What is Life Insurance?

Written by Robert Ferry on April 12, 2022
What is Life Insurance?

Life insurance is an agreement between a person and their insurance provider which aids to protect the future of that person and their family. A person pays monthly installments or a yearly premium to the insurance provider, and in return, the person's family will receive money. The money will only be given if the person expires, so the family is entitled to receive the amount for which the person was insured.

Life insurance is an ideal way to protect one's family financially, which is convenient and cost-effective. Through life insurance, a person can safeguard their family's future after their death while ensuring the family is financially secure to pay bills, dues, or fees of any kind.

Life insurance is a long-term investment that protects the beneficiaries' future if the person is no longer alive to fulfill their financial duties. Often, it is seen that the premium a beneficiary receives is used to pay mortgage payments, child's tuition, credit card expense, or other similar essential expenses. Having life insurance means that a person is securing their family's future by thinking long-term, and that is why the person is paying annual payments to the insurance provider.

A person often plans for something, but life has something else planned. As a result, it is better to ensure that they look after their family's needs if the person cannot be around. The needs may include staying in their house and paying for all the things they wish to buy or consume. The life insurance contract between the policyholder and the insurance company is designed in the form of a bond that pays lump sum money to the beneficiaries if the person dies.

The article will help you understand life insurance. We will also list down the factors and processes that will aid you in understanding the operations of life insurance and its impact on the people and their families. A FAQs section will be added to answer some general questions related to life insurance.

Let us look at the basics of life insurance to develop a fundamental understanding of it.

Fundamentals of Life Insurance

Life insurance is considered the most cost-effective insurance in any part of the world. As the name suggests, it replaces a person's income after their departure from the world to relieve the person's family from any financial worry or distress.

The guide will include several important terms, so it is wise to know about them. The following will help you understand clearly.

What is an Insurance Policy?

An insurance policy is an agreement in a written contract that the person makes with the insurance company. The policy stands as proof that the person has life insurance. It includes the terms and conditions and the premium the person must pay monthly or annually.

What is an Insurance Premium?

The insurance premium is the payment a person pays to the insurance provider as stated in the insurance policy. The premium is payable either every month in installments or annually as a once-a-year payment. The premium is paid to keep the policy active.

Who is the Policyholder?

The policyholder is the person who buys the insurance policy from a designated insurance provider. The policy is usually bought for oneself or spouse, or it can be meant for someone else. A beneficiary can also be the policyholder. It is clearly stated in the insurance policy which is getting insured.

What is an Insurance Claim?

An insurance claim is a formal request made by the beneficiary to the insurance company informing them about the policyholder's death. The insurance claim aims to let the company know about the death benefit left by the policyholder for the beneficiary. The insurance company is entitled to acknowledge the claim and carry out a formal check before issuing the death benefit.

What is a Life Insurance Death Benefit?

A life insurance death benefit, also known as the insurance payout, is the amount paid to the beneficiary after the policyholder's demise. The death benefit is only paid once after the policy has been paid up, and there is no premium left to be paid. 

Who is the Life Insurance Beneficiary?

The life insurance beneficiary is the people that the policyholder will choose who would receive the death benefit from the insurance company. Usually, life insurance beneficiaries are the family members like the person's spouse or children, but a policyholder can name anyone. The beneficiary is responsible for receiving the payout from the insurance company after the policyholder's death. Some policyholders like to name an organization like a charity as the beneficiary of their insurance policy.

Let us look at the operational structure of life insurance.

How does Life Insurance Work?

In the previous section, we covered the fundamentals of life insurance by understanding basic terms. Here, we will discuss the operational mechanism through which life insurance work. Let us dive into it!

The process of life insurance follows the policyholders making payments monthly or annually as premiums. The life insurance companies will give back death benefits to the beneficiaries upon the policyholder's death.

However, there are certain situations where the policyholder can get their hands on the death penalty before their death. For instance, in a terminal illness diagnosis like cancer, the policyholder can get a particular part of the life insurance funds while they are still alive. This is made possible with the help of an insurance rider known as the accelerated death benefit given back before the policy expires. To enable this, the policyholder must provide proof like documentation of the illness. Still, it is better to state that before the life insurance contract to avoid any inconvenience.

People also choose to customize their life insurance policy according to their family's needs and preferences. Certain elements to consider to make this happen would include the type of policy you wish to buy, the number of years you want that policy to last, and the premium you wish to pay.

By paying the premium on time, a policyholder can be assured that the insurance company will treat the policyholder's beneficiaries with the same attitude. In doing so, the company will release the defined funds to the state beneficiaries efficiently.

There are several factors that the insurance company considers to determine the rate for specific policyholders. They include the following

  • The age of the candidate looking to buy a life insurance policy
  • The health of the candidate by assessing their medical records
  • The individual's life expectancy is based on their health, age when applying for the policy, and medical history.
  • Lifestyle choices and external factors

The general advice is that people apply for life insurance at a young age because it would cost less. As the person ages, buying life insurance would be costly since coverage in terms of premium is more, and the rate is unfavorable.

Consider the following example.

Adam is a middle-aged man who is 36 years of age, healthy, and does not smoke. He earns about $70,000 per year, which means his death benefit would be between $700,000 to $840,000 because he had the wisdom to buy the coverage 10 to 12 times his annual income.

Considering that Adam is married and has three young kids, he decided to purchase the 20 years of coverage to be debt-free in his late 50s and financially covered through life insurance. His decision has enabled him to be stress-free in retirement, and by time, his children would be grown-ups. If Adam dies due to unexpected death before the 20-year coverage is over, the beneficiaries he named will get the life insurance amount securing their financial future.

Let us look into the coverage under life insurance.

What does Life Insurance Cover?

In the previous section, we covered the practical mechanism of life insurance. Here, we will discuss the different elements covered under life insurance.

Once the beneficiaries receive the death benefit from the life insurance company, they can use the funds for whatever purpose they feel like. For instance, look at the following possible expenses

  • Paying day to day expenses for groceries and other household essential items
  • Paying for mortgage or other debts like credit card bills
  • Paying for burial expenses and other costs linked to it like outstanding medical bills
  • Paying for college tuition or similar educational expenses

The death benefit will help a family carry on with their lives like before the policyholder's demise. The family can pay for the things they need to utilize without worrying from a financial perspective.

The life insurance company must be contacted before the policyholder's death to start the procedure of insurance claim and death benefit. If the life insurance policy is still active, the beneficiaries can receive the death benefit from the life insurance company. The insurance provider will check the policyholder's health condition and see the policy's status before approving the funds.

The following are the scenarios under which the policy provider must pay the payout to the beneficiaries

  • Natural death which may include old age, heart attack, or terminal illness
  • Accidental death, which may include airplane or car crashes, along with accidental drug dose
  • Suicide committed leading to death after the suicide period stated in the contract ends
  • Homicide might include murder unless the beneficiary was part of it or an accomplice

Some certain exceptions and exclusions are part of the life insurance policy to which the policyholder agrees before signing the contract. The following are the exclusions under which the insurance provider is not required to pay the death benefit and, in specific situations, can sue the beneficiary for false claims.

  • Expired Policies: The life insurance policy can only stay active until the policyholder makes the payments on time. If the policyholder does not make the premiums, the policy will be rendered inactive, and the insurance company will not be prone to pay the death benefit.
  • Fraud: If a person commits a fraud that involves them lying about their application, it could have severe consequences. The worst-case scenario would be that the insurance provider can cancel the life insurance policy during the life or after the death of the policyholder. Another consequence could be that the insurance provider might substantially reduce the death benefit payout if the policyholder's actions are found guilty.
  • Criminal Activity: Several circumstances come to light where the policyholder was caught committing a crime to get the insurance provider's payout quickly. And in other circumstances, the beneficiary committed a crime to get their hands on the insurance money, including homicide on the policyholder. In either of the cases, the life insurance company is not required to make a payout to the family; instead, they can choose to file a complaint against the accusers.
  • Miscellaneous: The life insurance company ensures that the policyholder knows of other exclusions not covered under the policy. Some exclusions consist of dangerous sports and hobbies like sky diving which are risky, adventurous sports and can result in fatality. Suppose a policyholder dies while doing such sports. In that case, the insurance company will not be allowed to make the payout or entertain the insurance claim for the death benefit of the individual.

The life insurance payout has several options that insurance companies offer to policyholders and beneficiaries. These payout options are how a beneficiary will receive the funds left for them by the policyholder. They include the following:

  1. Lump-Sum Payout: In the lump-sum payout, the beneficiary can receive the entire death benefit in one go. Many life insurance companies prefer this form of disbursement to close the contract by paying the full and final payment at once. Under this option, there is greater flexibility with zero tax on the payout, ideal for both parties.
  2. Installments or Annuities: The beneficiary can get the proceeds and accumulated interests from the policyholder's death benefit with installments or annuities. Under this category, there are frequent payouts scheduled over a given period. This category is prone to tax on the payout, which means there will be deductions, so it might not be ideal for some beneficiaries. If the death benefit is significant, it can take some time for the entire payout to be paid out by the insurance company in installments.
  3. Retained Asset Account: The retained asset account is similar to a checkings account that the insurance provider has. The initial balance on this account is the death benefit that the insurance companies owe to the beneficiary.

The beneficiary can write cheques against this account as its balance is the beneficiary's property. As a result, the interest will be accrued overtime against the balance. The account can only be used to write cheques and cannot be used to make deposits.

Let us look at those individuals who can have life insurance.

Who Needs Life Insurance?

The previous section covered what life insurance covers, and life insurance coverage cannot be applied under what circumstances. Here, we will look at those who can apply for life insurance and benefit from it.

The death of a person would bring a financial impact on the lives of those connected to this individual. Hence, life insurance acts as a financial plan which safeguards your family members in monetary terms. And so anyone who has loved ones that they wish to be looked after their death should get life insurance.

The following people can apply for life insurance and enjoy its benefits as a consolation for losing their loved one.

Parents Having Young Children and Adult Teenagers

If the dependent family member dies, having life insurance will be helpful for the family to bear the loss without worrying about how the finances will be covered. It can get challenging for single parents to bear all the household expenses and the cost of raising young children. Life insurance gives that family a second chance and the family to follow their dreams by ensuring the children's needs are taken care of.

The death benefit can be used to look after the financial situation of raising the kids. If both the parents die, the death benefit can be used to make a trust fund for the children under the supervision of a guardian. The funds will only be used for the child's education and personal expenses. If there is no listed guardian, the fiduciary can manage the trust fund until the child is of the age to make their own financial decisions.

Older People Without Savings

Certain classes of adults work most of their lives but do not have enough funds to last the tenure of their children without encountering financial difficulties. As a result, these people apply for life insurance, resulting in death benefits for the policyholder's families after their demise. In that way, these older people can look after the needs of their respective families.

Young Adults Who Want to Safeguard Their Future

People are of the mindset that they would like to think of their life in the long run. This means that they are optimistic about the number of years they will be on this planet and so would like to ensure that their families are financially looked after in the future. Young adults also wish to take advantage of the favorable rates they get if they apply for the application now rather than later.

Applying at a young age will get low rates relative to applying at an older age. The reason is that people are relatively more healthy at a young age, so the rates are low.

Adults Having Private Student Loans

A certain class of students still have student loans that they are paying off while working or studying. Such students are entitled to receive life insurance at reasonable rates. If the borrower dies and cannot pay off the loan in time, the debt will be shifted to the cosigner. The life insurance companies ensure that the borrower's family will not have to face further difficulties.

Business Owners

Large business companies, firms, and corporations purchase life insurance for their employees as part of their incentives to work for them to ensure the families of such individuals are taken care of. The insurance companies create insurance contracts with the business companies rather than the employees to avoid inconvenience. All employees are considered essential to the company, and their loss would mean a loss for the company, which is why they are insured.

Let us look at the process of acquiring life insurance.

How Can a Person Get Life Insurance?

The previous section covered those individuals who can apply for life insurance at any stage. Here, we will see how a person can obtain life insurance and what elements are related to acquiring one.

To buy a life insurance application, a person would need to fill out an application which a telephonic interview will follow. Furthermore, the person would need to provide relevant documents about their personal information as part of the application process. People would also need to undergo a medical examination from the designated medical centers or hospitals that the insurance company provides. However, if people apply for a "no-exam life insurance policy, " no medical exam is needed.

Financial experts advise checking in with several life insurance companies and the rates they are providing before making a final decision. People can ask insurance companies to provide them with insurance quotes. As a result, they could go with the one that offers the lowest rate.

Although the eligibility requirement for each life insurance company differs from other companies, there are some standard criteria that all life insurance companies follow. They include the following

Medical Checkup

One of the determining factors directly linked to the rates included the person's health condition applying for the life insurance. So all candidates must undergo a medical check-up before finalizing a life insurance policy. This is not the case for non-exam life insurance policies where no medical exam is required to avail the policy.

Documents

The policyholder has to provide certain documents to complete the application process so that the life insurance company can better assess their application. The documents required consist of:

  • Proof of identity, citizenship, and age: A resident person can give a copy of their driver's license, passport, or birth certificate to provide some identification. The reason is that all these documents have those required criteria covered. A non-resident person can provide a copy of their green card as proof.
  • Proof of residency: Prospective policyholders have to provide some documentation that shows where they reside. Those renting can show a lease agreement or a rent receipt having their name as tenants and where they live. For homeowners, proof could be like a mortgage payment or a property tax statement in their name having the location of their residence. Some people also provide utility bills for their residences.
  • Proof of income: People seeking life insurance need to provide documentation that shows where they are working. Such documents may include pay stubs or an employment letter from the company that hired them. Others provide a tax return statement or earning statement from the bank that has their account information. Those who are unemployed can show an unemployment letter. They can state they are currently not employed anywhere and their monthly statements from the bank show their earnings and savings.
  • Social security number: Some life insurance companies ask for the social security number of the prospective policyholder, but that is only meant for preliminary background checks. Once that is cleared out, the SSN is not needed anymore for the tenure of the application.

Let us look into the different types of life insurance.

What are the Main Types of Life Insurance?

In the previous, we discussed a person's process to buy life insurance. Here, we will the main types of life insurance that companies offer to the customers to choose from. People look at these two categories and the subcategories to select life insurance that fits their preferences. Let us dive into them!

There are two main types of life insurance that include the following

Term Life Insurance

The most affordable type of life insurance is term life insurance, so people are attracted. Life insurance companies sell this particular type of insurance to people in the majority. According to a study, most people decided to get themselves insured in the third quarter of 2021.

The Term Life Insurance provides financial protection to the policyholder's family for a specific amount of time while ensuring the premium payment is constant through the policy's life. Under this type of insurance, the policy is of varying periods which differs from one insurance company to another. But the term is usually between 10 to 30 years, and people can choose any period they feel like.

The more significant is the insurance period, the higher is the insurance premium and the rates related to the payment. If a person expires before the period ends, the family (beneficiary) will receive the full death benefit as a payout which will not incur any form of taxation.

Policyholders also have an option to renew the policy for an extended period in the event the policy term concludes. The policy renewal will be prone to coverage in increments of one year, which brings both benefits and drawbacks. The benefit is the inception of guaranteed renewability every year with the drawback that the rates will be higher each year.

Permanent Life Insurance

Permanent life insurance provides coverage for a lifetime to a policyholder, making this type of life insurance more expensive with a more extended period than the prior one. The more costly nature of this life insurance is its duration, which lasts lifelong due to the cash value that accrues over the years.

The cash value component is accumulated based on the deferred tax that accrues the cash value of the policy's life. The cash value is the saving part of the policy that can go through withdrawals in times of need. If you choose to surrender a permanent life insurance policy, the policyholder will receive the cash value less the costs incurred to surrender the policy.

There are specific policies under which the cash value builds up rather slowly, so people should be patient before making a withdrawal. 

Permanent life insurance is further segregated into branches which consist of the following:

Whole Life Insurance 

The whole life insurance provides a set death benefit to the beneficiaries. The cash value element increases at a guaranteed rate of return which provides a greater payout to the life insurance beneficiary. Under this category, the policyholders can earn dividends which can be used to pay for the premium payment. The dividends can be put into the savings accounts, also known as the cash value.

Universal Life Insurance

Universal life insurance offers greater flexibility relative to the previous type of permanent life insurance. The policyholders have the choice to change their premium payments and their death benefit, but the insurance provider imposes certain limitations. The cash value is directly proportional to the policy type, so any changes in the policy will see changes in the cash value.

Burial Insurance

The burial insurance is similar to whole life insurance but on a smaller scale that has a limited death benefit to cover the burial costs. Different life insurance companies offer different amounts of burial insurance, ranging from a minimum of $5000 to a maximum of $25000.

Survivorship Life Insurance 

Survivorship Life Insurance is a type of insurance under which two people are insured in one policy consisting of both parents or a married couple. If both the parents or spouses die, their death benefit will be paid out to their children or the listed beneficiaries. The death benefit will be for both the individuals that have passed away. This type of life insurance is usually for a more extended period and involves financing a trust fund for the future, usually for the time after retirement.

Frequently Asked Questions

What is the Cash Value?

The cash value is the part of the premium that is kept in a different account in the case of permanent life insurance. The cash value serves many roles, but it depends on the type of policy linked with the permanent life insurance. For instance, it can be reinvested or kept to earn interest. The cash value can further be used to pay for the premium amount or some portion. Policyholders can also make withdrawals from the cash value category.

Do Life Insurance Policies Pay Dividends?

It depends on the type of policy a person has signed up for. There are some whole life policies under which a person can earn dividends depending on the premium payment and cash value earned. Every insurance company has different terms and conditions for different policies, so it is better to contact your insurance provider for prominent details.

How Long do You Have to Claim Life Insurance?

Claiming life insurance depends on the law set by the state to which the insurance company adheres, so it is better to check the state law website for factual information. Next, you can reach out to your insurance provider, who will provide you with further details on the subject.

Can a Person Get Life Insurance if They Have Cancer?

Different insurance companies have different rules and regulations that they follow. Similarly, they also have varying policies and terms and conditions for those policies. Hence, if a person is diagnosed with cancer, they may not apply or qualify for some life insurance policies. You need to check out the website or contact insurance providers representing different companies to know about it.

Since a medical exam is needed to apply for an insurance policy, some policies might not be available to a cancer patient policy applicant. Some insurance companies look into the medical record, the stage of cancer, the treatment they will go to, and the probability of the person recovering from cancer before making a final decision.

Conclusion

This guide has covered the basics and in-depth knowledge of life insurance that will get you started on applying for one. We have discussed all the relevant coverage under life insurance and the irrelevant items that life insurance will not cover. Moreover, we provided details of the significant yet different types of life insurance that people can choose. These life insurance are available the offer by each insurance company with a difference in their quotes and rates.

The article has also covered the requirements like documents needed to apply for life insurance. We have also covered the different people that can apply for it. Furthermore, we talked about how life insurance works and what knowledge and information a person would need to get one.

Financial experts advise people to carry out their due diligence before deciding on the life insurance they would need and would be suitable to their preference. A person looking to get life insurance needs to understand premium, cash value, beneficiary, etc., which are covered in the first section. Everyone needs to evaluate themselves separately to know which life insurance would be the best fit for them.

Life insurance has no restriction on who can apply as the companies welcome everyone to secure the future of their loved ones and their families financially. But there are specific requirements that every prospective policy applicant needs to fulfill. It is safe to secure your future now and early while there is still time and rather convenient and cost-effective. People wait for the right time, which often leads to some inconvenience. So it is better to apply now to reap the benefits in the future.

Article written by Robert Ferry

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