An Overview of Life Insurance
A life insurance policy is a contract between a policyholder and an insurance company that pays a sum of money, known as the death benefit, when the insured individual dies. In return, the policyholder pays a premium that can be collected monthly, quarterly, semi-annually, annually or in a single lump sum. Life insurance is available in several different forms and can be used for a variety of purposes.
Why You need Life Insurance
Life insurance provides money that can be used for any purpose. Some of the most obvious uses include:
Paying the cost of a funeral
Repaying existing debt, including medical bills
Providing cash for living expenses
Maintaining a family business
Funding a child’s college costs
Protecting your spouse’s standard of living
Funding an insurance trust
Paying estate tax
Providing a lifetime of annuity payments
Depending on the policy specifics, the beneficiary can take the death benefit as a lump sum or as a series of annuity payments for a specified time or for the lifetime of the beneficiary. Second-to-die life insurance pays its death benefit only after two people (usually spouses) die, which is useful for estate planning. Generally, the death benefits from life insurance are tax-free.
Life Insurance Underwriting
Obtaining life insurance begins when you fill out an application form. The form collects information about you, your medical history, your lifestyle, your family history and any special risk factors that apply to you. The insurer collects the information and assesses your life expectancy through a process called underwriting.
Specifically, the underwriter will judge your likelihood of dying during the insurance coverage period, and the amount the insurer needs to charge in premiums. In some cases, the underwriter will reject your application or reduce the coverage period.
The first step in the underwriting process is for the insurer to check the quality of your application for complete and correct information. The insurer may require a phone conversation to clarify or fill-in some information. If the application checks out, the insurer will dispatch a paramedic to your home for a short, free physical exam and fluid collection (blood and urine). The paramedic will take down your basic measurements, including weight, height, pulse and blood pressure.
If any red flags arise, the insurer will ask your physician for an Attending Physician Statement, a summary of your medical history, including any conditions treated, your symptoms and prognosis. The underwriter might also check your records in the Medical Information Bureau for medical data and for consistency between your current application and previous ones.
The underwriter will also verify your prescription drugs, your driving record and your creditworthiness. Using all this information in conjunction with actuarial tables, the underwriter will issue you a final rating that determines whether you’ll be issued a policy, and if so, how much you’ll pay in premiums.
Types of Life Insurance
Your goals and needs help determine which type of life insurance you’ll choose. The main types of life insurance are:
Term life insurance: this is life insurance that remains in force for a specified period, such as 10 or 20 years. Term life is the least expensive kind of life insurance, and the premiums remain level for the coverage period, although some policies decrease the death benefit each year. Typically, policies are renewable when the coverage period ends, albeit at a significantly higher premium. Some policies give you an option to convert a term policy to another type without undergoing new underwriting. Term life policies typically pay a death benefit as a lump sum. Many companies offer group life insurance to its employees.
Universal life insurance: this is permanent insurance for a lifetime of coverage. These policies provide flexibility in premiums and coverage amounts, and are often used in estate planning as a way to preserve your wealth for your beneficiary. The policy builds up a cash value, a form of savings that can be used for loans, as a cash source, or to pay future premiums. The cash value can also be converted into an annuity.
Whole life insurance: this type of policy is like universal life, except it lacks the latter’s coverage and premium flexibility.
Variable life insurance: this is permanent life insurance with a savings component that is comprised of separate sub-accounts for different types of investments, such as stocks, bonds and mutual funds. The amount of the death benefit is linked to the performance of the savings component.
Features of Permanent Life Insurance
Permanent life insurance policies offer a number of optional features that affect their value:
Policy loans: most permanent life insurance policies allow the policyholder to borrow some portion of the cash balance. You must pay interest and fees on these loans, which increases the cost of your insurance.
Accidental death benefit rider: an additional amount of death benefit will be paid if the insured is killed in an accident.
Waiver of premium rider: with this rider, you won’t have to pay premiums if you become disabled and are therefore not able to work.
Disability income rider: you’ll collect monthly income should you become disabled.
Accelerated death benefit rider: allows you to collect a portion of your death benefit right away if you’re diagnosed with a terminal illness.
Inflation rider: provides for inflation adjusted increases to your premiums and your death benefit.
Cancelling an Insurance Policy
There can be many valid reasons to cancel an insurance policy. For example, the beneficiary might predecease you. Cancelling a term policy is easy – just withhold premiums and inform your insurer in writing. Once cancelled, all the premiums you paid in are forfeited and you have no death benefit.
If you cancel your policy mid-payment cycle, you might receive a partial refund on your last premium payment.
Cancelling a permanent policy is a little trickier, especially if it has cash value. If you’d like to collect the cash value, be aware of the policy’s surrender charge, which is essentially a cancellation fee that decreases over time. You’ll receive cash value only in excess of the surrender charge.
Another option is to accept a reduced paid-up option, which stops premium collection and offers a permanent reduced death benefit. Finally, consider selling your policy to a settlement company for a cash lump sum. The company takes ownership of the policy, pays all subsequent premiums and collects the death benefit when you die.