How Does Life Insurance Work?

Life certainly has its fair share of fiscal ups and downs, and the best thing we can do is to arm ourselves against the unexpected–household costs, education expenses, hospitalisation, and even the death of a loved one. Having life insurance can help us and our families in times of financial woes.

So, exactly what is life insurance? 

Simply put, life insurance is a type of financial investment (policy) that ultimately serves as financial protection to you (policyholder) and your loved ones (beneficiaries) in the event of your unexpected death. Being insured can help your family cover various expenses, such as funeral costs, outstanding debts, and living expenses. 

Life insurance policies can be customized to meet specific needs and budgets, and there are several types of life insurance available, including term life insurance, whole life insurance, and universal life insurance. When you purchase a life insurance policy, you pay regular premiums to your chosen insurance provider and in exchange, the insurance company will provide a lump sum payment to your beneficiaries upon your death. 

Life insurance can be an important part of your financial planning, providing peace of mind and security for your loved ones. 

How does Life Insurance Work?

If you’re just planning to get a policy and been thinking about how does life insurance work, read more to get an idea of setting your life up for financial security:

1. Payment of premiums. 

The policyholder pays regular premiums to the insurance company in exchange for a death benefit payout to their designated beneficiaries in the event of their death.

2. Death benefit is based upon certain criteria. 

The amount of the death benefit and the cost of premiums are determined by factors such as the policyholder’s age, health, and lifestyle. Generally, younger and healthier policyholders pay lower premiums than older and less healthy individuals.

3. Life insurance has options for your specific needs. 

The policyholder has the option to choose a term life insurance policy, which provides coverage for a specific period of time, or a permanent life insurance policy, which provides coverage for the policyholder’s entire life as long as premiums are paid.

4. Guaranteed payout to beneficiaries. 

If the policyholder dies while the policy is in force, the insurance company pays out the death benefit to the designated beneficiaries. This money can be used to cover funeral expenses, pay off debts, or provide financial support for the policyholder’s loved ones.

Most policyholders take the time to review and update their life insurance policies regularly to ensure that their coverage aligns with their current needs and circumstances.

What does Life Insurance Cover?

Life insurance is designed to provide financial protection to your loved ones in the event of your death. While the specific benefits and coverage offered by life insurance policies may be different, life insurance does not cover some expenses that occur while you are still alive. 

The specifics of what life insurance covers can differ from one policy to another, but here are some general things that life insurance can cover:

1. Death benefits

This is the primary purpose of life insurance. If the policyholder dies during the term of the policy, the beneficiaries receive a lump sum payment (the death benefit) that is tax-free.

2. Final expense

Life insurance can cover the costs associated with the policyholder’s funeral and burial expenses, as well as outstanding medical bills or other debts.

3.  Income replacement

If the policyholder was the primary breadwinner in the family, life insurance can provide a replacement for their lost income, helping to ensure that the family can maintain its standard of living.

4.  Estate taxes

Life insurance can help to cover estate taxes that may be owed upon the policyholder’s death.

5. Business continuity

Life insurance can help to provide funds to keep a business running if the owner or a key employee dies.

6. Giving to charity

Life insurance can also be used as a way to make a charitable gift to a nonprofit organization or other cause. 

Life Insurance Will Cover:

Accidental death 

Life insurance may provide coverage for accidental death, but it depends on the specific terms and conditions of the policy. 

Illness or Injury

This one normally is not included in the coverage but there are other types of insurance, such as health or disability insurance, that can provide assistance for illness or injury.

Natural Death

Life insurance policies generally provide coverage for natural death, as long as the death occurs within the term of the policy and the cause of death is not excluded by the policy.

Suicide

Many life insurance policies usually have a suicide exclusion, which means that if the policyholder dies by suicide within a certain period after the policy is purchased (usually two years), the policy will not provide a death benefit. However, after the exclusion period has passed, the policy may provide coverage for suicide.

Homicide

When it comes to unfortunate events such as homicide, life insurance policies usually provide coverage for it as long as the death is not caused by the policyholder’s criminal actions or involvement in illegal activities. The beneficiary may need to provide evidence to support the claim and the insurer will investigate the circumstances surrounding the death.

Life Insurance Does Not Cover

High Risk Activities

There is exclusion in high-risk activities, such as skydiving, bungee jumping, and professional sports, due to the increased likelihood of injury or death associated with these activities.

Criminal Activities

Life insurance policies generally do not provide coverage for deaths resulting from criminal activities. If the policyholder dies while committing a crime, the insurer is likely to deny the claim, as it is against the law and the terms of the policy to benefit from such actions.

Other Exceptions

In addition to high-risk and criminal activities, life insurance policies may exclude coverage for certain other events or circumstances. For example, most policies will not cover deaths resulting from certain pre-existing medical conditions or health issues. 

Deaths resulting from natural disasters or acts of war may not be covered by some policies.

Types of Life Insurance

There are 2 types of life insurance policies around, term life and permanent life. The following defines each:

Term Life

Term life insurance provides:

• Coverage for a certain amount of time (1-30 years). 
• Pays out a death benefit if the insured passes away during that time.

Permanent Life

Permanent life insurance, on the other hand, has:

• Lifelong coverage. 
• Includes a savings component that can accumulate cash value over time. 

While term life insurance is generally more affordable, permanent life insurance offers more benefits and can be used as an investment vehicle.

Choosing a Beneficiary

Choosing a beneficiary for your life insurance policy is an important decision that requires careful consideration.

What’s a beneficiary, and who qualifies as one? 

A beneficiary is the person or entity that will receive the death benefit payout upon your passing, so it’s crucial to select someone you trust, and who will benefit from the funds.

Here are some common examples of who can be named as a beneficiary in a life insurance policy:

• Spouse or domestic partner
• Children (including adopted and stepchildren)
• Parents
• Siblings
• Other family members, such as grandchildren or nieces and nephews
• Friends
• Business partners
• Charities or non-profit organizations

You should regularly review and update your beneficiary designation to ensure that it reflects your current wishes and any changes in your life circumstances. 

How to File A Life Insurance Claim

Filing a life insurance claim can be easy as follows:

Obtain a copy of the policy – If you don’t have a copy of the policy, request one from the insurance company.

Contact the insurance company – Call or email the insurance company’s customer service or claims department to notify them of the policyholder’s death and request claim forms. The insurance company may also require you to provide a copy of the death certificate.

Fill out the claim forms – The claim forms will ask for information such as the policyholder’s name, policy number, date of death, cause of death, and information about the beneficiaries.

Prepare the required documents – The insurance company may require additional documentation such as a copy of the policyholder’s will or trust, medical records, and proof of identity for the beneficiaries.

Submit the claim – Submit the completed claim forms and any required documentation to the insurance company. You can do this by mail or online, depending on the insurance company’s instructions.

Wait for the claim to be processed – The insurance company will review the claim and may contact you if they need additional information. Once the claim is approved, the insurance company will send a payment to your beneficiary. 

How does Life Insurance Payout

Life insurance payouts can be a crucial lifeline for families in times of need, offering some measure of financial stability during a difficult and emotionally challenging period.

The size of the payout depends on the policy’s face value, which is the amount of coverage purchased by the insured. 

These payouts are the amount of money given to the beneficiaries of a life insurance policy upon the death of the insured person and can provide financial aid to cover expenses such as:

• Funeral costs
• Outstanding debts
• Day to day living expenses
• Tuition/schooling costs
• Loans (auto, home) 
• And any other expenses that can definitely help the beneficiary

The length of time that beneficiaries have to wait to receive a payout from a life insurance policy may depend. It usually takes anywhere from a few weeks to a few months for the insurer to process the claim and issue the payment. 

Here are some ways the beneficiary can receive payouts:

• Lump sum payment

Insurance companies may pay the beneficiary the entire death benefit in a single payment.

• Instalment payments

Beneficiaries may receive the death benefit in a series of payments over a specified period of time.

• Annuity payments

The insurance company may offer the beneficiary an annuity, which is a stream of regular payments over a longer period of time.

• Interest-bearing account

The insurer may place the death benefit in an interest-bearing account, and the beneficiary may receive regular payments plus interest.

• Retained asset account

Some insurance companies may offer beneficiaries a retained asset account, which is essentially a bank account holding the death benefit. The beneficiary can withdraw funds as needed.

Life insurance payouts can be a crucial lifeline for families in times of need, offering some measure of financial stability during a difficult and emotionally challenging period. 

Conclusion

Deciding to get life insurance is an important financial decision that can provide peace of mind for you and your loved ones. The decision to do so is based on its advantage: life insurance can help protect your family’s financial security in the event of your unexpected death.

How life insurance works:

• Life insurance can provide financial security for your loved ones in the event of your unexpected death.
• It can help cover the costs of funeral expenses, outstanding debts, and other end-of-life expenses.
• Life insurance can also serve as an inheritance for your beneficiaries, providing them with a lump sum of cash.
• With certain types of life insurance, you can build cash value over time, which can be used for future financial goals or emergencies.
• Having life insurance can give you peace of mind, knowing that your loved ones will be taken care of in your absence.

Frequently Asked Questions

How long do you have to have life insurance before you die? 

There is no set amount of time you need to have life insurance before you die. Life insurance coverage is typically effective as soon as the policy is in force and premiums are paid. 

Some types of life insurance policies can hold the policyholder’s funds for a long period of time, potentially decades.

This can be beneficial for those who want to ensure that their loved ones are financially protected even after they pass away.

That said, it’s important to carefully consider the terms and conditions of any life insurance policy before making a purchase.

How much does life insurance cost?

The cost of life insurance varies depending on several factors, including age, health, and coverage amount.

Generally, younger and healthier individuals will pay lower premiums than older or less healthy individuals. The type of policy and its features also affect the cost, with term life insurance typically being less expensive than permanent life insurance.

The cost of life insurance can range from a few dollars per month to several hundred dollars per month or more. It would definitely help to  get a quote from an insurance company or an independent agent to determine the cost of life insurance for your situation and needs.

Can I get life insurance if I have a pre-existing condition?

It is possible to get life insurance even if you have a pre-existing condition, but it may be more difficult and costly.

The cost and availability of life insurance coverage will depend on the type and severity of your pre-existing condition.

It’s important to shop around and compare options from different insurers to find the best life insurance policy that best suits you. 

What does cash value refer to?

Cash value in life insurance refers to the amount of money that builds up over time within a permanent life insurance policy.

It represents the portion of the policy’s premiums that are invested by the insurer and accumulate over time. This way, policyholders can access this cash value through loans or withdrawals, though doing so may reduce the death benefit or result in taxes or fees.

Cash value can provide policyholders with added financial flexibility and potentially even serve as a source of retirement income in some cases.

What is a lump sum payout?

A lump sum payout is a one-time payment of a specified amount of money .It is often used to settle a debt, compensation for damages or to provide a retirement benefit.

Lump sum payouts can be received in various forms such as cash, checks, or electronic transfers.

Why can’t a minor be a beneficiary for my life insurance policy?

In general, minors (individuals under the age of 18) cannot be named as beneficiaries for a life insurance policy due to legal and practical reasons:

1. Minors are considered legally incompetent to manage financial affairs, which means that they cannot receive a life insurance payout directly. 

2. If a minor is named as a beneficiary, the life insurance company may require the appointment of a guardian or trustee to manage the payout until the minor reaches the age of majority. This can be a cumbersome and expensive process, and may not align with the policyholder’s intentions for the payout. 

As a result, it is recommended that policyholders name an adult as a beneficiary or establish a trust to manage the payout for the benefit of the minor.

Sources

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• https://www.investopedia.com/articles/personal-finance/121914/life-insurance-policies-how-payouts-work.asp – April 2023
• https://www.progressive.com/answers/life-insurance-101/ – April 2023
• https://www.nerdwallet.com/article/insurance/how-does-life-insurance-work – April 2023