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Life Insurance

Life Insurance is an insurance policy designed to pay out if the insured person dies. They were created to make sure that if the main income holder of a household dies, the payout from the policy can be used to help continue to support his or her family. Over the last 50 years, Life Insurance policies have greatly expanded in both form and function, and sometimes can look more like investment vehicles than simple insurance policies.

Getting a Life Insurance Policy

With most other types of insurance, the policy is very straightforward – there is an assessment of the risk, then you pay the insurance company, who then pays you if something goes wrong. With Life Insurance, it can be hard to know the exact level of risk when the policy is taken out, and you probably do not be paid directly if you die, so the structure of the contract is a little bit different.

Cost and Insurability

deathAnyone who purchases life insurance on their own will need to have their “risk of death” evaluated by the insurance company. They typically look at factors like personal and family medical history, how in-shape and healthy the person is, and whether a person is a smoker. Smoking is the quickest way to see premiums go up. If the insurance company thinks you might die soon (for example, if you already have a serious illness, or if you have a family history of a serious illness and you yourself have an unhealthy lifestyle), you can be turned away entirely.

Individuals can skip this 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 4.

  • 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 person the Policy Owner pays in exchange for life insurance coverage.
  • Insured. This is the life that is actually being insured – if this person dies, the Insurer needs to pay out the death benefits.
  • Beneficiary. This is the person who receives the death benefits from the Insurer if the Insured dies. The Policy Owner can usually change the beneficiary at any time.

In many cases, the Policy Owner, Insured, and Beneficiary are all the same person (for example, a father who purchases a life insurance policy 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 (such as a person purchasing a policy for themselves, while listing their spouse as the beneficiary).

The Policy Owner and Beneficiary can also be the same person with insurance covering someone else. This is common in larger companies taking 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 person may take out a life insurance policy on his or her spouse, with the beneficiaries listed as their child.

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 murdering that person to collect the death benefit. To combat this, all life insurance policies requires that the Policy Owner must 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

familyThis 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 Life Insurance Policies are most commonly used by heads-of-household to insure themselves with their family listed as the beneficiary until they retire. If you see “Low Cost Life Insurance” advertised, it is usually Term Life Insurance. The premiums for a Term Life Insurance policy will be fairly low for young people, but the premiums increase with age.

There is also a sub-type of Term Life Insurance called Senior Life Insurance. This is specifically for older people, with a very low death benefit (less than $50,000), and is designed just to cover funeral costs.

Endowment Life Insurance

This insurance is sort of like the inverse of Term Life Insurance – it has a set expiration date, but instead of the policy expiring and the policy holder getting nothing, the beneficiary is paid out cash (either as a lump sum or many payments over time). These policies are often used by parents as a sort of “College Savings” account for their children – the insurance matures the same year as the children graduate high school, and the endowment used to cover college tuition.

Whole Life Insurance

accidentThis detail is important – Term Life Insurance usually starts out cheaper, but as a person gets older, a Whole Life Insurance policy will usually end up being cheaper over their entire lifetime. This is because with a Term Life policy, your premiums are based on the chance that you will die while the policy is enforced. 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 account, since your total premiums paid 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, meaning the family had 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 instantly in an accident, the policy pays a much higher death benefit to compensate the family for the very sudden loss.

Life Insurance as an Investment

Many people treat their Life Insurance Policies as a type of investment – there are some very good reasons for doing this.

Investing in Whole Life Insurance

life insuranceThere are a wide range of Whole Life insurance policies, but one common feature is that they may offer dividends to shareholders if the total payout from everyone insured is less than they have collected in premiums. Since these dividends tend to increase over time (simply due to inflation), but your premium never goes up, later in life these dividends can be nearly as much as your total premium (meaning you pay almost nothing and keep your insurance).

Whole Life policies also have a Cash Value, which can be used for two things:

  1. You can take a loan out from your Whole Life insurance policy tax-free, up to the cash value of the loan (if this loan is not paid back before you die, it is subtracted from the Death Benefit).
  2. If you cancel your policy, you can get a percentage of this cash value back as a “Surrender Value”.

The Cash Value will also constantly 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

It is common for Endowment Life Insurance to be used as an investment vehicle to save up for college, or other big expenses. However, Endowment Life generally offers similar growth rates as a normal savings account.

Endowment policies are often sold as a means for extravagant spenders to force some savings – since it combines a savings account and Term 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 that Term Life Insurance policies are significantly cheaper than the other policies, with the only difference of no “cash value” at the end.

This means that if you were to compare the cost of an Endowment policy with a Term policy, putting 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 end of the day with the Term policy than Endowment policy (the same is even more true comparing to Whole Life policies). The only disadvantage is that you need to make a point to save that difference, which can be an issue for high-spenders.

Whatever type of Life Insurance you choose, it is an extremely important part of any person’s financial future.

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