A comprehensive answer to the query that how does life insurance work, is that a policyholder is obliged to pay the premium according to the contract with the insurance company on a monthly or annual basis, depending upon the feasibility of the policyholder. If the policyholder dies, the legally contracted amount is paid by the insurance company to the nominated beneficiary.
What is life insurance?
Life insurance is an agreement between a policyholder and an insurance company, according to which the insured person has to pay a specific amount of money during his lifetime, and in case of death of an insured person, a predetermined amount is paid by the company to the beneficiaries nominated by the policyholder.
The amount that is paid by the insured person is known as premium and that premium is paid as a death benefit to beneficiaries. Buying life insurance is like fixing a leak in your roof, the longer you wait, the more expensive it gets.
People who don’t completely understand that what is life insurance, they just take it as a way to benefit the heirs of a policyholder in case of his death.
Life insurance is an agreement between the insurer and policyholder in which policyholder pays premium, either monthly or annually, to the insurance company and beneficiaries get death benefit when the policyholder dies.
Components of life insurance
There are three basic components:
Insurance premium is the money that a policyholder has to pay annually or monthly basis depending upon the policy plan or feasibility of the insured.
A cash-value plan in an insurance policy is an additional component of permanent life insurance. Cash-value is the amount of premium that is kept as investment by the insurance company and it grows because of the interest accumulation. It is accessible to the policyholder and can be withdrawn when needed.
The total lump-sum of money that the beneficiary receives by the insurance company in case of death of the policyholder is called a death benefit. It is a common component in all policies.
Life insurance policy consists of three basic components, a policy premium, a cash-value plan and death benefit. Term life insurance does not offers a cash-value plan.
How does life insurance work?
Every person with an insight of being insured has some queries in the mind that how does insurance work? There are several factors involved in the process of life insurance. The first and foremost step towards life insurance policy is the choice of a suitable life insurance policy.
Choice of a life insurance policy
- Your life is the result of the choices you have made. Different life insurance policies are suitable for different people.
- For example, if there is someone with a strong financial position and can pay large premiums can buy a policy with a high death benefit.
- If one can’t afford the policy with large premiums, he can go for a term life insurance policy with relatively small premiums and medium death benefits.
Payment method and selection of a beneficiary
Payment of premiums can either be made annually or monthly basis depending upon the policy plan or the ease of policyholder.
In each life insurance policy, the policyholder nominates a beneficiary who will receive the death benefit in case of the unfortunate death of the policyholder.
When a policyholder dies, the beneficiary has to show the life insurance policy to the insurance company and then file a claim to receive the death benefit.
Claim for the death benefit
According to the formalities of life insurance policies, beneficiaries have to submit the death certificate of policyholders along with other proofs for identification and death.
When the insurance company is completely satisfied after the required investigations to avoid any fraud, it pays the claimed and documented money to the beneficiary nominated by the policyholder during the contract of the life insurance policy.
After choosing life policy, policyholder nominates a beneficiary. When insurer dies, death benefit is claimed by beneficiary. After evaluating the death certificate and other documents submitted by beneficiary, company hands over the death benefit.
Types of life insurance
Life insurance policies can be categorized into many types depending upon the policy plan. Each type of life insurance policy has different plans, but the basic policy plan and components of policies are the same for all the types.
For example, the premium is paid in all types, although the period for payment varies.
Life insurance policies can be subcategorized as:
- Permanent life insurance
- Term life insurance
1. Permanent life insurance
If a person wants to choose a life insurance policy and wants to know what is permanent life insurance , he should thoroughly research the details regarding all the available policies.
What makes permanent life insurance different from others is that;
Permanent life insurance policies provide the facility of not only the death benefit but also the cash value.
The death benefit is the amount that is granted to the beneficiaries of the policyholder when h dies.
Apart from the death benefit, the cash value is another component of permanent life insurance that is a saved amount and accessible to the policyholder even during his life. Permanent life insurance policy is further subdivided into following types:
1. Whole life insurance
Whole life insurance policy is also named as ordinary life insurance or traditional life insurance anyone interested to buy this policy, must be clear that what is whole life insurance and how does it differ from other policies.? It’s the most popular type of permanent life insurance policy.
One of the key features of whole life insurance also serves as a saving account along with the provision of the death benefit.
Cash is built up in the saving component at a specific rate depending upon the dividends paid by the company.
One of the most attractive qualities of the whole life insurance policy is that in the saving components, cash is accessible to the policyholder during his lifetime and can either be withdrawn or borrowed by the company.
2. Universal life insurance
Following the rule to always look before you choose, a person who intends to buy a life insurance policy should make a slight comparison that what is universal life insurance and how does it differ from the other types of insurance.
The death benefit can be increased if a policyholder passes the medical examination. Moreover, the saving component also known as cash value account keeps on increasing because of the interest accumulation.
If there is enough money in the cash-value account, a policyholder can alter the premiums he has been paying previously, if he is sure that he can do it by the money in the cash-value account.
But if he reduces his premiums or cash value amount is consumed as well, it may result in the insurance policy may end.
3. Variable life insurance
Another type of permanent life insurance is a variable life insurance policy. Variable life insurance policy shares the same features of whole life insurance, for the example death benefit and savings account, but it is comparatively riskier than the whole life insurance.
- A policyholder can make investments in the form of bonds or money market funds, and if the investment does not perform up to the mark, there is a decline in the cash value and death benefit.
- However, some companies assure the policyholder that death benefit will not decline below the specific, pre-determined level.
4. Variable-Universal combined life insurance
Variable-Universal life insurance policy shares the positive and negative features of both types of policies.
For example, it shares the benefits of universal life insurance policies associated with the risks of variable life insurance.
5. Burial insurance policy
Burial insurance is a minor life insurance policy sharing the domain with whole life insurance with small investments and small death benefit.
If a person knows that after his death it would be difficult for his family to bear the expenses of his funeral and burial, he can buy a burial policy with a small premium, such as $4000 to $20,000.
6. Guaranteed-issue life insurance
Guaranteed issue life insurance is also a subtype of permanent life insurance, that is provided to the person having serious medical issues.
Such kind of people are usually not insured because of the greater risks associated with their health conditions.
This insurance policy provides the guarantee to pay the death benefit in case of death of the insured, however, that death benefit is not paid during the initial two years of policy enforcement.
If the policyholder dies during that period, the beneficiaries will be provided with the premiums plus interest by the insurance company.
7. What is survivorship life insurance?
Survivorship life insurance also referred to as second-to-die life insurance is a policy mostly used by married couples.
A unique feature of this policy is that the death benefit is not paid to beneficiaries if one of the partners dies.
The condition to pay the death benefit is the death of both partners. This policy is preferred by the couples who have to pay the heavy estate taxes and they don’t want their heirs to suffer from those taxes.
Permanent life insurance provides the cash-value along with the death benefit. It is further divided into whole life policy, variable life policy, universal life policy, variable-universal life policy, burial life policy, guaranteed-issue life policy, and survivorship life insurance policy.
2. Term life insurance
Term life insurance is part of a good defensive game plan. As obvious by the name, it’s a kind of life insurance policy that is expired after a pre-decided term. To make it apprehensible that what is term life insurance and how does it differ from the permanent life insurance, it’s better to have a bird’s eye view of the salient features of term life insurance.
This policy covers the specific term. When that term reaches, the policy gets expired. Now it’s up to the will of the policyholder, either he is eager to renew it or terminate it.
In case of renewal, he will sign the contract for the next term that is pre-decided and if he does not want to continue the policy, he can withdraw his money.
Premiums can be increased by each renewal or depending upon the health conditions of the policyholder as per the plan of some insurance companies.
Is life insurance taxable?
A most commonly asked question by everyone who intends to be a policyholder which is asked as is life insurance taxable or not? Life insurance is not taxable except for some special circumstances.
Life insurance becomes taxable if the death benefit is not handed over to beneficiaries immediately after the death of the insured. Rather it is kept in the company account and interest is accumulated over it. That interest money is taxable.
Moreover, if the employer pays the premium on behalf of the employee, that money if exceeds a specific amount is considered taxable because it is counted as the income of policyholder.
How to select life insurance?
“Make good choices today, and you will not regret tomorrow.”
The first choice that one has to make is choosing between Term life insurance and permanent life insurance. Both kinds of policies with associated benefits and drawbacks have been discussed earlier. Who should go for which policy? it will be discussed here.
People who want to take benefits from a life insurance policy for a certain period instead of a lifetime, they should choose the term life insurance policy.
Another striking feature of term life insurance is that it can be availed by a person with a limited budget. Because it offers financial security for a specific period and also no cash value account associated with it, so it is cheaper than permanent life insurance.
How to choose a beneficiary?
A beneficiary in the life insurance policy is the one who can claim the death benefit of a policyholder in case of his death.
It’s not necessary to choose and nominate a single beneficiary, rather, a policyholder can nominate more than one beneficiary and percentage of money that will be given to each.
In addition to the primary beneficiary, there is a contingent beneficiary.
The contingent beneficiary is the one who will get the death benefit in case of the death of the primary beneficiary nominated by the policyholder.
However, not all the policyholder nominates the people as their beneficiary, some may nominate the trusts either to the existing ones or by creating a new trust.
In some situations, there is a need to update the name of the beneficiary depending upon the situation, for example, if a policyholder nominates his/her spouse as a beneficiary and later their marriage ends, he/she can update the beneficiary. This can be done by a discussion with the insurer and then applying to change the beneficiary.
In addition to primary beneficiary, there is a need to nominate a contingent beneficiary. Contingent beneficiary is the one who will get death benefit if primary beneficiary dies. According to the situation, such as death or divorce, the beneficiary can be updated by policyholder.
How to claim a death benefit?
If the policyholder is passed away, the beneficiary has to make a claim to the insurance company for the death benefit. The basic requirements for making a claim is to submit the death certificate along with the required documents for the identity of the policyholder.
If documentation is completed, the death benefit can be received in no time, probably within a month. If you are a beneficiary, and the policyholder dies, then don’t sit back and wait for the insurer to contact you. How can they get to know that policyholder is no more?
An important point is that the beneficiary doesn’t need to submit an original form of the life insurance policy. only you need to know the name of the insurance company and you can contact them regarding the claim.
Life insurance riders
Life insurance riders are the additional benefits that an insured person can purchase in addition to the typical benefits of the life insurance policy.
Different companies may offer a different kind of riders. The procedure to buy a life insurance riders is that the policyholder has to pay money in addition to the premium although some companies adjust the rider in basic premium package. Several kinds of riders are mentioned below:
Accidental death benefit rider
According to this rider, if a policyholder meets an accidental death, the life insurance policy will provide the extra coverage in addition to the normal death benefit.
Disability income rider
This rider provides a monthly stipend to the policyholder if he becomes disable and can not work for months or years.
Waiver of premium rider
Waiver of premium rider provides the benefit of relief from the payment of premium in case of inability of a policyholder to work and pay.
Accelerated death benefit rider
ADBR provides a facility to get a part or whole amount of death benefit if a policyholder is diagnosed with a life-threatening illness and near to death.
Long term care rider
It is also a kind of accelerated death benefit rider and pays the expenses of the nursing home, living assistance, and in-house care when the policyholder is disabled and needs full-time assistance for routine activities.
Riders are the extra benefits offered by insurance company if the policyholder pays extra money other than the premium.
Qualifying for life insurance policy
Generally, the people who are young and healthy with no serious ailments can easily qualify for a life insurance policy as compared to the elderly and sick people.
Another parameter that is considered while providing a person with life insurance, is a thorough check of is activities. For instance, life-threatening activities like smoking, skydiving, or any other risky hobbies can cause hindrance in buying life insurance or it may become costly.
When an applicant applies for life insurance, he is not granted with the one immediately. Instead, insurance companies do a thorough evaluation before providing life insurance services.
One can buy a policy from the company that suits him best either financially or physically. Different insurance companies offer different packages including small-size policy plans or specialized plans for the special needs of an applicant.
Moreover, if an applicant finds it difficult to search for the company with his desired policies, he can seek help from a broker without any fee. If you are willing to buy a life insurance policy, you will end up with the policy of your choice.
Younger and healthier applicants are easy choice for insurance companies as compared to the sick and elderly ones. Applicants with risky or life-threatening hobbies are least considered.
Frequently asked questions
There are some common questions mostly asked by people regarding life insurance policies. Brief answers to those questions have been given below:
1. Who has the best life insurance policy?
The names of the best life insurance companies of the year 2020 are given as:
Prudential financial- an American company.
Best in overall performance
State farm life insurance company- Canadian company
Provides best instant issuance.
Transamerica cooperation-an American company
Offers the best value.
Northwestern mutual-an American company
Provides best whole life insurance
New York life-United states company
Offers best term life insurance policies.
Mutual of Omaha-a USA based company
Offers best life insurance without medical examination
USAA life insurance company- New York-based
Provides best universal, term, and whole life insurance
2. What are the benefits of life insurance?
Life insurance is beneficial in many ways depending upon the requirements of the policyholder. If you have younger or handicapped children who are unable to live without your support, a life insurance policy is the best way to secure their future if you, unfortunately, pass away.
Similarly, life insurance can help your heirs to pay their hasty estate taxes in case of your demise. Permanent life insurance also serves as a saving account in form of a cash value plan, and you can take a loan from that money whenever you need during life along with the death benefit after death.
3. How much does life insurance give you?
According to most life insurance companies, and enough amount for life insurance is 6 to 10 times the salary of one year. However, life insurance that is required can be calculated by multiplying one’s annual salary to the years left in retirement.
There is another method called the standard of the living method. According to this, the total amount that the heirs will need to maintain the life standard in case of death of the insured is multiplied by 20. That will be the amount needed for life insurance.
4. What happens to your life insurance if you don’t die?
It happens in the case of a term life insurance policy. In a term life insurance, if the policyholder doesn’t die, the money that he has been paying as premiums will be in the account of the insurance company. All the premiums that an insured person pays to the insurance company while he is alive, will finally be paid to his family.
5. What type of death is not covered by life insurance?
The following types of deaths are not covered by life insurance policies:
Death due to intoxication, drug overdose, or excessive consumption of alcohol.
Death because of tobacco consumption, if it was not previously told to the insurance company while signing the contract that insured is tobacco addicted.
Death due to suicide or any other cause involving policyholder himself.
Most companies don’t even cover the deaths due to sexually transmitted diseases e.g. HIV or AIDS.
Death due to the involvement of policyholders in illegal activities.
Murder by the beneficiary.
Different types of life insurance policies work in a slightly different way except for the basics that are common in all policies.
Life insurance can be categorized as Permanent life insurance and term life insurance.
A permanent life insurance policy provides the full life coverage along with the death benefit in case of insured death.
It has further subtypes including whole life policy, universal life policy, variable life policy, variable-universal life policy, and the burial life policy.
Components that are common in all life insurance policies are Insurance Premiums and death benefits.
Permanent life insurance has an additional component called a cash value plan.
Term life policy gets expired after a pre-decided term and needs renewal or termination depending upon the desire of the policyholder. It just consists of premium and death benefit.
The death benefit is provided if the insured dies within a specific term.
Different riders (additional benefits) are offered by many insurance companies, according to which the insured can apply for extra benefits by paying extra in addition to the premium.
Life insurance policy can be chosen according to the budget and plan of the applicant.
The procedure to claim for the death benefit is that the beneficiary contacts the insurance company and submits the death certificate of the insured in addition to other documents required by the company.
Suicidal death, intoxication, murder by the beneficiary, murder due to illegal activities of the insured, and death due to STDs is mostly not covered by life insurance policies.