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What is life insurance?

Understand how life insurance works and whether it's right for you

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Life insurance is a contract and, like any other legal document, it’s filled with language that clarifies the terms of your policy under the law. Learning the jargon and how to shop for a policy gives you the opportunity to double-check the terms and make sure you get the coverage you need.

What is life insurance and how does it work?

In simple terms, you pay a monthly premium to insure your life. If you die while your policy is active, your heirs receive a payout, called the death benefit, to recover financially from your loss.

Here’s the basic process of shopping for and using life insurance:

  1. Pick the type of life insurance you want, such as term or whole life, or a no-exam policy.
  2. Decide how much coverage you can afford and how long you need coverage.
  3. Shop around for quotes and choose the best life insurance company.
  4. Sign up for your policy and start making monthly payments.
  5. If you die during the active term, your family receives a payout. If you don’t, you can open a new policy, or sometimes get your premiums back.

What kinds of life insurance are there?

You have lots of options for life insurance policies, which can also make it more confusing. Start by asking yourself these basic questions to decide which is right for you:

How long do you want to be covered for?

  • Term life insurance covers you for a specific amount of time, such as until you retire or your kids graduate.
  • Whole life insurance covers you for your entire life, though at a much higher cost in premiums.

Do you need flexibility?

  • Universal life insurance lets you choose your premiums and payout over time.
  • Adding riders to your policy lets you add coverage for your kids or take out your cash value if you get a terminal illness, for example.

Do you have pre-existing conditions?

  • No-exam or guaranteed issue policies can qualify you for a policy without a medical exam or health questionnaire, though with less coverage.
  • Burial insurance is an option for seniors or those with pre-existing conditions to pay for basic end-of-life expenses.

Who should get life insurance?

Life insurance is about helping your family recover from your loss financially. If you’re in good health, your family doesn’t have much debt or doesn’t rely on you for your income or childcare, you likely don’t need health insurance. But consider getting life insurance if you fall into one of these groups:

  • You’re the sole breadwinner
  • You’re a stay-at-home parent
  • Your family couldn’t afford to pay the bills without your paycheck
  • You have credit card or medical debt
  • You have large loans like a student, medical, car or home loan
  • You have family who will rely on your income, such as special needs children or elderly parents
  • You have a large estate to pass on and want to protect it
  • You’ve maxed out your investments and want to invest with whole life

What life insurance terms should I know?

What’s included in your life insurance depends on the type of policy you purchase. You can expect to see the following life insurance phrases when reading a life insurance policy statement:

  • Death benefit. This is the amount guaranteed to the beneficiaries after the insured person dies. The amount is determined when the policy is purchased and is usually based on outstanding financial obligations as well as the policy owners income. This is the only benefit paid out on a term life insurance policy.
  • Cash value. If you buy a permanent life insurance policy, part of your premium is placed into a savings component of your life insurance, or its cash value. As your cash value accumulates, you can either make limited withdrawals or borrow against the value. You may also choose to use the cash value portion of your policy to pay your premiums, if paying them becomes a hardship in your later years.
  • Riders. Riders are add-ons to your policy that usually cost a little extra, but provide additional benefits. The riders available to you depend on the insurance carrier, but some of the more popular include the following:
    • Waiver of premium. If you become disabled, this rider covers your premiums until the end of the policy so that you don’t lose your coverage. If this is applied to a term policy, the rider pays the premiums until the end of the term. If applied to a permanent policy, the rider only pays the part of the premium that covers the death benefit. So your policy remains active, but won’t accumulate cash value.
    • Disability income. If you become disabled and cannot work, this rider replaces a portion of your income.
    • Accelerated death benefit. This rider is sometimes included in your policy for free. It allows you to receive a part of your death benefit early if you become terminally ill to help pay for any expenses you may have related to your illness. The amount of the death benefit you can access and the definition of terminal illness varies by insurer.
    • Guaranteed purchase offer. Allows you to add coverage in the future without having to retake your medical tests.
    • Conversion. Allows you to convert your term life insurance policy into a permanent policy at the end of the term. Converting your policy typically increases your premium.
    • Long-term care. Similar to the accelerated death benefit, this rider allows you to receive part of your death benefit to pay for the expense of a long-term care facility.
  • Dividend options. If your insurer pays dividends on your whole life policy, you can add the Paid-Up Additions option, which reinvests your dividends by purchasing mini paid-up whole life insurance policies that add to your cash value and death benefits every year. You can also choose to have your dividends pay your premiums or have them deposited into your bank account.

What is a life insurance declaration page?

The declaration page shows a summary of the details of your policy, and may include some or all of the following sections:

  • Personal information of the insured. Your name and customer number are included, as is your gender and age.
  • Policy number. This number is unique to your life insurance contract and you’ll need it to make any changes or access the policy funds in the future.
  • Policy dates. The date of issue and the effective date of the quote should both be listed.
  • Policy information. This area should include any riders or dividend options attached to the policy, as well as the policy type.
  • Benefit amount. This is the death benefit you purchased on the original policy and won’t include any additional policy funds or decreases due to withdrawals.
  • Premium amount. This is the amount you are required to pay to keep your policy active.
  • Beneficiary. The name of the person receiving the death benefit after you’re gone.
  • Policy owner. The person who took out the policy, if different from the insured or beneficiary.
  • Risk class. This is an assigned class based on whether you are a smoker.

How do I read a life insurance policy?

Every insurance policy will be slightly different and, while the main sections below are pretty standard to most life insurance statements, they may not be in this exact order.

  • Cover and declaration pages. The front pages of your statement will have your personal information and a high-level overview of your policy details.
  • Illustrations. Either on your declaration page or as a standalone section, your statement will include a table showing your benefit amounts and projecting the cash value accumulation as you pay your premiums.
  • Definitions. Most policies have a page to define the industry-specific terms that will be used throughout the statement.
  • Policy owner. Owning the policy gives you certain rights to make changes and even transfer ownership to someone else. Those rights should be explained in a section that also explains the rules and fees associated with making a withdrawal, taking a loan out on the policy or surrendering the policy for cash.
  • Settlements. This section details how to make a claim after your death and how the benefit will be paid to the beneficiary.
  • Exclusions. This section lists anything that would invalidate or lessen payment of the death benefit, including suicide or fraud.
  • Contestability. Every policy comes with a set period within which the insurer can investigate your personal information and medical condition if you die before the period expires. The contestability period is usually two years from the issue date. That should be defined in this section.
  • Premiums. This section provides details on your premiums, including when they are due, whether there is a grace period and whether your policy allows for reinstatement if you let it lapse.
  • Riders and endorsements. Anything you’ve added to your policy should be defined in this section along with what is covered and how to make a claim.

    What is a life insurance illustration?

    The life insurance illustration is a table on your declaration page that schedules your payments and shows how your dividend options and riders affect the cash value and death benefit of your policy. The schedule usually starts five or 10 years into your policy, which is typically when your cash value starts to show a larger accumulation.

    For example, if you pay your premiums on a $50,000 whole life policy, your loved ones are guaranteed $50,000 as your death benefit. But if you take advantage of the paid-up option for your dividend, your life insurance illustration will project how the added mini policies might increase your death benefit and cash value. These projections are listed as non-guaranteed because the actual amounts are based on your annual dividend, which is impossible to predict.

    How do I cash in my life insurance policy?

    If you are the policy owner, you can access the cash value of your permanent life insurance in three ways:

    • Withdrawal. Depending on your policy terms, you may be able to make limited cash withdrawals. You won’t have to pay taxes on your withdrawal as long as you don’t withdraw more than what you’ve paid in to the policy in premiums. But there may be a fee attached, and some insurers subtract your withdrawals plus the fee from your death benefits.
    • Loan against cash value. You can apply for a loan against the cash value of your policy, but if you don’t pay it back, the amount of the loan plus interest is subtracted from your death benefit.
    • Surrender the policy. If you decide you no longer need your insurance policy, you can cancel it and take the cash value, minus a surrender fee. But once the policy is canceled, your beneficiaries will no longer get the death benefit, no matter how long you paid into the policy.

    When would the death benefit not be paid out?

    It’s pretty rare for a life insurance policy claim to be denied, except in cases of suicide within the first two years of opening the policy, or suspected murder or fraud. Usually all you’ll need is a death certificate to start the claims process.

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    Bottom line

    It may seem like legal jargon at first, but understanding the information in your policy can give you peace of mind that you’re getting the life insurance coverage you signed up for. But before you sign, make sure you’ve shopped around your insurance options to get the best coverage for you.

    Common questions about life insurance policies

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