Life Insurance Basics – It's Not As Bad As You Think
The life insurance policy pays a death benefit to a named beneficiary (which is stipulated in the contract by the policy owner) upon the death of the insured.
Life insurance was originally designed as a way to help pay for burial costs. However, today, life insurance is used for a wide variety of purposes both personal and business including insuring the life of business owners (to keep the business operating after the owner's death), key employees, supplemental retirement income, defined benefit plans, to protect an individual's pension benefits (i.e. "pension max"), and traditional income replacement (in the event of the death of either spouse).
Today's life insurance contracts also include suicide provisions to prevent insurance companies from having to pay claims on policies where the insured has committed suicide within the first two years of the policy. Insurance companies also require that there be an "insurable interest" between the policy owner and the insured (to help prevent a conflict of interest between the owner of a policy and the person being insured).
While not technically accurate, financial advisers and insurance agents tend to divide insurance contracts into the two different "types": term insurance (temporary) and cash value insurance (permanent).
Term insurance is temporary or "pure" insurance. The policy owner pays a defined amount of money for a specific amount of death benefit. When payments stop, the insurance ends. Term policies tend to be very inexpensive when the insured is very young, and are guaranteed to get more expensive as the insured becomes older. Due to expected mortality rates, term policies also tend to have a very low payout ratio which is estimated to be between 1% – 3%.
Cash value policies are often defined by insurance companies as "a death benefit with a savings component". This "savings component" is actually a cash reserve that is designed to grow in value until the reserve equals the death benefit. In the beginning, the policy owner pays for the death benefit and an additional amount of money is set aside in a cash value account which is part of the insurance contract. With each premium payment, the costs associated with mortality and other expenses are either guaranteed to decrease every year – in the case of whole life – or is expected to decrease every year – in the case of universal life (if the level death benefit option is elected).
A unique feature of cash value policies is that the cash value is allowed to grow income tax deferred. The money can then be withdrawn or a loan can be taken against the cash value if it is ever needed. The interest credited (earned) to a cash value policy is normally comparable to other competing savings instruments such as bonds, bank CDs, or high yield savings accounts. The major difference is that life insurance cash values grow tax deferred inside the policy and can be accessed on a tax-free basis unlike other savings options.
A Word About Buying Life Insurance
Many individuals attempt to use online calculators or quoting software or simply pick an arbitrary amount of life insurance that they "feel" is the right amount. However, they could be purchasing too much or too little insurance.
For example, such factors as personal financial goals, age, annual income, when an individual plans on retiring, total debt (including mortgage debt), number of children, the investment experience of the other spouse, expected pension benefits, expected social security benefits, and so on must all be taken into account when purchasing life insurance.
Even after all of this analyzing is done, the advice of a good financial professional can be invaluable in helping you figure out how to comfortably afford your new policy.
