Life insurance is an insurance policy designed to pay out if the insured person dies. These policies were created so that if the main income holder of a household died, the payout from the policy could be used to support his/her family. Over the last 50 years, life insurance policies have greatly expanded in both form and function. Sometimes they look more like investment vehicles than simple insurance policies.
Getting a Life Insurance Policy
As happens with most other types of insurance, the policy is very straightforward . There is an assessment of the risk, the policy is created, monthly premiums are paid, and the insurance company pays out when something goes wrong. However, with life insurance, it can be hard for the insurance company to know the exact level of risk you present, and when “something goes wrong,” you have died, so the money is paid to your survivors instead of you. This makes the structure of the life insurance contract is a little bit different than for other types of insurance..
Cost and Insurability
Anyone who purchases life insurance on their own will need to have their “risk of death” evaluated by the insurance company. The company typically looks at factors like personal and family medical history, how healthy and in-shape the person is, and whether or not the person is a smoker. Smoking is the quickest way to increase the cost of premiums. If the insurance company thinks you might die soon, it won’t agree to insure you. Examples of issues you have that would cause concern include having previously suffered a serious illness, having a family history of serious illness, or having an unhealthy lifestyle.
Individuals can skip this risk evaluation if they are able to get group insurance, usually through their employer. With group insurance, everyone in the group pays the same premium. The insurance company makes an estimated average for the whole group.
Parties to the Contract
There are at least two parties involved with any life insurance policy, but there can be up to four.
- Policy Owner. This is the person who is responsible for paying the premiums on the policy and is the legal owner of the policy.
- Insurer. This is the insurance company, the entity the policy owner pays in exchange for life insurance coverage.
- Insured. This is the individuals whose life is actually being insured. If this person dies, the Insurer will pay out the death benefits.
- Beneficiary. This is the person who receives the death benefits from the Insurer when the Insured dies. The policy owner can usually change the beneficiary at any time.
In some cases, the Policy Owner, Insured, and Beneficiary are all the same person. An example is a father who purchases a life insurance policy for himself which is paid out to his estate upon death. It is more common for the Policy Owner and Insured to be the same person while the Beneficiary is someone else. An example is a father who purchases a life insurance policy for himself while listing his spouse as the beneficiary.
The Policy Owner and Beneficiary can also be the same person with insurance covering someone else. This is common in large companies who take out life insurance policies on high-value employees. If the employee dies, the company receives a death benefit to help offset the loss of value from the employee. This is extremely common with movie stars.
All four parties can also be different. For example, a husband may take out a life insurance policy on his spouse with the children listed as beneficiaries.
In these examples, you may have spotted an opportunity for fraud. There have been cases in the past where people have taken out insurance policies listing someone they barely know as the insured and themselves as the beneficiary; then they murder that person to collect the death benefit. To combat this, all life insurance policies require that the Policy Owner prove that they will suffer a serious loss if the Insured dies.
Types of Life Insurance
There are several broad types of life insurance, each with different benefits and cost structures.
Term Life Insurance
Term life insurance is typically the least-expensive type of life insurance. A term life insurance policy is good only for a specific period of time, usually 5, 10, or 20 years. Then the policy expires. Term insurance policies are most commonly used by heads-of-household to insure themselves until they retire. The family members are listed as the beneficiaries. This provides financial security for a family when the main income provider dies. If you see “low-cost life insurance” advertised, it is usually for term life insurance. The premiums for a term life policy will be fairly low for young people, but they increase with the age of the Insured.
There is a sub-type of term life insurance called Senior Life Insurance. This policy is specifically for older people and provides a very low death benefit, usually less than $50,000. It is designed just to cover funeral costs for the Insured, alleviating that financial burden for a spouse or children.
Endowment Life Insurance
Endowment life insurance is almost the inverse of term life insurance. It has a set maturity date, but instead of the policy maturing and the policy holder getting nothing, the beneficiary is paid out in cash, either as a lump sum or in several payments over time. These policies are often used by parents as a sort of “college savings” account for their children. The insurance policy matures the same year as the child graduates from high school, and the payout is used to cover college tuition costs.
Whole Life Insurance
A Whole Life insurance policy has no expiration or maturity date. It is guaranteed to remain in force for the life of the Insured, as long as premiums continue to be paid. Premiums for a term life insurance policy usually start out cheaper and increase as the Insured ages, but a wholelife insurance policy will usually be cheaper over the lifetime of the Insured. This is because with a term life policy, your premiums are based on the chance that you will die while the policy is in force, so the older you get, the more likely it is that you will die. With a whole life policy, you keep paying into the same “risk pool” for many years. If you have a whole life policy long enough, the insurance company has no risk at all from your death since the total amount you’ve paid for premiums will be close to your total death benefit.
Whole Life Insurance policies often have extra “riders” or benefit packages which pay out double or triple in the case of certain types of death. For example, a typical death benefit is paid out after someone dies of an illness or a disease. The beneficiary has some time to prepare for the death ahead of time. Many whole life policies will include an “Accidental Death” rider, so if the insured is killed unexpectedly, the policy pays a much higher death benefit to compensate the family for the sudden loss.
Life Insurance as an Investment
Many people treat their life insurance policies as a type of investment, and there are some very good reasons for doing this.
Investing in Whole Life Insurance
There are a wide range of whole life insurance policies, but one common feature is that they offer dividends to shareholders if the total payout from everyone insured is less than the company has collected in premiums. Since inflation causes these dividends to increase in value over time but your premium stay the same, the dividends you receive can end up being nearly as much as the total premium you pay. This means you pay almost nothing and still keep your insurance.
Whole Life policies also have a cash value, which can be used for two things:
- You can take a loan out from your whole life policy tax-free, up to the cash value of the policy. If this loan is not paid back before you die, the amount you owe is subtracted from the death benefit paid to the beneficiary.
- If you cancel your policy, you can get a percentage of this cash value back as a “Surrender Value.”
The cash value will continue to increase the longer you have your policy, so it is common for whole life policy holders to use the tax-free loan from their cash value to help with buying a house or making other large purchases.
Investing in Endowment Life Insurance
An Endowment policy is a life insurance policy which pays a lump sum at maturity or when the Insured dies. Typical maturities are ten, fifteen or twenty years. It is common for endowment life insurance to be used as an investment vehicle to save for college or other large expenses. However, endowment life generally offers similar growth rates as a normal savings account.
Endowment policies are often sold as a way to force extravagant spenders into saving. The policy combines a savings account and a term-life policy into one package.
Investing in Term Life Insurance
Term life insurance in and of itself is not much of an investing vehicle, but a common approach with financial planners is to “Buy term and invest the difference.” The concept is based on the fact that premiums for term life policies are significantly cheaper than for other policies, with the only difference being that the insured receives no “cash value” at the end of the term.
Financial planners look at the math involved. If you compare the cost of an endowment policy with a term policy, the cost for an endowment policy is higher. Rather than paying the higher premiums, they suggest that you get a term policy with lower premiums and invest the difference.
Endowment policy premium – Term policy premium = Amount you can invest
If you invest the difference in premiums into a high-yield savings account, mutual fund, ETF, or other investment vehicle, you will probably have more cash at the maturity date. The same is even more true if you compare term premiums to whole life premiums. The only disadvantage in this approach is that you need to make a point to save that difference, which can be an issue for many individuals.
Whatever type of life insurance policy you choose, the safety provided through life insurance is an extremely important part of any person’s financial future.