renewable for a new term or convertible to whole or universal life insurance.

How Does Life Insurance Work: Whole Life

Unlike term life insurance, whole life policies are written for the insured’s life. No policy term is predefined in the contract between the life insurance company and the insured. Whole life insurance also provides a death benefit encompassing the insured’s whole life when premiums are paid on time.

Whole life insurance combines cash value with the policy’s death benefit:

  • Some insurance agents sell whole life as an investment but, when compared to other conservative investment options, the policy’s cash value return is typically quite low.
  • In addition, some whole life policies pay sales agents generous commissions and ongoing commissions as long as the contract remains in force.

However, whole life insurance can save the day when the insured needs to borrow against the policy or withdraw money for supplemental income at some point in life. In contrast to term life insurance, the benefits of whole life insurance may be enjoyed while the insured is alive.

If you’re considering whole life insurance as part of a financial plan, consult a financial advisor to learn if this type of life insurance is the best one for you.

How Does Life Insurance Work: Universal Life

Universal life insurance policies are more complex, so plan to ask more questions about how this form of life insurance works.

The cash value portion of your universal life policy may be linked to short-term movements of a stock market index or short-term interest rates instead of a long-term whole life insurance policy rate. Policyholders may receive premium return of capital payments that can add to the rate of return on the universal life insurance policy.

How Does Life Insurance Work: Compare Types

Comparing the types of life insurance can help you decide the right type of life insurance for you. Let’s recap the pros and cons of the different life insurance types:

  • Term life insurance may be less expensive than other life insurance types. Your premium dollar may stretch more, especially during the early years of a term policy. You can purchase term life insurance for up to 30 years. If you die, your beneficiary receive a tax-free death benefit. However, your term policy won’t help you save money and coverage for your entire life isn’t guaranteed.
  • Whole life insurance offers the benefit of fixed premium payments, tax deferred cash value growth, and insurance cover over your entire life. Your beneficiary receives a tax-free lump sum when you die. In contrast, some policyholders prefer a flexible premium structure. If you’re an experienced investor, you might not like the comparatively low rates of return on your money. A decision to close out the policy at some point in the future may involve payment of surrender charges.
  • Like whole life insurance, universal life policies provide coverage over your life as long as the policy remains in force. You must make premium payments, although you have some flexibility about when and how much to pay into the policy at certain requested times. If you don’t pay in enough premiums or you take out too much money or if interest rates decline, your death benefit can decline to less than the initial amount underwritten. Non-variable universal life insurance policies are considered a better bet for conservative individuals.