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How Life Insurance Works


A couple listens to a pitch from an insurance salesman.
A couple listens to a pitch from an insurance salesman.
Don Smetzer/Riser/Getty Images

Life is one big question mark: Will you be happy? Will you find love? Will you star in a reality TV show? Who knows? The only thing we can be sure of in life is that someday it will end. When, where and how are yet to be played out.

Your hope is that you die old and wealthy, able to leave your children enough money in your will to give them a head start on a successful life. But things don't always work out that way. You could cross the street tomorrow and get run over by a pack of wild Segways.

Sure, it's a morbid thought, but it makes you wonder how your family would get by without you. Would they have enough money to keep the house? Could the kids pay their own way through college? Would your wife have to cash in your stamp collection?

Life insurance should really be called "death insurance." Like other types of insurance, life insurance is protection against the unknown. When you buy life insurance, you're paying for the peace of mind that your family will be taken care of in the event of your sudden demise. Life insurance is the life jacket in the fishing boat, the air bag in the car. You hope to never have to use it, but it's nice to know it's there.

Some people call life insurance gambling. They think that you're throwing away a bunch of money on the off chance that you'll die young. But when life insurance is handled correctly, it isn't gambling at all. It's simply part of a larger economic plan whose goal is the financial security of your family.

So what is the best type of life insurance to buy and how much coverage do you need? If you don't have any kids, do you even need life insurance? Keep reading to find the answers to these questions and more!

What is Life Insurance?

Before offering a life insurance policy, you'll be asked for a full medical history, your lifestyle and hobbies.
Before offering a life insurance policy, you'll be asked for a full medical history, your lifestyle and hobbies.
Sandy Jones/Photodisc/Getty Images

People buy life insurance to provide money for their families if they die young. When you buy a life insurance policy, you pay a monthly, quarterly or annual premium for the term of the policy. The term can be as short as one year or as long as a lifetime. If you die within the term of your policy, your beneficiary will receive a fixed amount of money.

The earliest records of life insurance come from ancient Rome, where burial clubs pooled money among the poor to pay for members' funerals [source: Imber]. Beginning in the Middle Ages, life insurance was dominated by fraternal and religious organizations, labor guilds, and mutual life insurance companies. Similar to credit unions, mutual life insurance companies are owned by the members, who share in any profits. In the late 17th century, astronomer Edmond Halley (yes, the comet guy) came up with the first actuarial tables for calculating the risk of insuring an individual based on mortality statistics [source: Warren]. The higher the risk, the higher the premium.

Risk calculation is still a big part of the life insurance business. When you apply for a life insurance policy, you'll be asked to fill out a full medical history (including your family medical history). You'll also be asked questions about your lifestyle and hobbies, your credit history, your driving record and your travel habits [source: SmartMoney.com]. All of this information is used by insurance actuaries to figure out how much they should charge you for a life insurance policy, or if they should deny you a policy altogether.

The most important factors that affect the price of life insurance premiums are age, sex and pre-existing medical conditions. Older people will generally pay more for a life insurance policy, as will men. Heart conditions, high blood pressure, mental illness, or a strong family history of heart disease or cancer will raise your insurance premiums. Insurance companies also offer higher rates to people who participate in "dangerous" hobbies like skydiving or scuba diving. Smokers can expect to pay rates that are twice as high as non-smokers [source: SmartMoney.com].

To collect on a life insurance policy, a surviving family member must fill out an official claim. Usually, he or she will also have to provide a certified death certificate that states the date, location and cause of death. In some cases, he or she will also be asked for original copies of the insurance policy. Once approved, the claim is settled with one lump sum payment to the person indicated in the policy as the beneficiary.

Unfortunately, life insurance claims can also be denied. Many life insurance policies don't cover suicide. If an insurance company suspects that a claim is fraudulent, it will investigate it fully. If it finds that the claimant lied about the cause of death, or that the policyholder neglected to mention pre-existing medical conditions or dangerous hobbies, it could deny payment.

But does everyone need life insurance? And what are the best times to buy a policy? Read on to learn more.

Who Needs Life Insurance?

People of retirement age may keep a life insurance policy to pay for end-of-life expenses, such as the costs of settling an estate.
People of retirement age may keep a life insurance policy to pay for end-of-life expenses, such as the costs of settling an estate.
Inti St. Clair/Photodisc/Getty Images

Not everyone needs life insurance. The general rule is that you only need life insurance if you have dependents. Typically, dependents are children who still live at home or have yet to graduate from college. But a dependent could be anyone who is financially dependent on you, like a spouse, sibling or an aging parent.

Life insurance is generally designed for younger, working people with families. Here's why: Life insurance is meant to replace your "value" to your family once you're gone. For a working parent, a big part of that value is your salary. If you die, you'll want your family to receive enough money to replace your salary for at least the next five to seven years [source: Money.com].

Even if you're a stay-at-home parent, you still have financial value to your family. Let's say you care for two small children. If you die, then your spouse will need to keep working, which means the kids will need a nanny or day care. You might not need a huge life insurance policy, but you can buy a policy that fits the financial needs of your family.

Some people buy life insurance policies when they get married, particularly if the insured person makes considerably more money that the spouse, or if either the insured or the spouse have other financial dependents, like parents or siblings. Most people buy life insurance when they get pregnant with their first child.

Once you've reached retirement age, there's less of a need for life insurance. Now your children are most likely financially independent and you're already living on retirement savings and investment income. One reason for an older person to keep a life insurance policy is to provide extra money for his or her spouse to cover unexpected medical and long-term care expenses later in life.

Some older people hold onto life insurance policies as a way to pay for "end of life" expenses like the cost of settling an estate. But the most basic reason for retaining a life insurance policy later in life is also the oldest reason: to cover the cost of your funeral and burial.

Another reason to buy life insurance to is to pay for a particular expense. If you buy a home, it's common to sign up for a 30-year mortgage. But what if you die in 10 years? There are special life insurance policies that are tied directly to mortgages, decreasing in value as you continue to pay off the mortgage debt.

A less common reason to buy life insurance has to do with business rather than family. Let's say you're a partner in a small business and the success of the business relies significantly on your ability to bring in clients and money. Some people buy life insurance policies that name their business partner as the beneficiary. This chunk of cash could help the business stay afloat while they learn to get along without you.

So now you have a better idea of who needs life insurance. But what type of life insurance policy should you buy? Are they strictly for emergencies or can they also be reliable investment tools? We'll talk about all of the different types of life insurance in the next section.

Types of Life Insurance

The most basic type of life insurance is term life insurance. Term life insurance policies cover the policyholder for a set number of years, anywhere from 1 to 30. For younger, healthy people, term life insurance is the least expensive option. You pay relatively low rates for a fixed number of years with a high level of coverage.

Something to consider if you choose term life is that the premium is only fixed for the length of the policy. If the policy expires and you want to renew, you'll pay a higher premium because you're older now, and maybe less healthy. Term life policies have no cash value of their own. They don't accrue interest and you can't borrow money against them. Basically, they're "pure" insurance products. If you don't die, you can't collect.

All of the other types of life insurance fall under the heading of permanent life insurance. As the name implies, the policy is good from the day you buy it until the day you die, no matter when you die. Permanent life policies can either have a fixed or flexible premium.

The biggest difference between term and permanent life policies is that permanent policies include a cash value component. This means that the insurance company invests your premium payments to build up cash reserves in your account. The advantage of permanent life is that you aren't taxed on investment earnings until you cash in the policy, and you can borrow from your cash reserves tax-free. The disadvantage is that premiums are much higher than term life policies and investment performance can be volatile.

There are several different types of permanent life policies:

  • Whole Life is the most basic permanent life insurance policy with a fixed premium. It has a savings component that earns cash value, but the policyholder has no control over how or where the money is invested.
  • Universal Life allows the policyholder to shift funds between the insurance and savings components of the policy, even using savings to make premium payments. Premium rates are also flexible.
  • Variable Life gives the policyholder control over where his or her savings are invested (stocks, bonds, mutual funds, etc.). The rate of return on investments not only affects the cash value of the policy, but increases or decreases the amount of the final death benefit. Premiums with this policy are fixed.
  • Universal Variable Life combines the flexibility of universal life with the investment control of variable life. Premiums are flexible and the amount of the final death benefit and cash value depend on the performance of investments.

So how much life insurance do you really need? And for how long do you need it? Find out in the next section.

How much life insurance do I need?

Life insurance can help pay for your childrens' college education if you should die early.
Life insurance can help pay for your childrens' college education if you should die early.
James Woodson/Digital Vision/Getty Images

Life insurance is just one part of a larger financial plan. How much life insurance you buy depends on the specific financial needs and circumstances of your family. How many kids do you have? Do you plan on paying for their college education? How big is your mortgage? What other debts do you have?

The trick is to strike a balance between being over-insured and under-insured. Paying too much in premiums can be just as damaging to your overall financial plan as paying too little [source: California Department of Insurance].

The easiest way to think about life insurance is as income replacement. The first step is to figure out exactly how much income you provide to your family. This is not simply your salary. You have to subtract income tax and the amount of money that you spend on personal expenses like clothing, food, travel, memberships, etc. What's left is the real amount of money that you contribute to the family.

The next step is to figure out how long you're going to need to replace your income. As a general rule, you only need life insurance until your dependent children are out of the house or until your retirement savings kick in. So if you're 30 years old, you might want a policy that covers you for the next 30 years. Take your adjusted annual income and multiply it by 30 years. That's the amount of coverage you need. This amount is also called the face value or death benefit of a life insurance policy.

But remember that the amount of life insurance you buy needs to fit within your budget. There's no point in buying a policy with a high face value if you can't afford the premium payments. At some point, you'll default on your payments and the policy will be canceled.

If you can afford to pay a higher premium, though, you should think about purchasing a plan that will cover major life expenses like paying for your kids' college education and covering the mortgage. Then there are other possible expenses, like taking care of aging parents or childcare costs if you're the primary caregiver for the children.

If you start adding it all up, it may seem like a lot of money. But once again, you need to strike a balance. If your life insurance premiums prevent you from paying back high interest debt like credit cards, then you're paying too much. For most people, the idea of life insurance isn't to set up your family for life, but to help them get through the first five to 10 years after your tragic loss. That's why some experts fall back on the old life insurance rule of thumb: Buy enough to replace your salary for five to seven years.

So where should you buy life insurance anyway? From a pushy door-to-door insurance salesperson? And how do you avoid paying for something you really don't need? Read our life insurance shopping tips in the next section. ­

Life Insurance Shopping Tips

The image of the annoying insurance salesperson is a stereotype that goes back a long time.
The image of the annoying insurance salesperson is a stereotype that goes back a long time.
George Marks/Retrofile RF/Getty Images

The first life insurance shopping tip is to buy when you're young and healthy. But don't buy insurance too young. Wait until you have your first dependent. Young, healthy people pay much lower premiums, so look for a policy that has a fixed premium for the length of the policy.

Now what about those pesky life insurance salespeople? Insurance salespeople, like car salespeople, get a bad rap because their income depends on commissions. Naturally, it's in the salesperson's best interest to leave out any bothersome details that might prevent you from buying the most expensive product. That said, a good insurance salesperson can help tailor a policy that's exactly right for your needs. But it certainly pays to be an educated consumer.

Think hard before you buy a permanent life insurance policy. Insurance salespeople push whole life and other cash-value policies because they're big moneymakers for the insurance company and for the salesperson. If you buy a permanent life policy, as much as 80 percent of your first year of premium payments will go straight to the salesperson's commission. With a term life policy, he or she'll only get 10 percent [source: Money.com].

The truth is that most people don't need permanent life insurance policies. They only need to replace their income until they've reached retirement age or their dependents are old enough to take care of themselves.

Insurance agents try to sell permanent life policies as investment vehicles and important cash reserves for low-interest loans. The problem with this argument is that there are many other tax-deferred investment instruments out there that have lower commissions and greater flexibility than permanent life insurance. IRAs and 401(k)s protect earnings from taxes, charge tiny commissions and allow account holders complete control over their investments. To have that kind of flexibility and control with a permanent life insurance policy, you'd need to buy a universal variable policy, which charges high premiums and high commissions.

The idea of borrowing money from the cash value of your insurance policy also sounds attractive. But first consider your credit history and the likelihood of accruing more debt. If you have a good credit score, you can get low-interest loans from banks and other lenders. And if you default, you won't eat up your life insurance death benefit (the main reason you bought the policy in the first place). But if you have a bad credit history, and there's a good chance that you'll be taking on even more debt, then the interest rates offered by a life insurance policy might be attractive.

Also make sure that you're aware of the consequences for canceling an existing life insurance policy and buying a new one. Some policies charge expensive early termination fees, and you may be subject to additional "start-up costs" to activate the new policy. If you bought your existing policy when you were young, then you're surrendering a relatively low fixed premium. Sometimes there are waiting periods before you can access cash reserves in a new policy, and there can also be tax consequences for switching policies. Bottom line: Speak with a representative of your existing company before signing up with a new one.

The Web can be a great resource for shopping for life insurance. Sites like Insure.com let you fill out a questionnaire about your insurance needs and compare prices from many vendors. Look for companies that are highly rated by an independent institution like Standard and Poor's and A.M. Best [source: Money.com].

For even more information on insurance, financial planning and related topics, investigate the links on the next page.

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Sources

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