How Does Life Insurance Work?

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What is life insurance?

Life insurance is a contract between you and an insurance company. Essentially, in exchange for the premium you paid, the insurance company will pay your beneficiary a lump sum called death benefit after your death.

Your beneficiaries can use the money for any purpose they choose. This usually includes paying daily bills, paying a mortgage, or sending your child to college. A safety net with life insurance ensures that your family can stay at home and pay for your plan.

There are two main types of life insurance: term life insurance and permanent life insurance. Whole life insurance such as whole life insurance or universal life insurance can provide lifetime protection, while term life insurance provides a certain period of protection.

Main types of life insurance

Term life insurance

According to the Insurance Barometer report, in addition to being the most affordable type of life insurance, term life insurance is also the most popular type of life insurance (71% of purchasers)

Term life insurance provides protection for a certain period of time, and the premium payment remains unchanged during the validity period of the policy. The typical choice is a policy period of 10, 15, 20, 25 or 30 years.

If you die during the validity period of the policy, your beneficiary can file a claim and receive a tax-free death benefit.

After the policy expires, you can renew it in increments of one year. This is called guaranteed renewal. But the annual renewal rate will be higher.

Whole life insurance

Permanent life insurance provides lifetime protection. It is more expensive than regular living because it:

Can last a lifetime.

The cash value is usually established.

The cash value is accumulated in the form of deferred tax during the validity period of the policy. It serves as the savings part of the policy. Generally, you can borrow or withdraw money based on the cash value of the policy. If you decide to terminate the policy, you can get the cash value less any surrender costs.

In some insurance policies, the cash value may grow slowly over many years, so don't expect to get a large amount of cash value immediately. Your policy description will show the estimated cash value.

There are several types of permanent life insurance:

Whole life insurance provides a fixed amount of death compensation and cash value, and grows with a guaranteed rate of return. Many whole life insurance policies pay dividends that can be used to reduce premium payments or increase your cash value.

Universal life insurance generally provides more flexibility than whole life insurance policies. You can change your premium payment and death benefit within certain limits. With a universal life insurance policy, the cash value will depend on the type of policy. For example, the cash value of an index universal life insurance policy is linked to an index such as the Standard & Poor's 500 Index. Variable universal life insurance policies usually have investment sub-accounts that you can choose and manage.

Funeral insurance is a small whole life insurance policy, and its death benefit is usually between US$5,000 and US$25,000. Funeral insurance is designed to cover only funeral expenses and final expenses.

Survival life insurance or "second death life insurance" provides insurance for two people under one policy, usually a married couple. When both spouses have passed away, the policy will pay death benefit to the beneficiary. Often, survivor life insurance is part of a larger financial plan to fund a trust or pay federal estate taxes.

How to choose a life insurance policy type

With all the life insurance options available, choosing the right life insurance may seem complicated.

First decide between term life insurance and permanent life insurance.

If you need life insurance for a specific time, consider a term life insurance policy. For example, if you want insurance to cover your working life as an "income substitute" when you are away.

If your budget is limited, term life insurance is also a good choice. Since term life insurance provides protection for a specific time and it is not a cash value life insurance policy, the rate will be lower than permanent life insurance.

As you enter different stages of your life, your life insurance needs may change. Many term life insurance policies can be converted into permanent policies. The options will depend on your policy and insurance company. The term life insurance conversion allows you to convert to a permanent policy without having to reapply or participate in a life insurance medical examination.

On the other hand, a permanent life insurance policy will last you a lifetime. If establishing cash value is important to you, check out the permanent life insurance options. However, if you buy a perpetual policy just to take advantage of the accumulation of cash value, according to the policy, you'd better put your money into savings or investment tools so that you don't have to pay for life insurance and expenses in the perpetual policy.

The cash value is usually not prepared for the beneficiary. After death, any cash value is usually returned to the life insurance company. Your beneficiary gets the death benefit of the policy, not the death benefit plus the cash value. In other words, certain types of insurance policies will provide death benefit plus cash value, but at a higher price.

How to choose the amount of life insurance coverage

A good rule of thumb for estimating how much coverage you need is:

Add up all the expenses you want to pay, such as income replacement from work, mortgages, and children's college expenses.

Subtract the amount your family can use to cover these expenses, such as savings and existing life insurance. If your spouse needs retirement savings in the future, please omit retirement savings.

The resulting number is how much life insurance you need. It may seem high, especially if you have been considering income substitution for years. Nevertheless, life insurance quotes are free, so there is no harm in pricing the insurance you need.

If it turns out that it is unaffordable, you can buy what you can now afford to lock in preferential prices. You can buy it later, but please note that in a few years your rate will depend on your age and any health conditions you develop.

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