What is Life Insurance and How Exactly Does It Work

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I’m sure at some point in your life you’ve wondered what life insurance is and how it works.

It’s a fair question as it’s a complicated topic that a lot of people don’t think about until later in life. Or ever, which can lead to financial problems down the road.

According to statistics compiled by ThinkAdvisor, 85% of consumers in a 2013 survey agreed that most people need life insurance, yet only 62% actually had it. The article also says that consumers think life insurance payments are three times the actual price. And, 70% of Americans failed a 10-question basic life insurance IQ test. There’s clearly a lot of confusion about what life insurance is and how it actually works.

My goal is to help you better understand life insurance. In this post, I’ll try to clear up that confusion to make sure you and your family are protected.

What is Life Insurance?

So, what exactly is life insurance? How does it work? Is it really complicated?

As someone who bought life insurance in 2017, I can say it does take some work but it’s not as bad as you might think. I’m confident you’ll understand the basics once you finish reading this post.

The easiest way to think about life insurance is that it’s coverage that pays out a specified amount to your designated beneficiaries when you pass away.

As long as you keep paying the premium, the life insurance company will keep assuming the risk. If you suddenly stop paying the monthly, quarterly or annual premium, then the coverage will be lost and your loved ones won’t be protected.

One key point to keep in mind is that the older you are, the higher the insurance premium usually. So make sure to get started earlier. The younger and healthier you are, the sooner your family is protected and the cheaper the payments.

As you can see, the idea of life insurance itself is pretty simple. But choosing the type of insurance, taking the medical exam, applying for it, and choosing the benefits gets a little more complicated.

The Two Main Types of Life Insurance

Before you start shopping around for life insurance, it’s important to know the two main types of life insurance: term life insurance and whole life insurance.

Term Life Insurance

This is the easiest type of insurance to understand. Term life insurance offers a guaranteed level death benefit for a fixed period of time. The terms are usually 10, 20 or 30 years. Term life insurance is often purchased for short-term needs.

Most term life insurance plans are “level” policies, meaning the premiums are fixed for the term. For example, if you buy a 20-year policy, you may pay $150 every month for 20 years. That premium amount is locked in for the term.

Here are the other key features of term life insurance:

  • Term life insurance is cheaper than whole life insurance.
  • Unlike whole life insurance, there is no cash value associated with term insurance. It only pays out in the case of death. If you outlive your insurance policy, there is no refund or deferred saving plan. Just like auto or pet insurance, the premiums are non-refundable.
  • The premiums for a level plan are set for a fixed term. The premiums can’t increase during your term, even if you have a change in health.

Check out the best term life insurance companies to learn more.

Whole Life Insurance

Whole life insurance offers lifetime coverage with the additional benefit of accumulating a cash value. It is often purchased for supplemental retirement income.

Because it doesn’t expire, it’s known as a type of permanent life insurance.

Here are the key features of whole life insurance:

  • Whole life insurance offers lifetime coverage as long as you keep meeting the premium requirements.
  • Cash value is associated with your account, which makes it an automatic savings vehicle. A portion of the premiums accrue in a “cash value” account. This typically earns interest and dividends. You can make a withdrawal from it or take out a loan against it, provided that the cost of insurance has been paid. To build cash value, you can pay more than the scheduled premium or reinvest dividends into the cash value.
  • You have the ability to take out policy loans. The benefit here is potential access to money (as it is a loan) without needing to apply or qualify for a loan elsewhere. Interest is assessed on the outstanding balance and loans may or may not ever have to be paid back. If you don’t pay the loan back, you’ll reduce your death benefit.
  • Fixed monthly premiums are paid every year. The premiums can be paid out of pocket. Or, you can pay using policy dividends or borrow from the cash value of the account.
  • It’s by far the most expensive type of life insurance. And it’s more complicated than term life insurance.

Check out all the differences for term life insurance versus whole life insurance for more information.

I typically recommend buying term life insurance because it’s cheaper and easier to understand. That usually makes it more you’ll get started. Don’t let the complexities of whole life hold you back from ever getting started buying life insurance.

The Process of Getting Life Insurance

It’s actually pretty simple to get started with a term life insurance plan. Here is the seven-step process:

1. Shop Around for Rates

The rates will vary from company to company. They’re dependent on your age, medical history, coverage amount, term length and other factors. You have three main ways to buy life insurance:

  • Directly from an insurer
  • Through an insurance agent
  • Through an insurance broker

An insurance agent represents one or more insurance companies. An insurance broker represents the insurance buyer. Both sell insurance, but insurance agents typically work for one insurance company and only sell those policies. Brokers can have relationships with several companies and offer more plans.

As you can imagine, there are a ton of options when it comes to buying life insurance. I recommend shopping around to find the best rates. While you should have some urgency, don’t rush into such a huge financial decision.

If you don’t go with a broker, you can start the process by getting free quotes from Policy Genius, a comparison website for term life insurance companies. You will need to submit sufficient details to get an accurate quote on the policy type and coverage you’re interested in.

2. Speak With an Agent and/or Submit an Application Online

Once you narrow your choices down to a few companies, I recommend speaking with an agent from each one. They can help you tweak coverage amounts and term lengths over the phone. Plus, they’ll help answer any questions you might have during the application process.

Remember that you don’t have to pay anything for this consultation. By comparing prices, benefits, exclusions and riders, you can narrow down your choices to an affordable policy with adequate coverage.

In my case, I also had a phone interview that took around one hour once I submitted my application. This was a detailed look into my past medical history, prescriptions and personal life. Make sure you have enough time blocked off for this interview and have all of your medical records ready. Get prepared to answer a lot of questions.

3. Get Your Health Exam

For the majority of life insurance plans, a health exam is required. This means you’ll have to do bloodwork and a few other tests to ensure you’re relatively healthy. Pre-existing conditions play a major role in your life insurance needs, and could affect your premium.

In my case, I didn’t have to go to the doctor for an exam. The insurance company had someone come directly to my house for a 30-minute checkup. While this is a minor inconvenience, don’t let it be the reason you don’t have life insurance.

4. Play the Waiting Game

This part is a bit tedious. You might have to wait a week or several weeks before a decision on your application is made.

After considering the full scope of your application, the insurer will decide whether to provide you with coverage and, if so, what your premium will be. Don’t be surprised if they ask you to submit further information, including medical records and tests.

5. Choose a Beneficiary or Beneficiaries

Part of the process of signing up for a life insurance policy is designating the people who will receive your policy’s benefits after you die. Most policyholders designate their spouse or children, but you can assign your benefits to anybody who depends on you financially.

If you want to change your beneficiaries at any time, updating your policy is fairly simple. You can usually do it online, or by calling the company. If you have an estate planner, you’ll want to let them know of any beneficiary changes as well.

It’s a good idea to review who you’ve chosen as beneficiaries every few years. As life happens and things change, make sure you always have the right beneficiaries for your plan. Events like births, deaths, marriage and divorce are also good times to review your policy.

6. Finalize the Life Insurance Policy

One of the last steps is to sign your policy contracts. After your application is accepted, you’ll sign a contract of agreement with the insurer, who then puts your coverage in place.

Now it’s time to celebrate that you’re no longer among the Americans who don’t have life insurance!

7. Start Paying Your Premiums

The final step in the life insurance process is to begin paying your premiums. You’ll pay your premiums as specified in your contract. As long as you continue making payments on your policy, it remains active.

Most plans offer some sort of discounts if you pay annually instead of monthly or quarterly, so be sure to ask about those.

FAQs About Life Insurance

Got more questions about life insurance? Here are answers to some of the most common:

How Much Life Insurance Should I Buy?

A typical rule of thumb is 10 times your current annual salary. For instance, if you make $60,000 per year, then you should have at least $600,000 in life insurance. However, everyone’s situation is different, so make sure to consider the following:

How Much Debt Do You Currently Have?

Debt is a great place to start when choosing how much life insurance to buy. Here’s a quick example. Let’s say you have the following debt obligations:

  • Mortgage: $150,000
  • Credit cards: $10,000
  • Car loans: $30,000

These three types total out at $190,000 of debt. You may want to consider adding your debt total to the 10x rule. That means if you make $60,000 then you would want $790,000 in term life insurance ($600,000 + $190,000).

How Many Children Do You Have?

Kids are one of the main reasons people choose to buy life insurance in the first place. While children are great, they can be very expensive. Always remember the goal of life insurance is to keep your family safe and provide future income for your spouse or children.

Start thinking about these things when choosing life insurance:

  • Do you want to pay for your kids to go to college or at least help fund their tuition? Maybe factor in about $40,000 per child.
  • Do you need to pay for daycare costs if something were to happen to you? This could be a big one, depending on the age of your child and the area where you live.
  • Do you want to pay for their weddings? If so, consider $20,000 per child.

What Do Life Insurance Agents Do?

A life insurance agent’s only goal in life is to help you find a policy that best meets your needs. I used a life insurance agent and it was a huge help when making my decision. They will factor in your family obligations, finances, health and personal circumstances.

You should be presented with a number of options that meet your criteria, and the agent will clearly explain the details. They are there to expedite the process, answer questions and eliminate doubt.

Once you’ve purchased a policy, the agent should be available to review the details of the policy, including beneficiary designations, every few years.

Who Gets the Payout if Something Happens?

If something does happen to you, the designated beneficiary or beneficiaries are paid out. You don’t have to choose one person, either. You can choose:

  • A person or a group of people, such as a family member or multiple family members
  • A trust you’ve established
  • A charity or nonprofit organization
  • Your estate

It’s important to know that some states have restrictions on who can be named as a beneficiary. You’ll want to research whether your state has any.

What About Life Insurance My Employer Offers?

A lot of employers offer some sort of life insurance policy, often at no cost to you. While this is a nice perk, it may not be enough.

Employer-sponsored plans are blanket policies, meaning you don’t get to decide coverage amounts or anything specific. Study the plan and if it doesn’t provide enough protection, get another policy to supplement it.

Can I Have More Than One Type of Life Insurance?

Yes, you 100% can. It’s common for people to start with term life insurance in their 20s or 30s. Then they add another term plan when things when their financial situations change.

As long as you can cover the premiums, there is no limit in terms of life insurance options.

Can I Cancel My Life Insurance Policy?

Yes. If you decide you no longer need the protection of your plan, you can let your insurer know that you’d like to cancel your life insurance.

If you change your mind after canceling your policy, you’ll likely face higher premiums in the future. Remember, the older you are, the higher your premiums will be.

If you recently signed up for a policy and you’d like to cancel, there is typically a cool-off period. Many providers allow you up to 30 days to change your mind without any fees or penalties.

What If I’m Already in My 40s?

The sooner you act, the better. But if you’ve waited until your 40s, don’t let that hinder you from starting now. You can still usually get life insurance.

However, once you get into your 60s, however, premiums get so high that I recommend insuring yourself. In other words, save on your own to provide income to your loved ones when you pass.

Final Thoughts About Life Insurance

Life insurance is a difficult subject to think about, as it means thinking about your life ending. Still, it’s necessary to have in place. The last thing you want is to leave your family dealing with a financial struggle along with grief.

The younger and healthier you are, the easier and cheaper the process. Remember, you can have more than one type of life insurance or continue to buy different term plans every few years.

If you’re more financially savvy and want even more protection, look into whole life insurance plans. But if you’re just getting started, I recommend term life insurance. Keep it simple so you can sign up quickly and easily.

The worst thing you can do is end up like one of the statistics from the beginning of this article — the people who know they need life insurance but never act on it. Don’t just blindly depend on your employer for a plan. Make sure you have enough coverage, and if you don’t, set up on your own plan.

Do you have life insurance? Why or why not? Let us know on social media.

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