Source: Investopedia 06/05/18:
What is ‘Life Insurance’
Life insurance is a contract between an insurer and a policyholder in which the insurer guarantees payment of a death benefit to named beneficiaries upon the death of the insured. The insurance company promises a death benefit in consideration of the payment of premium by the insured.
BREAKING DOWN ‘Life Insurance’
The purpose of life insurance is to provide financial protection to surviving dependents after the death of an insured. It is essential for applicants to analyze their financial situation and determine the standard of living needed for their surviving dependents before purchasing a life insurance policy. Life insurance agents or brokers are instrumental in assessing needs and establishing the type of life insurance most suitable to address those needs. Several life insurance channels are available including, whole life, term life, universal life, and variable universal life (VUL) policies. It is prudent to re-evaluate life insurance needs annually, or after significant life events like marriage, divorce, the birth or adoption of a child, and major purchases, like a house.
How Life Insurance Works
There are three major components of a life insurance policy.
- Death Benefitis the amount of money the insurance company guarantees to the beneficiaries identified in the policy upon the death of the insured. The insured will choose their desired death benefit amount based on estimated future needs of surviving heirs. The insurance company will determine whether there is an insurable interest and if the insured qualifies for the coverage based on the company’s underwriting requirements.
- Premium payments are set using actuarially based statistics. The insurer will determine the cost of insurance (COI), or the amount required to cover mortality costs, administrative fees, and other policy maintenance fees. Other factors that influence the premium are the insured’s age, medical history, occupational hazards, and personal risk propensity. The insurer will remain obligated to pay the death benefit if premiums are submitted as required. With term policies, the premium amount includes the cost of insurance (COI). For permanent or universal policies, the premium amount consists of the COI and a cash value amount.
- Cash value of permanent or universal life insurance is a component which serves two purposes. It is a savings account, which can be used by the policyholder, during the life of the insured, with cash accumulated on a tax-deferred basis. Some policies may have restrictions on withdrawals depending on the use of the money withdrawn. The second purpose of the cash value is to offset the rising cost or to provide insurance as the insured ages.
Life Insurance Riders
Many insurance companies offer policyholders the option to customize their policies to accommodate their personal needs. Riders are the most common way a policyholder may modify their plan. There are many riders, but availability depends on the provider.
- The accidental death benefit rider provides additional life insurance coverage in the event the insured’s death is accidental.
- The waiver of premium rider ensures the waiving of premiums if the policyholder becomes disabled and unable to work.
- The disability income rider pays a monthly income in the event the policyholder becomes disabled.
- Upon diagnosis of terminal illness, the accelerated death benefit rider (ADB) allows the insured to collect a portion or all of the death benefit.
Each policy is unique to the insured and insurer. Reviewing the policy document is necessary to understand coverages in force and if additional coverage is needed.