How Does Life Insurance Work? An Easy Guide
Updated April 16, 2021
Reading time: 9 minutes
To the skeptical customer, life insurance may seem too good to be true…
Or because it’s difficult to understand, it can seem misleading. But the general feeling is the same: “How do I know it’s actually going to pay out after I pass away?” A life insurance policy is a legal contract between you and your life insurance company. Understanding your rights as a policyholder and knowing the terms of your contract are the means of easing your fears.
By using Insurify, you’ll know what you’re getting into when you’re ready to buy life insurance. Peace of mind for you and your loved ones is a great benefit of life insurance, and you should not let misunderstanding your policy and your rights stand in your way. You can rest assured with Insurify. You don’t need to share your personal information to compare quotes or research life insurance products and companies.
This depends on the type of policy you have. At the end of a term life insurance policy, which is a policy that lasts for a limited amount of time, you may be able to renew the policy or leave the policy behind. If you allow the policy to terminate, you typically do not receive any benefits.
If you have a permanent life insurance policy, you can surrender it for the cash value, and the contract is over. Both types pay a death benefit to your beneficiaries if you pass away while the policy is active. Different types of life insurance policies do different things. Let’s examine various types of life insurance policies and how their benefits compare.
A term life insurance policy lasts for a predetermined period of time. It can be as little as one year or 20 years or more. If you pass away during the term, the policy’s death benefit pays out. If you outlive the time frame, the policy ends without a payout. Most term life insurance policies are renewable at the end of the term without evidence of insurability.
Another form of term life insurance, called decreasing term life insurance, is designed to cover important expenses, such as your mortgage or your child’s college tuition. The policy is designed to last the same number of years as your debt. The amount of coverage coincides with your expense and decreases along with your premiums and the debt. If you pass away during the term, your important expense is covered.
Term life insurance policies can also be attached to a permanent life insurance policy in the form of a rider. Riders allow you to tailor fit a permanent policy to meet your needs. They add additional protection and usually cost a small to moderate amount. Term life riders include a cost-of-living rider, which allows you to increase your policy’s coverage to fight inflation, and a waiver of premium rider if you become disabled.
Permanent life insurance, also called whole life insurance, lasts the policy owner ‘s entire life. This type of life insurance policy has higher premiums than a term life policy. It provides a savings and investment feature that grows cash value, and as long as the premiums are paid and the policy stays in force, the death benefit is guaranteed.
A whole life insurance policy is the most traditional form of permanent life insurance. Cash value grows in the insurer ‘s general account at a minimum rate. You can use cash value while you are alive for whatever purpose you choose. If your policy still has cash value when the benefit is paid out, it does not roll over to your beneficiaries. Permanent life insurance policies differ by the way cash value is grown.
A universal life insurance policy is a form of permanent life insurance that is special in the way it provides flexibility. You can increase premiums, decrease premiums, or pay no premiums. You can also decrease the death benefit or, subject to insurability, increase it. A universal life policy grows cash value in a savings and investment account that can be used to cover premiums.
Variable life insurance is permanent life insurance where the cash value works similarly to mutual funds. There’s a minimum death benefit; however, premiums are placed in investment subaccounts. The cash value and death benefit rise and fall with market performance. A variable universal life policy combines features of variable life, where premiums grow in subaccounts, with the flexibility of a universal life policy.
Your life insurance policy ‘s face amount or death benefit is the amount of money that your family members or beneficiaries receive when your policy pays out. You choose the death benefit based on your financial needs. Life insurance covers more than just funeral expenses; it may also pay estate taxes, set up your child’s education fund, or provide income.
A life insurance policy is a legal contract between you and your life insurance company. The contract is called the policy and is enforceable by law. Life insurance policies have features similar to other legal contracts, and some contract agreements are unique to life insurance. A legal contract involves a binding agreement in which the law decrees a duty of performance. Elements of a legal contract include:
When the applicant of an insurance policy fills out the application and pays the first premium, the applicant is making the offer and is the offeror. The insurance company is the offeree and can accept, deny, or make a counteroffer with a policy that has different terms. If the first premium does not accompany the application, the applicant is inviting the insurer to make an offer and is the offeree.
The consideration of the contract is the thing of value given by both parties of the agreement. In life insurance, the consideration is the applicant’s premium payments and the insurer ’s promise to pay benefits. A contract that involves one or more incompetent parties is not enforceable. Both parties must be of legal age, mentally sound, and not under the influence of drugs and alcohol.
Contracts must be of legal purpose to be enforceable. Life insurance is presumed to serve a legal purpose. Both parties in the policy are expected to act with the utmost good faith. They have a right to expect accurate and complete information. Failure to disclose critical information could result in voiding the contract. The policy owner has a right to reasonably expect that the promises made by the insurer will be kept when the time comes.
The underwriting process is where the life insurance company determines whether to accept, decline, or counteroffer the life insurance policy. During the underwriting process, underwriters use risk classification methods to determine the chance of loss if they agree to the terms of the contract. This is also when life insurance premiums are determined.
Life insurance is regulated by the state. Regulatory associations, such as the National Association of Insurance Commissioners (NAIC), work to promote uniformity among states by introducing acts, such as the Unfair Trade Act. Regulation of life insurance includes punishing unfair trade practices, such as unfair discrimination and unfair claims settlement practices.
In life insurance, unfair discrimination occurs when people in the same risk classification are charged different premiums or fees or when different benefits go to different people based on race, color, creed, sex, marital status, disability, or national origin. This also applies when insurers refuse to renew a policy or gives lower commissions to life insurance agents based on these factors.
Unfair claims settlement practices include:
Failing to acknowledge claims in a reasonable amount of time,
Not informing claimants within 30 days of whether the claim was accepted,
Not giving a reasonable explanation of why a claim was denied,
Failing to promptly and fairly settle claims for which the insurer is liable, and
Causing claimants to file lawsuits by offering smaller amounts than agreed upon, which are eventually recovered in lawsuits.
Consequences for unfair trade and unfair settlement practices include a penalty of $1,000 per violation (not to exceed $100,000 in total unless the violation was a brazen disregard of the acts, in which case the penalty will be no more than $25,000 per violation, not to exceed $250,000). Insurers may also have their insurer ‘s license revoked or suspended.
Most states have adopted standard policy provisions based on NAIC model laws. The incontestability clause states that after a policy has been in force for a certain amount of time, an insurer cannot dispute a claim for any reason other than nonpayment of premiums. This guarantees that life insurance policies can’t be voided due to a misrepresentation made by the policy owner after a stated amount of time.
Life insurance companies take measures to ensure claims can be paid. One method is through reinsurance. Reinsurance is when insurers share the risk of large policies with other insurers. This is done with a contract between the two companies, where premiums and risk of loss (a large payout ) are shared.
If your life insurance company goes bankrupt and is insolvent, your state’s guaranty association will ensure your policy’s coverage. State guaranty associations are overseen by the commissioner in every state, and they work to provide means for insolvent insurer s’ policy benefits to be paid. Guaranty associations also protect annuities and property and casualty insurance policies.
You can check your life insurance company ’s financial status by checking independent rating organizations, such as A.M. Best and Standard & Poor’s. These rating services analyze life insurance companies ’ financial strength by their capital, liquidity, and competitive advantages.
Life insurance companies usually exclude certain risks from life insurance coverage. Typical exclusions include war, aviation, hazardous occupation and hobbies, and suicide. Some of these exclusions last the lifetime of the policy, and some for a specific amount of time. The suicide exclusion typically lasts two years to deter people from buying a policy just to get a benefit for their loved ones by taking their life.
Life insurance policies have a provision that details how your life insurance beneficiaries can start the claims process and how and when benefits will be delivered. Usually, insurance companies will ask for a copy of the death certificate to initiate the claim. Settlement options are defined in the policy. You can choose the settlement option or let the beneficiary decide.
Benefits from life insurance policies are paid out in a variety of ways. The two categories that determine how your policy will pay out are settlement options without life contingency and settlement options with life contingency. A settlement option without life contingency means the life of the beneficiary does not affect the policy’s payout. There are four settlement options for these policies.
lump-sum cash payment
payments for a fixed period
payments of a fixed amount
A lump-sum cash payment delivers the benefit to your beneficiaries in one single payment. An interest-only payment option is when the insurer holds the policy until a future date and pays out only the interest until then. A fixed period is when the death benefit is paid in equal amounts to fit a specified time frame. And a fixed amount delivers the benefit over a period of time determined by the a mount of coverage.
A settlement with a life contingency option is based on the life of your beneficiary. Also called “life income settlement options,” these are payments that beneficiaries can’t outlive. This works by purchasing an immediate annuity with the policy’s payout. The amount of periodic payments is determined by your beneficiaries’ life expectancy. Younger beneficiaries receive smaller payments than older beneficiaries.
How much life insurance your policy pays out is determined by the death benefit you choose and whether you have made withdrawals or loans against your permanent life insurance policy. Policies designed to cover final expenses have a smaller death benefit and lower life insurance rates than policies designed to create an estate. Consider consulting a financial planner when deciding the face amount of your policy.
Death benefits from personal life insurance policies are usually tax-free. Settlement options that involve growing interest on the proceeds from the death benefit may be subject to taxation, but only on the interest portion of the policy payout, not the principal death benefit.
With Insurify, you can compare life insurance quotes from the security of your own home. Review and compare quotes from leading life insurance companies without having to provide your personal information; your personal data is not sold or shared.
Because life insurance needs vary, life insurance payouts differ. Typically, a life insurance policy arranged to cover funeral costs pays out less than a policy designed for other personal uses, such as creating an estate.
Usually, a life insurance policy’s death benefit is tax-free. If your policy’s settlement option involves accumulating and distributing interest, the interest portion is subject to income tax.
If your life insurance company becomes insolvent, your state’s guaranty association works to ensure your policy’s coverage.
Life insurance works to provide a death benefit to your beneficiaries in exchange for your premium payments. It is a legal contract enforceable by law. Policies detail your rights as a policyholder, and state regulations protect you from unfair settlement claims practices. The bottom line is that if you do not violate a policy exclusion and your policy is in force when you pass away, your insurance provider is expected to honor the contract.
By using Insurify, you can analyze which insurance companies’ policies and premiums are best for you. Get life insurance quotes from quality life insurance providers, and apply in mere minutes.
Aissa Martell is a licensed insurance producer in the State of New York. She is a creative writer and has been freelance writing for five years. She’s happy to share her knowledge of the insurance industry and its products.Learn More