How does life insurance work?
Understanding how life insurance works can help you plan for the future of your loved ones or help protect your business.
We get a lot of questions, not only about "what is life insurance" and how it works when you pass away, but also about how it works in the here and now.
How do life insurance policies work?
In simple terms, you buy a life policy from a life insurance company, pay a monthly or annual premium and name one or more beneficiaries to receive the death benefit. If the policy is active when you pass away, your beneficiaries will usually receive the death benefit in a tax-free lump sum.
What can life insurance be used for?
The primary purpose of a life insurance policy is to provide a death benefit that can help protect your loved ones' financial futures.
When a life claim is paid, the beneficiary can use the death benefit to cover financial obligations such as:
- Final expenses including funeral and burial/cremation costs
- Rent or mortgage payments
- Lost income from the insured
- School or college tuition
- Outstanding debts like loans or credit card bills
- Regular expenses like groceries and utilities
Many causes of death are covered whether it be an accident, an illness, natural causes, homicide or suicide. However, there are exceptions where insurance companies may deny a life insurance claim, and a few examples are:
- If the insured is participating in high-risk activities, such as sky diving, at the time of death.
- If the insured is not truthful about the condition of his or her health when applying for life insurance and a claim occurs within the first two years.
- If a beneficiary is found guilty of, or in some way responsible for the death of the insured.
- If suicide occurs within the first two years of the policy being opened.
Term vs. permanent life insurance
Term life insurance offers coverage for a limited period of time, known as the “term.” It can be a good choice to cover short-term debt or a temporary need for coverage. Benefits include:
- Several different terms to choose from — commonly for 10, 20 or 30 years
- Premiums that stay the same for the policy term
- Ability to convert term coverage to a permanent policy, regardless of your state of health.
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Permanent life insurance, which includes variations such as whole life insurance and universal life insurance, offers coverage as long as you live, provided your policy stays in force. Other benefits include:
- Builds cash value over time that grows tax-deferred and allows access to your cash value should you need it.
- Optional riders that can "tailor" a policy to fit you and your family's needs.
- Eligible for dividends, although the payment of a dividend or the amount of a dividend are not guaranteed.
Life insurance for business owners
While individuals typically purchase life insurance to provide money for their family or a charity when they pass away, life insurance can be an essential planning tool for business owners too. Many business owners protect their future interests with life insurance. For example, business partners may ensure that life insurance proceeds are there to purchase the deceased partner's share from the remaining family members. This is commonly known as a buy-sell agreement, and can be an affordable alternative for the remaining partners to purchase the outstanding shares of the deceased partner. Businesses could also use the policy's cash value in times of financial opportunity.
Talk to a professional to learn more
While we've scratched the surface on how life insurance works, we recommend sitting down with an agent to talk about your personal situation and the options that would make the most sense for you.