Understanding Life Insurance: Case Open Basics

Life insurance is a contract between an insurance company and a policy owner, where the insurer guarantees to pay a sum of money to one or more named beneficiaries when the insured person dies. In exchange, the policyholder pays premiums to the insurer during their lifetime. The two main types of life insurance are term life insurance and permanent life insurance. Term life insurance covers the insured for a limited period, while permanent life insurance covers the insured for their entire life. Permanent life insurance is more expensive than term life insurance but it builds cash value that can be used to supplement income in retirement, cover college tuition, or make large purchases. This cash value can be accessed through withdrawals, policy loans, or by surrendering the policy.

What is the purpose of life insurance?

Life insurance is a contract between an insurance company and a policyholder. The insurance company agrees to pay a sum of money to one or more named beneficiaries upon the death of the policyholder. The purpose of life insurance is to provide financial security to your loved ones upon your death. It can help cover expenses such as mortgage repayments, debt, and daily living expenses.

Life insurance can also provide peace of mind and assurance that you have provided a legacy for your loved ones. It can offer a valuable combination of benefits, such as income replacement, tax-free benefits, and guaranteed cash value growth. Life insurance can also help eliminate household debt and preserve a family business.

There are two main types of life insurance: term and permanent. Term life insurance covers a set number of years, while permanent life insurance does not expire and covers the policyholder for their whole life. Permanent life insurance policies include whole, universal, and variable types, each with unique features and benefits.

When choosing a life insurance policy, it is essential to consider your needs, budget, and the level of coverage required. Factors such as age, gender, health, and lifestyle can impact the cost of premiums. Life insurance is an important tool to provide financial support and security to dependents or beneficiaries after the death of the insured policyholder.

How does life insurance work?

Life insurance is a legally binding contract between an insurance company and a policyholder. The policyholder pays premiums to the insurer during their lifetime, and in exchange, the insurance company guarantees to pay a sum of money to the policy's beneficiaries when the policyholder dies. This sum of money is known as the death benefit.

Life insurance policies can be split into two main categories: term and permanent. Term life insurance covers the policyholder for a set number of years, after which the policy expires. Permanent life insurance, on the other hand, covers the policyholder for their whole life, provided that they continue to pay their premiums. Whole, universal, and variable life insurance are the three most common types of permanent life insurance policies.

Whole life insurance does not have an expiration date, and a portion of the premiums paid into the policy builds up a cash value over time. This cash value can be borrowed against, but if the loan is not repaid, the death benefit will be reduced. Universal life insurance also provides coverage for the entirety of the policyholder's life and can build up cash value over time. It differs from whole life insurance in that it offers more flexibility when it comes to making payments. For example, if there is enough cash value in the policy, the policyholder may be able to skip a premium payment. Variable life insurance is another type of permanent life insurance that can build cash value, but it also has the potential to increase the value of certain subaccounts within the policy for even greater growth over time.

Term life insurance is generally more affordable than permanent life insurance, and female customers tend to get lower rates than male customers of the same age and health status. The cost of life insurance depends on several factors, including the type of policy, the amount of the death benefit, the policyholder's age, sex, health, weight, tobacco use, and lifestyle.

Life insurance policies can include additional features, such as living benefits, which allow the policyholder to access a portion of the death benefit while they are still alive if they are diagnosed with a covered illness. Policyholders can also purchase riders to add features to their policy. For example, a guaranteed insurability rider allows the policyholder to add more coverage to their policy in the future without undergoing a medical exam.

What are the different types of life insurance?

There are several types of life insurance policies available, each offering a variety of features. The two main types of life insurance plans are term or permanent plans, or a combination of the two. Here is a list of the different types of life insurance:

Term Life Insurance

Term life insurance is designed for those who need coverage for a certain number of years. It is generally more affordable than permanent life insurance and provides coverage for a set number of years. Common terms are 10, 20, or 30 years. The best term life insurance policies balance affordability with long-term financial strength.

Whole Life Insurance

Whole life insurance is a type of permanent life insurance that provides coverage for your entire lifetime, as long as you keep paying the premiums. It also includes a savings component that a portion of your premium will pay into. The savings component has a fixed interest rate that builds cash value over time, which is part of the reason whole life policies typically cost more than term life policies.

Universal Life Insurance

Universal life insurance is another type of permanent life insurance option, providing coverage for your entire life as long as you pay the premiums. It offers more flexibility than a whole life policy, allowing you to increase or decrease your death benefit and adjust or skip your monthly premium within certain limits. Universal life policies also have a savings component that grows and allows for borrowing.

Variable Life Insurance

Variable life insurance is a riskier type of permanent life insurance. It is tied to investment accounts, such as bonds and mutual funds, and the cash value can rise and fall based on your payments and the performance of your selected investments. Variable universal life insurance has adjustable premiums, which may suit those who don't want to commit to paying the same amount each month.

Final Expense Life Insurance

Also known as funeral or burial insurance, final expense insurance is a type of whole life insurance that offers a smaller and more affordable death benefit to help cover end-of-life expenses like funeral costs, medical bills, or outstanding debt. It is easier for older or less healthy individuals to qualify for this type of insurance.

Other Types of Life Insurance

There are also other types of life insurance, such as indexed universal life insurance, simplified issue life insurance, instant life insurance, and guaranteed life insurance. Supplemental life insurance can provide additional coverage beyond what your company's group life policy offers, while survivorship life insurance covers two people on a single policy that pays a death benefit once both policyholders have passed away.

How to choose the right life insurance plan

When choosing a life insurance plan, it's important to consider your needs and goals, as well as the different types of policies available. Here are some detailed guidelines to help you select the right life insurance plan:

• Assess your life insurance goals: Goals vary from person to person. You should plan for your life insurance goals with a suitable policy. If safeguarding your family's financial security is your primary goal, consider a term insurance plan, which offers high coverage at affordable rates. If you're looking to save for your child's education or planning to buy a house, investing in a unit-linked insurance plan might be a good option. You can also opt for a retirement plan to ensure regular income for your post-retirement years.
• Calculate the optimal insurance cover: It is recommended that your life insurance cover should be at least ten to fifteen times your annual income. However, there are several other factors to consider, such as outstanding debts, future expenses like your child's education or marriage, and your family's ability to maintain their current lifestyle in your absence. Calculate these expenses and subtract your liquid assets to arrive at an adequate life insurance cover.
• Determine the premium and find the best deal: Use online premium calculators to determine the premium for your desired insurance cover. Compare different plans to find the one that offers the highest coverage within your budget. Assess your premium-paying term based on your expected earnings in the upcoming years.
• Select the correct policy term: The policy term should ideally cover the number of years your family will be financially dependent on you. A good rule of thumb is to subtract your current age from the age at which you expect your income to stop or wish to accomplish a particular life goal.
• Opt for a reputable life insurance provider: Choose a life insurance company with a strong Claim Settlement Ratio (CSR). The CSR indicates the percentage of claims settled by the company in a financial year. Look for companies with a CSR of over 95% for consecutive years. You can check the updated CSR of different insurers on the Insurance Regulatory and Development Authority (IRDAI) website. Also, read customer reviews to understand the claim service provided by the insurer.
• Be transparent with your life insurance provider: Disclose any relevant information, such as tobacco or alcohol consumption, hazardous occupation, existing illnesses, or family history of critical ailments. These factors influence your risk profile, and providing accurate information is crucial to prevent future claim rejections.
• Read the final policy document carefully: Before finalizing the policy, ensure you understand all the terms and conditions, including the lock-in period and any circumstances that may invalidate the claim.
• Buy life insurance early: Life insurance premiums are typically lower when you're younger. Consider purchasing a life insurance policy as soon as you start earning, and gradually increase your coverage as your income grows.
• Choose a comprehensive plan: Opt for a plan with appropriate riders to protect against medical contingencies that may affect your income. Some common riders include the Critical Illness rider, Accidental Death Benefit rider, Permanent Disability rider, and Terminal Illness rider. Look for an insurer that offers these benefits without hidden fees.
• Regularly evaluate your life insurance needs: It's important to periodically assess your life insurance needs as your financial goals may change with age, marriage, childbirth, or other life events. Review your coverage and make adjustments as necessary to account for inflation and changing circumstances.

How to access your cash from a life insurance policy

There are a few ways to access your cash from a life insurance policy. However, it's important to note that not all life insurance policies are created equal. Term life insurance policies, for example, don't have a cash value component, whereas permanent life insurance policies do.

Permanent life insurance policies are typically more expensive than term life insurance policies because they provide coverage for your entire life and can build cash value. This cash value can be used to supplement your income in retirement, cover college tuition, or make a down payment on a home, among other things.

• Surrender the policy: You can cancel the policy and take the surrender value in cash. However, this option means you will no longer have life insurance coverage, and the cash you receive may be lowered by any fees. Surrender fees can be significant, especially for newer policies.
• Make a withdrawal: You can often take a cash withdrawal from your permanent life policy, and this money is usually not subject to income taxes as long as it doesn't exceed the amount you've paid into the policy. However, doing so may reduce your death benefit.
• Take out a loan: You can typically borrow money through your policy, with the insurer using your policy as collateral. Life insurance loans include interest payments, but the rates are usually lower than those for personal loans or home equity loans. There's no loan application or credit check required, and you may choose not to repay the loan, but the outstanding balance will be deducted from your death benefit.
• Use cash value to pay premiums: You can use the money in your cash value to pay part or all of your policy premiums, making it easier to maintain your coverage. This is a popular option for older policyholders who want to use retirement income for living expenses but still want to keep their life insurance coverage.

It's important to carefully consider the pros and cons of each option before making a decision, as the way you access your cash value will impact the amount available to you, your death benefit, and your account's growth. Additionally, the ability to access cash value can be very handy for life insurance policyholders, but there may be tax implications and other consequences. Consulting a financial advisor can help you understand all the potential consequences of accessing your cash value.

Frequently asked questions