Life Insurance Basics: How It Works & What It Covers

Key Takeaways

  • Insurance is sold, not bought, so the first step is to identify the NEED for insurance.
  • Howland Capital neither sells insurance nor benefits in any way if a policy is put in place.
  • Life insurance can provide valuable financial protection for loved ones in the event of your passing.
  • Term life insurance provides protection for a set period of time, while permanent insurance offers lifetime coverage.
  • While a guaranteed financial safety net and income replacement are top reasons to buy life insurance, tax-free benefits, and cash-value growth are also important to consider.

What is Life Insurance?

At its core, life insurance is a form of financial protection for loved ones should something happen to you. More specifically, life insurance is a contract with an insurance company that—in exchange for premium payments—guarantees a cash death benefit to beneficiaries if the insured dies while the policy is active.

There are different types of life insurance, and all of them can help cover expenses at any life stage, whether they are current, ongoing, or anticipated in the future. Who depends on you financially? If you are married, life insurance proceeds could be valuable protection if your spouse relies on your income. If you have a family, a life insurance benefit could cover childcare costs or help fund a future college education. If you are retired, cash from a life insurance policy can give heirs access to tax-free money to pay for immediate costs and more.  Note that when we say “tax-free,” we primarily mean free of income tax.  If the policy falls within the insured person’s taxable estate, it may still be subject to estate tax.

The following is our primer on life insurance basics.

The 2 Types of Life Insurance to Know

Finding the right life insurance for your financial goals starts by understanding the two main types of life insurance policies: term and permanent. Term life insurance provides protection for a set period of time, while permanent insurance has the potential to offer lifetime coverage. Here are the details about each type.

Term Life Insurance

Term life insurance covers you for a fixed number of years, such as five, 10, 20, or 30, and pays a death benefit if you pass away during the covered term.

Term life insurance policies offer a level premium and death benefit, and some give you the ability to convert to a permanent policy if your needs change during the term of the policy. The longer the term you choose, the higher the premium payments will be, but with term life, you are buying the largest death benefit protection for the lowest cost.  Term policies are particularly well suited to offset future college tuition or outstanding mortgage liabilities.

Permanent Life Insurance

Unlike term life, which comes with a time limit, permanent life insurance potentially offers lifelong protection as long as you make the premium payments. Many types of this coverage also build cash value on a tax-deferred basis, which you can withdraw or borrow against for financial needs. (Withdrawals or outstanding loans reduce the death benefit and usually come at a high interest rate). Because of the additional benefit, premium payments are higher than what you would pay for a term life insurance policy with the same amount of death benefit coverage.

Under the permanent life insurance umbrella there are four categories:

  • Universal life
  • Indexed universal life
  • Whole life
  • Variable universal life.

Here’s a quick look at each:

Whole life insurance is the most popular type of permanent life insurance (in other words agents sell these policies the most because of the high payouts to them!), with fixed premium payments and a guaranteed death benefit. Your cash value is guaranteed to grow by at least a minimum amount annually, and you might also receive dividends based on the performance of the insurer’s investments, which you can reinvest, receive as cash, or use to offset premium payments.

Universal life is more flexible in that it allows for changes to both your premium and death benefits. The rate of growth of your cash value, however, is subject to change and is based on an interest rate set by the insurance company. A minimum death benefit is guaranteed to policyholders.

Variable universal life has features that are more like an investment account; the cash value is invested in a mutual fund of your choice, and your premium and death benefit therefore fluctuate. As such, there is no guaranteed minimum death benefit or guaranteed cash value.

Indexed universal life is a type of universal life insurance with a cash value that is based on the performance of a market index as offered by the insurer (such as the S&P 500 or Nasdaq Composite Index). Premium payments are flexible, and the death benefit is adjustable, but there are caps on returns and no guarantees as to premium amounts or market returns.

Permanent vs. Term Life Insurance: Which is Best for You?

How can you decide which type of insurance suits your needs best? The answer will depend on your personal circumstances, but there are some helpful ways to compare the two and make a good match.

Term life insurance may be a good fit if:

  • You are looking for a straightforward policy that provides a fixed death benefit amount at an affordable cost.
  • You are interested in the type of policy protection for a specific amount of time, say, until your children graduate from college or your mortgage is paid.

Permanent life insurance may be a good fit if:

  • You are looking for the protection of life insurance with no end date and are willing to make higher premium payments for that benefit. This type  could be particularly useful if you have illiquid assets in your taxable estate such as a family property or a closely held business.
  • You are interested in having a cash-value component, controlling how your premium payments are invested, or gaining other long-term financial planning benefits.

In the end, and depending on your situation and financial goals, sometimes a combination of term and permanent is the answer.

How Much Life Insurance Do I Need?

While a general rule of thumb is to have life insurance that equals at least 10 times your annual gross income, that overall recommendation may not fit everyone. Some people may need more than that amount of coverage, while others might need less because two people with the same income can have very different needs. A sole earner with three young children, for example, may need more life insurance than a dual-income couple with a grown family.

You can figure out a more precise number by doing a little math.

  • Add up the expenses your family would be responsible for in the event of your passing. Such expenses could include a mortgage, car loans, medical bills/health insurance and college tuition.
  • Determine your current financial resources and income replacement; for example, a spouse’s income, savings and investments, a pension, etc.
  • Subtract resources from anticipated living expenses to establish a ballpark amount of life insurance to consider.

To get a more accurate idea of how much life insurance to buy based on your situation, check out the calculator at nonprofit LifeHappens.org, which can give you a quick estimate based on answers to seven questions.

What factors can affect your policy costs?

Several factors influence the cost of life insurance coverage, and an insurer’s underwriting process is their way of reviewing a person’s “insurability.” What will they take into account when setting premium payments for your policy? Here are the key factors:

  • The younger you are, the lower your payments will generally be.
  • Premium payments tend to be lower for women because their life expectancy is longer than men’s.
  • A life insurance company may or may not require a medical exam, but certain medical conditions may translate to higher premium payments in some cases.
  • Family medical history. Hereditary disease could also affect your payments.
  • A healthy lifestyle—such as not smoking or engaging in risky pursuits such as an extreme sport—can work in your favor when it comes to setting premium payments.
  • Certain higher-risk jobs, like pilots or construction workers, may also demand higher life insurance premiums.

4 Reasons You Might Consider Taking Out a Life Insurance Policy

Everyone has their own, individual reasons for buying life insurance. But doing so really centers on providing financial security for yourself and the ones you care about. What are your reasons?

Reason #1: A guaranteed financial safety net. If you die, your beneficiaries will receive a lump-sum payment that’s guaranteed to be paid in full, right away.

Reason #2: Income replacement. Proceeds help continue to cover immediate or future expenses that do not disappear when your income does.

Reason #3: Tax-free advantage. A life insurance policy’s death benefits are typically disbursed tax-free. However, estate taxes may apply so be sure to speak to a professional when deciding how to purchase a policy.

Reason #4: Cash-value growth. Permanent life insurance can provide cash value that is guaranteed to grow—tax-deferred—as you pay the premiums.

How to Choose the Best Life Insurance Policy

To choose the best life insurance policy for your needs, it pays to shop around, compare policies and costs, and get advice. What is more, it is also wise to check the financial strength of the insurance companies you are considering—so you can count on their longevity and ability to pay out benefits for what may be a decades-away need. Howland Capital was founded on family, so we understand how important it is to make adequate life insurance a part of your financial plan. Check in with your adviser today to learn more.

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