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When someone passes away, it's not only a devastating emotional loss — it can also lead to financial struggles. A life insurance policy can help to protect against this hardship. So, how does life insurance work?
Whether you're looking to buy life insurance for the first time, want help understanding your existing coverage or are a beneficiary of another person's policy, this guide will give you an overview of the process from start to finish.
What Is Life Insurance?
Life insurance is a contract whereby an insurance company promises to pay an agreed-upon amount of money upon the death of the insured person, in exchange for the payment of premiums. The policyowner chooses a death benefit amount and a beneficiary to receive the money. Then if the insured person dies while coverage is in force, the life insurance company pays the proceeds to the beneficiary the death benefit.
While life insurance policies generally follow this same basic format, there can be significant differences depending on which type of policy you purchase.
What Are the Different Types of Life Insurance?
There are many different types of life insurance policies available. Here are three of the most common types.
Term Life Insurance
Term life insurance is temporary coverage. When you purchase a policy, you can usually pick how long the coverage will last. If you pass away during this time, the life insurance company will pay your beneficiary the death benefit. If you outlive the term, the coverage will end. Because it is temporary, term life insurance may have a lower premium than other types of life insurance.
Whole Life Insurance
Whole life insurance is a type of permanent coverage. These policies do not have an expiration date, so you can stay covered for your entire life — as long as you keep paying the premiums. The premiums for whole life are generally more expensive than term life, but the cost stays the same and will not increase as you get older.
Another feature available with whole life insurance is that the policies can build cash value. This means that part of your premium has growth potential, and you can borrow or withdraw this money while still alive. Just keep in mind that loans will accrue interest. They also may generate an income tax liability, reduce the account value and the death benefit, and may cause the policy to lapse.
Universal Life Insurance
Universal life insurance is another type of permanent coverage. These policies give you the flexibility to change the death benefit, as well as how much you pay in premiums, and they also offer a cash value component.
It's important to note that any changes are subject to the limits placed on these policies under the tax code. Additionally, any increases in coverage may be subject to underwriting. There must also be enough cash value in the policy to cover monthly charges if a lower premium is paid than the amount selected at issue or if a premium payment is skipped. Additional premium payments may need to be made to keep the policy in force.
What Are the Details to Consider When Applying for Life Insurance?
For those considering life insurance, these are some of the details you may want to think through before you apply.
The Death Benefit Amount
Before applying for coverage, you'll need to decide how much life insurance to purchase. Buying too much would mean paying for insurance you don't need, and buying too little could impact your intentions for the death benefit.
You may want to consider opting for a death benefit that can help to replace a certain amount of years of your salary. Another option is to make a list of everything you'd like to cover if you passed away: your final expenses, money to replace your income, college tuition for your kids, your mortgage, etc.
You may also want to use a life insurance calculator to determine how much coverage you may need, or you can discuss your situation with a financial representative, who can help you determine the right amount of coverage to buy.
Underwriting & Costs
Once you decide the type and amount of insurance you want to purchase, the next step is to apply for coverage. It is not guaranteed that you will be able to buy life insurance. Generally, you first have to go through a process called underwriting.
During underwriting, the insurer reviews your financial and health status. You may need to submit blood and urine for lab testing, see a nurse or doctor for a physical and have the insurer check your medical records. You'll also likely need to answer questions about your lifestyle, such as whether you have any dangerous hobbies or driving violations.
Life insurance is more expensive for someone with health issues or other risk factors because there is a higher chance of that person passing away earlier. If someone is too high-risk, the insurer may deny their application altogether.
Choosing a Beneficiary
As part of completing your application, you will also choose a life insurance beneficiary. This is the person or entity that would receive the death benefit if you died while insured. You can pick almost anyone to be your beneficiary, including your spouse or partner, other family members, a business partner or the guardian of your children. You could also pick a charity, trust, business or other organization to receive the money.
If you don't name a beneficiary, the money would go into your estate when you die. Then, the money would generally go through the probate process and the courts would distribute it. This could lead to extra costs and delay receipt of the death benefit. You could help to avoid this by naming a proper beneficiary.
What Happens After You Apply for Life Insurance?
Once you're offered a policy, here are some of the considerations around accepting and managing it.
Review the Offer
If you qualify for coverage, the insurer will send you an offer listing how much coverage you qualified for and what the premium will be. The contract will also list the policy number, when the coverage would start, your beneficiary, your personal information and any other legal conditions or agreements that apply to your life insurance coverage. If you are happy with their offer, you can accept the contract and purchase the policy.
Pay Your Premium
Once your policy is active, you must pay your premium to keep it going. Depending on your contract, you might pay on a monthly, quarterly, semiannual or annual basis.
How does life insurance work if you ever miss a premium? The insurance company may offer a grace period and allow you to make a late premium payment without losing coverage. However, in most cases, if you do not pay by the end of the grace period, your coverage will end.
The insurer might also offer a reinstatement period, during which you could make up the missed funds to reactivate your old policy. While this may help you avoid having to go through the application process again, you'll likely still have to complete reinstatement paperwork and submit evidence of continued insurability, which can be almost as complex as applying for a new policy.
All of these details will depend on the insurance company and your contract, so it's important to keep in mind that you can avoid gaps in coverage by paying your premium on time. Many life insurance policyowners also find pre-authorized checking (PAC) to be a convenient way to help make sure their premiums are paid regularly and on time.
Understand Cash Value
If you have a permanent life insurance policy with cash value, it's important to understand how it works. The insurance company may offer an online portal where you can check the balance or request to borrow money from your cash value. You'll likely receive this information through paper statements, too.
While having access to your cash value can be convenient, loans will accrue interest, and they may generate an income tax liability, reduce the account value and the death benefit, and cause the policy to lapse. Consider these details before taking a loan.
How Does a Beneficiary Collect the Death Benefit?
You might wonder what happens if you or another loved one passes away while covered by a policy. How does life insurance work during the payment process? These are the steps a beneficiary would typically take after such an event.
File the Death Benefit Claim
To file a life insurance claim, the beneficiary would need to contact the insurance company or their financial representative to report the death of the insured and request a death benefit claim form. They will likely need to fill out a form to verify information such as the deceased's name, the policy number and the beneficiary's contact information. Additionally, the beneficiary will likely need to submit a copy of the deceased's death certificate.
With this information, the life insurance company will review the situation and make sure that the cause of death was not for an excluded reason. Typically, most life insurance policies don't pay a death benefit for certain causes of death during the contestability period, which is often the first two years of the policy. The policy contract will explain these details, as well as any other possible exclusions. If the claim is approved, then the insurer will pay the death benefit to the beneficiary.
The life insurance company can only pay the death benefit to the listed beneficiary. That's why it's important for policyowners to update these instructions as soon as there is a change to their circumstances. If the policy lists the wrong person, such as an ex-spouse that the insured intended to remove as the beneficiary, the life insurance company would still be obligated to follow the listed instructions and pay the beneficiary on file.
Consider Payment Options
There are a few different ways to receive the death benefit of a life insurance policy, though benefit payment options are subject to the terms of a particular policy. One option is to take a lump sum for the entire amount. This can be a lot of money to receive all at once, so another option is to receive the money in installments over time.
A beneficiary could also use the life insurance death benefit to purchase an annuity, which is a contract they can purchase and then set up to receive payments from over time. This way, they could turn the life insurance money into a guaranteed stream of income that lasts years or even the rest of their life.
If a beneficiary needs time to grieve and plan, they may be able to request the that the insurer hold onto the money and just pay them the interest. Once they are ready to use the money, they can request the full benefit.
Review Tax Liabilities
Typically, the government does not charge income tax on life insurance death benefits. For example, if the beneficiary has the insurer hold the benefit and only pay them the interest, that interest would be tax liable. For policyowners with no listed beneficiary or with their estate listed as the beneficiary, the government will add the benefit to the estate value upon their passing and could charge estate taxes to whoever inherits it. According to the IRS, the federal limit for estate taxes is 11.58 million, as of 2020, meaning an heir can assume this much value from an estate, including the life insurance death benefit, without owing federal taxes.
There are a few states that also charge estate and inheritance taxes, and the threshold is lower. For example, Massachusetts and Oregon both tax estates in excess of $1 million. This could be something to plan around if you live in a state with these taxes and your estate is over the threshold. Generally, most Americans likely would not owe tax on a life insurance death benefit.
How to Get Started
For more help understanding how to buy life insurance, as well as planning your policy or understanding those of your family members, consider reaching out to a financial representative for more information. They can explain these topics in more detail and help to ensure that your coverage will meet your needs.