Life Insurance: What Is It and How Does It Work?

Life Insurance: What Is It and How Does It Work?
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If you're the type of person who plans for the future, you've probably thought about taking out life insurance. Essentially, life insurance is a product that provides a payout to beneficiaries specified by the person who took out the policy upon his or her death.

Relatives often use this money to cover high funeral costs for the policyholder, which can include transportation and expensive services. The money can also be used to guarantee that the deceased's heirs have the means to maintain their standard of living. This article will teach you about what life insurance is, how it works, what it covers and what types of life insurance are out there.

Life Insurance: This article will cover

How Life Insurance Works

Life Insurance Coverage: Why You Need It

Types of Life Insurance

How Life Insurance Works

We all have a reason to buy a life insurance, but the most important one is peace of mind. You can trust that, if something happens to you, your affairs will be in order thanks to the payout. This is reason enough to take out a life insurance policy, but there are many other reasons to do so [Discover the reasons to take out a life insurance policy]. Whatever your reason, it is important to make this decision as soon as possible, because life insurance is more useful and less expensive the earlier you take it out.

If you have already made this decision, you should be aware that life insurance is a contract between an insurance company and an individual customer, often called the policyholder or insured. The contract establishes that if the insured passes away with a valid insurance policy, the company will make a payout to the people or institutions specified by the customer.

It's very important to be properly informed when purchasing life insurance so that you don't make any mistakes when taking out life insurance.

There are many elements and factors to keep in mind, and though these products are not very complicated, you must review them carefully. First, you must learn the basic life insurance concepts:

  • Premium. The amount of money the insured will pay to the insurance company each month to guarantee an insurance payout upon their death. These payments will eventually add up to the payout amount. But they also generate large sums that can be invested in financial products as a supplement to the insurance. Insurance premiums are calculated based on the risk the insurance company assumes in taking on the customer. As the younger the insured, the lower the risk, premiums are generally lower at this stage of life. However, they are usually fixed; the insured will always pay the same amount.

    Policy. Your insurance policy is the contract binding you to the insurance company. It contains all the information about this relationship: terms, coverage, costs and clauses that affect the insurance in any way. [Find out more about the Main life insurance clauses]

  • Beneficiaries. The people or institutions that will receive a payout when the policyholder dies and the policy goes into effect. If there is more than one person or entity, the policyholder will have to decide the proportions in which the money will be distributed. What's more, the policyholder can choose to have the money managed by a trust. The trust administrator will then manage these sums as indicated by the insured.

    Customers can change their beneficiaries at any time while they are paying their premiums. They can also select alternate beneficiaries in case the main beneficiaries pass away before they can collect the life insurance. They can even designate a third line of beneficiaries called tertiary beneficiaries. [Learn how to choose your life insurance beneficiaries]

  • Payout. The amount the insurance company will pay upon the insured's death. It is also called a death benefit and is generally tax-free for beneficiaries.
  • Terms and validity. The insurance contract will establish how long the policy will be in effect (permanent or term) and if there will be any renewals or changes in premiums during this time. It is important to know at what times the premium amounts will change.

When going to take out a life insurance policy, the first thing you should do is request a quote. This is an estimate the insurance company makes using the information you provide them in a form. By comparing quotes, you can determine which insurance policy and prices are best for you and your wallet. [Learn How to request a life insurance quote]

Once you've found the right quote, you can request the product you're interested in from the insurance company. Then, an important period called qualification will begin. In this step of the process, the insurance company will evaluate factors that will determine whether or not you can take out the life insurance policy and how much you will pay for your premiums. The most important factor is your age: the older you are, the lower your life expectancy, and the higher the chance of death. If your life expectancy is low, the company determines that it is a risk to insure you, as you may not pay enough in premiums. In this case, they may decide to request higher premiums or not to grant you the policy.

Another important factor is your health. The company knows that it will take on a lot of risk in insuring you if you have a disease that affects your health. In order to make their decision, they may require medical reports. What's more, smoking, drinking and high-risk lifestyles—such as playing an extreme sport—are also factors that may result in the company deciding to charge higher premiums or not to insure you.

Lastly, they will take into account your sex, as there are significant differences in life expectancy and lifestyles between men and women.

It is important to answer the questions the insurance company asks honestly and cooperate with any medical exams they require. Keep in mind that if the insurance company finds out that you lied, you could lose your insurance. [All about How to qualify for life insurance]

Life Insurance Coverage: Why You Need It

You should be aware that life insurance is not an investment. Unlike other products, which can carry a financial risk, there is practically no risk to life insurance: if you keep up with your premiums, the payout will be made.

What's more, life insurance coverage is clear: it covers your death. If you die, your beneficiaries will receive a payout. As such, what you should be asking yourself is why you need life insurance. Some of the typical reasons why people take out life insurance are:

  • Maintaining standard of living. You can make sure that upon your death, your family or loved ones will be able to continue their standard of living.
  • Funeral costs. Funerals can be a huge financial burden. With life insurance, you can lessen this burden on your family. Remember that there is a specific type of life insurance for this: final expense insurance.
  • Paying off debts. If you want to make sure that your loved ones will not be responsible for your debts when you die, the best thing to do is take out a life insurance policy.
  • College education. Many people worry about dying and not being able to pay for their children's college education. Life insurance can assuage this fear.
  • Protecting a family member with special needs. For families that have children with special needs and problems, the prospect of dying can be particularly worrisome. With life insurance, you can guarantee that this dependent will be taken care of.
  • Obtaining a loan or mortgage. When granting a loan or mortgage, banks often require a life insurance policy that will be responsible for paying these loans if the holders pass away.
  • Saving. Though insurance is not strictly a savings tool, many policies have investment or savings mechanisms that, over the long term, could generate additional profits for the insured.

All of these reasons share one common theme: making sure that your death does not cause any additional problems for anyone and that your affairs will be in order.

Types of Life Insurance

Now that you know why you need one of these products, you should learn which one is right for you. In reality, there are only two main types of life insurance: term life insurance and permanent life insurance. There can then be combinations of both products. Let's take a look at their features.

Permanent Life Insurance

Permanent life insurance is the classic type of life insurance. It is designed for long-term validity: the insured will continue to pay premiums over their entire life. In general, this type of insurance is more expensive and involves higher premiums, as it has to offer coverage throughout the customer's life, which can be very long. The insurance company will assume greater risks as the insured gets older and the price increases. However, the premiums remain fixed: the insured will always pay the same amount.

Due to the fixed rate of premiums, in the first few years, the insured will pay much more than what it costs to insure their risk. This excess will offset the additional amount that will be paid in the last stage of life. However, it will also generate money that will build up as savings. At a certain point, when these excess payments reach a certain level, the law says that the company must make them available to the user in cash, which is called cash value. This is an additional benefit that cannot be added to the payout beneficiaries receive.

The capital that the insured deposits as premiums accumulates for the future payout, but the insured can partially withdraw it at a given point to either invest or to pay future premiums and maintain coverage during old age. It can also be used as a guarantee to request a loan. Keep in mind that if you withdraw the total amount of the payout, the company could consider the policy terminated.

There are four different types of permanent life insurance:

  • Whole Life Insurance :

    This life insurance remains in effect for the entire life of the policyholder, as long as they keep up with payments or do not surrender the value of the policy. You do not need to renew this type of insurance: the premium value is fixed and the beneficiaries will be paid upon the insured's death. As young people pay lower premiums because their life expectancy is longer, you should take out this policy if you are still young, because the cost of the premiums will always remain low.

    Some of these policies can be participating policies. This means that they pay annual dividends, which can be either taken as cash or added to the final amount of the payout. Not all insurance policies of this type are participatory, and the dividends are not always guaranteed.

    The savings that the insurance policy generates will accumulate, but are not added to the payout. However, the insured can collect the savings if the policy is suspended or changed.

  • Universal Life Insurance

    With this type of insurance, the insured can select the amount of final coverage, the cost of monthly premiums, and the cash that will accumulate during the term of the policy. What's more, you can request changes to the premiums, allowing for flexibility with payment. To that end, in these products, the excess money that is accumulated is invested in financial products that, depending on their performance on the market, will generate profits. With these profits, you can, for example, reduce your monthly premiums during times when you do not want to pay as much.

  • Variable Life Insurance

    With this type of insurance, there is more flexibility in choosing which products to invest the excess capital in. These tend to be variable income financial products, and their income can affect the final payout. This type of insurance usually sets a minimum final benefit and, beyond that, variable amounts depending on the return on these investments. When investing in variable income markets, keep in mind that profits are not guaranteed, and the return on the insurance will depend on these market transactions.

  • Variable Universal Life Insurance

    This combination mixes the features of universal and variable life insurance. It combines the return on insurance that invests in variable income financial products with the flexibility of being able to adjust premium payments according to your needs.

Term Life Insurance

The other main type of insurance is term insurance, which is simpler and less expensive. It is called term insurance because it is only valid for a certain period of time, meaning it has an end date or fixed term.

Term insurance is taken out for periods ranging from one year to thirty, and guarantees that if you die during this time, your loved ones will receive a payout. It is used by many people to, for example, take care of their children's college education or guarantee extra coverage during their children's younger years.

There are two types of term insurance: level term life insurance and decreasing term life insurance. The difference between these two is the amount of the payout.

  • Level Term Life Insurance

    In this case, the payout amount does not change, but rather remains fixed for the entire term of the policy. This is the most common type of term insurance and is offered at very affordable rates, as the risks that the insurance companies assume are lower.
  • Decreasing Term Life Insurance

    With this type of insurance, the potential payout decreases over the life of the policy, and with it, the premiums to be paid.

    Decreasing term insurance is useful in covering periods of insecurity, such as your children's younger years. But you should bear in mind that, as premiums are concentrated in time, they will be high. What's more, if you still need the insurance when it expires, you will have to be re-qualified to obtain it, which may also be expensive. Instead, you can take out multiple term insurance policies so that one will replace another when it expires.

Permanent versus term life insurance. Find out which is right for you

Whatever type you choose, term insurance is a very interesting option for many reasons: the qualification process is easier, the premiums are lower and the coverage is good. As such, many people decide to take out term insurance and, later on, exercise the clause to convert term insurance into permanent insurance. With this clause, the policy can be transformed into permanent insurance. This option is very convenient, because it allows you to have permanent insurance without needing to go through the initial qualification process again.

Overall, having life insurance is highly advisable. It provides peace of mind to both the insured and their beneficiaries, and, in some cases, can be a good savings product. If you would like to take out a policy, request a quote as soon as possible: remember that time is working against you and the longer you wait in purchasing one, the more expensive it will be.

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