What is life insurance?
In simple terms, life insurance will pay a lump sum to a beneficiary in the event that you pass away while the policy is in effect. The purpose of life insurance is to help cover any financial burden you may leave behind (funeral costs, medical bills, debts, etc.).
Do I need life insurance?
Here are some examples of people who should consider life insurance:
– Spouses/Parents. According to a 2018 study, 35% of households would have financial difficulty within just one month of a primary wage-earner passing. Life insurance can help close that gap and provide a safety net for your surviving spouse and/or children.
– Homeowners. Mortgages are a large debt to take on and do not disappear if you die. You can name a beneficiary on your policy whom you trust to continue those payments after you’re gone. You can even have the proceeds from the policy be paid directly to the mortgage lender.
– Business Owners. Often referred to as a Key Person policy, life insurance can help cover lost revenue and business expenses resulting from the loss of a key employee, such as a business partner.
– Students. Did your parents co-sign on your student loans? If the answer is yes, they will be liable for paying off those loans in the event that you pass away even if it happens years after you are out of college. Young people need life insurance, too!
– Anybody with no sizable assets. The average funeral costs between $7,000 and $10,000. Think about who would be responsible for paying for your funeral and final medical expenses if you pass away. Life insurance can help cover those costs and allow your loved ones more time to grieve.
– Young/Healthy. Life insurance premiums are much lower if you are under the age of 35. Increased age brings a higher risk to the insurance company. Therefore, the older you get, the higher your premium will be. People under 35 typically also fall into one, if not both, of the previous 2 examples.
You don’t necessarily need to fall into one of these categories to consider life insurance. You can even designate the proceeds of your policy to be paid to your favorite charitable foundation!
Death Benefit. aka Face Amount/Face Value. The amount of money that gets paid out if you die while the policy is in effect.
Term. This is how long the policy lasts. Depending on the type of policy, the term can expire after 1-30 years, or continue through your entire lifetime.
Beneficiary. This is who the death benefit gets paid to. This can be your spouse, children, a trust, or even a charitable foundation.
Premium. The cost to keep your policy active is called the premium. The premium can commonly be paid monthly, quarterly, or annually.
Underwriting. This is when the insurance company reviews all of the information they collected during the application process and assesses how risky you are to insure – or your risk class. Things like your age, health, hobbies, occupation, family health history, and many other factors are considered during the underwriting process. The outcome of this process will determine your premium. You may also be denied coverage altogether.
Risk Class/Classification. Your classification will determine how high or low your premium will be. The better your health is, the better your classification, and typically the lower your premium will be. The definitions for each classification will vary from company to company but may be similar.
Rider. Think of these as add-ons to enhance the overall utility of your policy. Riders will typically raise your overall premium but you may find the additional cost worth the added benefits they bring. Learn more about the different types of riders here.
Types of Life Insurance
There are many different types of life insurance but there are 2 main categories to remember:
Term insurance the most straight-forward and least expensive type of life insurance.
One of the main things to remember about term insurance is that it is only active for a set period of time – the term. Available term lengths are from 1 year to 30 years. Terms are typically only available in increments of 5 years (5, 10, 15, etc.). If the insured passes away during the term, the death benefit is paid to the beneficiary. If the insured does not pass away before the term ends, nothing is paid out to the beneficiary and the policy ends.
The other important thing to remember is that term policies do not have a cash value.
The premium on term policies are commonly level and stay the same for the life of the policy. However, in some cases the premium can increase or decrease. Read more about the different features of term life insurance here.
Permanent policies differ from term policies in a few, big ways.
Firstly, instead of there being a set term for these policies, permanent policies are active for as long as premiums are paid.
Secondly, these policies have the ability to accrue a cash value. In the event that the insured passes away while the policy is active, the beneficiary may receive the death benefit and the accrued cash value.
There are 3 unique sub-types of permanent policies: Whole, Universal, and Variable.
Take a look at the chart below to see a basic comparison between all of these policy types. Read each article about the individual types to learn even more.
Single-Premium Insurance (SPL)
Single-premium, or single-pay, insurance is a policy that is entirely funded with one lump sum payment. This option is only available on permanent insurance policies. In IUL products, an SPL policy allows the cash value to grow at a guaranteed rate without having to pay premiums. In variable products, an SPL policy allows the cash value to remain invested so it may fluctuate with the market. One of the benefits to a SPL variable policy is that the policyholder can pay additional premiums to grow the cash value if they so choose.
The downfall of single-premium policies is that they are all automatically considered to be modified endowment contracts (MEC). If an insurance policy is written after June 20, 1988 and fails the 7-pay test, it is considered to be a MEC. In a MEC contract, funding has exceeded the amount of premium that would have been necessary to pay the policy up within 7 years. Withdrawals or loans on these policies for policyholders younger than 59 1/2 are subject to a 10% tax penalty so they are ideal for people who do not plan on taking pre-death withdrawals.