Life Insurance: What is it, How does it Work, & How Can I Find the Best Policy?

What Is Life Insurance?

Chances are, if you’re on this website, you already have a basic understanding of life insurance as a contract between an insurance company (insurer) and a policyholder, in which the insurer promises a sum of money will be paid out once the policyholder passes away, in exchange for consistent and timely payment of premiums from the policyholder. 

Basically you, the policyholder, will pay a recurring amount of money (monthly or annually) to an insurance company and, should you die while your policy is active, the insurance company will pay a tax-free amount of money. The idea behind life insurance is to ensure your family or loved ones can achieve financial goals, such as paying off debts, paying for college, or paying a mortgage. 

There are a variety of types of life insurance, and the amount or type you may need depends on your unique financial situation, your risk to the insurer, and how long you want your policy to last. 

How Does Life Insurance Work?

Life insurance is a legally binding contract, you enter into after filling out an application and being approved. Life insurance policies typically consist of two main components:

1. The Premium –  The premium, as you may already know, is the money you pay for the insurance. So long as you are paying your premiums and your policy is in good standing, it is the insurer’s job to pay the benefit to your beneficiaries. Premiums are determined by a few factors, including how large the policy is, what type of life insurance policy you choose, and your risk to the insurance company. If you’re concerned about finding life insurance premiums to fit in with your budget, we can help!
   
2. The Death Benefit –  The death benefit, sometimes referred to as the “benefit,” is the amount of money the insurer will pay to your beneficiaries once the person insured dies. You, the insured, will choose a death benefit based on the estimated future financial needs of your family. Confused as to how much insurance to get? Give us a call!

Because life insurance is so customizable, your policy may also come with an additional component, called a life insurance rider.  Think of this like an amendment, or an addition, to the terms of your life insurance policy. We cover riders more in-depth in the article Riders, Explained.

If you choose a whole life insurance policy, your policy has a third component, called a cash value. Whole life insurance policies act as a savings account that the policyholder can use during his or her lifetime. Cash accumulates within the policy, on a tax-deferred basis, and this cash can be used to pay premiums, buy more insurance, or can be withdrawn as a loan.

The Application Process

You have to apply in order to qualify for a life insurance policy, which may seem daunting. No worries! An independent agent can help walk you through the application process, as sometimes applications can get complicated.  

A basic life insurance application will consist of a questionnaire asking for details about your lifestyle, including:

• Your medical history. Underwriters, or the individuals assessing your risk, will take a deep dive into your medical history before approving or denying your application. Your medical history includes your blood pressure, cholesterol levels, current or past medications, and current or past treatments for conditions. 

The assessment doesn’t stop there. Underwriters will also examine your height, weight, and age to determine the full picture of your health risk. Any history of drug use, alcohol, or substance abuse will also be taken into consideration when assessing how risky it will be for an insurer to take on your policy. You will most likely be asked to undergo a life insurance medical exam.  

• Your family’s medical/health history. Your health is not the only thing underwriters will look at during the application process. Your family’s health history – particularly cancer history, diabetes, cholesterol, and heart issues – plays a large role in your current and future health. As a result, most insurance companies consider an applicant’s family history when classifying their risk. A family history of cancer, heart disease, stroke, and early death will impact your application. This is especially why it’s important to hire an agent, who can fully present your case and advocate for you.
  
• Your tobacco use. We’ll get into this in more depth in a later post, but you should know that being a smoker won’t disqualify you for life insurance – although it does raise your risk and, most likely, your premiums. Most carriers assess risk differently, so you should review your carrier’s underwriting guidelines with your agent to discuss how smoking may impact your life insurance policy. 

The four main risk classes you’ll encounter are Preferred, Standard, Substandard, and Declined. Occasionally, companies will offer additional classifications, such as Standard Plus (sometimes known as Select) and Preferred Plus.

Your answers to each of these questions will determine your risk category and, subsequently, will factor into what you pay for your premium.  

Who Needs A Life Insurance Policy?

The short answer: anyone! A life insurance policy is a cornerstone of a strong financial plan. As much as we don’t like thinking about our mortality, it is important to plan ahead, especially for those who have families that are dependent on their income. Check out our “Life Insurance at Every Age” series for more specific information about what kind of life insurance might be right for your age group. 

Life insurance can be used for quite a few things, including: 

Paying for Retirement – We don’t typically recommend our clients rely solely on their life insurance policy to fund their retirement; however, policies with investment and cash value components can help boost retirement income. Keep in mind: that this will lower your death benefit, but if you have maxed out other investment accounts and tax-advantaged savings opportunities, policies with a cash value or investment component can provide an alternate source of retirement income. 

Borrowing Money or Taking Out Loans – Again: this is not an option that we recommend, but a life insurance plan with cash value allows the policyholder to borrow money from the insurance policy, and to use that cash value as collateral. An added bonus to this form of borrowing is that your credit score is not taken into consideration when borrowing, all interest returns to your account, and repayment is flexible. 

In some instances, you will be required to take out a life insurance policy in order to get a loan. This mostly occurs with SBA, or Small Business Administration, Loans. A life insurance policy is required to ensure the loan is paid back in the event that something happens to you, the lendee. 

Estate Tax Payment or Avoidance – If you are a wealthier individual looking to buy whole, or permanent, life insurance, this policy can be used to assist in covering estate taxes after your passing. The reason someone would want to do this is to preserve the estate value and to minimize your tax liability. Additionally, in almost all cases (with almost all policy types), the death benefit will be tax-free.

Hopefully, we were able to answer a few of your questions about the basics of life insurance. Take a look at our other blog posts for more in-depth information. If you have a question that we haven’t covered, give us a call! Our knowledgeable life insurance agents will be happy to answer any life insurance questions you may have!