What Is Life Insurance and How Does It Work?
During your life, you may accumulate many debts and financial obligations. Your wife may depend on you financially for survival. Your children may depend on you to help them with their college education. As a spouse and a parent, you will need life insurance. But, you'll also need to know what it is and how it works before you buy it.
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Purpose
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Life insurance may be purchased for many reasons. Insurance is purchased to provide an income for your family when you die. Or, you may purchase a life insurance policy to assist with your children's college education if you live by using a cash value policy. You may use a life insurance policy to insure your business partner's life so that if he dies, you can buy out his half of the business from his family. Alternatively, you can use cash value life insurance as a way to supplement your retirement income.
Death Benefit
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The death benefit is the central feature in a life insurance policy. A policy is purchased on the life of an individual. Normally, you would purchase insurance on your own life, but you may also purchase it on the life of your spouse or child. Alternatively, you may purchase it on the life of a business partner or anyone else whom you have a personal and economic interest in. When the insured individual named in the contract dies, the death benefit is paid out to a third person or organization called a beneficiary. The beneficiary is named by the person who takes out the policy (called a policyholder). The policyholder owns the contract, directs where the money will go to when the insured individual dies, and pays for the contract.
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Premium
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The premium is the cost associated with the policy. Premiums may be paid monthly, quarterly (four times a year) or annually. The premium is determined by the amount of death benefit purchased, the health condition and age of the insured individual, and the type of policy being purchased. Temporary insurance, called term insurance, offers insurance coverage for up to 30 years and carries a lower premium, on average, than permanent insurance. Permanent insurance, sometimes called cash value insurance, provides insurance coverage for the insured individual's entire life.
Cash Value
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Cash value refers to a cash reserve available in some types of policies. This feature is not available with term life products. A cash value policy uses a cash value reserve to offset the future cost of the insurance contract. As premiums are paid, a cash value accumulates. This cash value builds up against the death benefit. Because of this, the actual amount of death benefit that the policyholder pays for decreases. For example, if a policy has $100,000 of death benefit, but $25,000 of that is cash value, then the policyholder's premiums reflect the cost associated with purchasing only $75,000 worth of insurance. With cash value policies, the cost of insurance becomes lower (assuming all other costs remain equal) as time goes on since the amount of insurance being purchased decreases. This is often true even though the insured individual gets older every year and harder to insure.
The cash value is used as a savings and may be borrowed against for any reason. The borrowing activity reduces the available cash value for future borrowing as well as the death benefit payable at death. Once the loan is repaid, the cash value and death benefit are restored. Policy loans are tax-free as long as the policy remains in force and do not have to be repaid during the insured's lifetime. Some policies also allow withdrawals. Withdrawals permanently reduce the cash value and death benefit and are tax-free only up to an amount equal to the total premiums that have been paid into the policy.
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