What Is Life Insurance and How Does It Work?

Every good financial plan must consider worst case scenarios. It must also provide protection for you and your loved ones.

Given that, as you are planning your investment strategies, you will need to consider life insurance.

Having a basic understanding of what is life insurance and how it works is necessary to round out your financial knowledge.

What is Life Insurance?

how does life insurance workIn its simplest definition, life insurance is an “if, then” exchange contract between you and an insurance company.

If you pay money to an insurance company, then when you die, the insurance company will pay your family money.

However, insurance is not usually presented this simple. So, in the interest of being an informed consumer, let’s look at that same definition but with all the industry jargon included.

If you pay premiums to an insurance carrier, then when you die, the carrier will pay your beneficiaries the death benefit (face value) of your in-force policy. In addition, if there is any cash value in the policy when you pass, the insurance company will keep it.

Life Insurance Basics

For those of you that find these words new or confusing, we will engage in a quick “Life Insurance 101”.  In addition to looking at the industry terms used, we will also take a quick look at how life insurance works.

By the end of this article, you will have a good foundation to better understand and use life insurance to protect yourself and your family.  Moreover, you will be better equipped to navigate the marketplace and compare your options.

Life Insurance Definitions

Let’s start with a few basic definitions.

  • Policy – An insurance agreement and contract in written form.
  • Premium – Money you pay to an insurance company for your insurance coverage.
  • Carrier – An insurance company.
  • Beneficiary – The person (or people) that will receive a lump sum payment in the event of your death.
  • Death Benefit – The contracted lump sum payment available to your beneficiaries in the event of your death.
  • Face Value – The value of the policy received upon death or if the policy matures before you die.
  • Cash Value – The amount of accrued cash available inside a policy for whole life products.
  • In Force – Active, i.e. an “In Force” policy is a currently active insurance contract.

Types of Life Insurance

Next, let’s look at two major types of life insurance. Click on the links to go more in depth with each type.

  • Term Life InsuranceTerm life insurance is set in place for a specific amount of time (i.e. 10, 15, 20 or 30 years) that pays only upon death or before a specified age. There is no cash value associated with this type of policy.
  • Whole Life Insurance Whole life insurance, also called Permanent Life Insurance, is an insurance contract that can be kept active until a person dies and pays a death benefit. This kind of policy may accrue a cash value that can be accessed for use. Indexed Universal Life (IUL) policies fall under this category as well.

How Does Life Insurance Work?

Death Benefit / Retirement Cash / LTC Funds – Life insurance provides money to your family in the event of your death, but it is also used as a financial tool to provide cash in retirement.

In addition, life insurance has more recently become a resource for providing funds for Long-Term Care. Let’s break down each of these.

Life Insurance for Protection

The first and most common reason people have life insurance is for the protection of their loved ones from the impact of your death.

Everyone has different needs and wants, but people often need money to cover:

  • Daily Living Expenses
  • Mortgage/Rent Payments
  • Retirement Savings
  • Education Savings
  • Personal Debts
  • Small Business Obligations
  • Estate Taxes
  • Final Expenses (funeral expenses)
  • Charitable Giving

The death benefit lump sum payout will help your loved ones to cover some or all of these areas.

Life Insurance for Retirement Income

Another way to use life insurance is for a tax-advantaged retirement income.

Permanent insurance solutions such as Whole Life and Indexed Universal Life may have a cash value component built into the policy. As a result, you can structure your policy to accumulate cash at a rate that will help you supplement your retirement income.

So, How Does this Work?

When you pull money out of your retirement accounts, there are different rules for taxation based on the account.

If you are an investor that has already exhausted funding accounts with tax-free withdrawals (like your Roth IRA), then putting money into your life insurance cash value will give you another tax-advantaged option.

Money withdrawn from your IUL or whole life policy is considered a loan and is thus not taxed like regular income.

Of course, there are fees (like the cost of insurance) to consider when using life insurance as an investment vehicle. You need to do your research and talk to experts to make informed decisions. To start, you can learn more about how whole life works here or how indexed universal life works here.

Life Insurance for Long-Term Care Funds

Life insurance is an important tool even in retirement. Besides being a source of funds for final expenses and legacy gifts, many life insurance policies are now offering Long-Term Care Riders.

These riders offer access to the face value (death benefit) of the policy, before you pass, if you need it for a qualifying event. (These riders are sometimes called Chronic Illness or Living Benefit Riders.)

Nursing home expenses and chronic illness expenses are two examples of events that may trigger access to funds. These funds are pulled from the death benefit.

As a result, if you use them all up before you die, then you will not leave any death benefit money for your beneficiaries.

What About LTC Insurance or Medicare/Medicaid?

Long-term care costs are expensive, and they are not covered by Medicare. Medicaid will cover these costs, but you will need to essentially “spend down” your retirement savings before being able to use this government service.

Long-Term Care Insurance is another option, but it is also expensive and cost prohibitive for many people. This is especially true if you do not take out a policy until you are near or at retirement age. In addition, many people cannot qualify for LTC insurance at this time because of chronic health conditions.

For these reasons, a Long-Term Care Rider is a good option to help protect your money against large medical bills in old age.

Is Life Insurance Worth Getting?

It does not matter if you are single, married or divorced, before you die, you need to have a plan in place to meet the needs of those you leave behind. Comparatively, life insurance is often the most cost-effective way to do this.

The other options include self-insurance (having enough money saved up to cover these needs already) or relying on someone else to pick up the slack.

So, unless or until you have a large stash of cash to cover your obligations and responsibilities – yes, it is worth getting life insurance.

When Should I Get Life Insurance?

If you are lucky to be healthy enough to qualify for life insurance, then you should get something in place now.

Even if you are single, with no dependents and maybe even no debts, you should still consider what is available to you and what you could use it for. Insurance gets pricier the older you are and the more health concerns you have.

If you are not yet convinced or think insurance is not in your budget, then keep reading why you need life insurance here.

Before you buy, you need to consider why you want life insurance, both now and in the future. Your reason should greatly influence where you buy your insurance and what policies you consider.

Life insurance companies tailor their life products differently to meet different needs. Some products are designed to offer more cash value and growth while others are priced to provide the most death benefit value for the premium dollar.

A Case Study: The Savvy Millennial Investor Uses Life Insurance

As an example, let’s say you are a financially savvy 30-year-old who is on your way to financial independence at an earlier age than is typical.  You are married with no children but know kids are in your near future. You also have no major health problems and qualify for the good, non-smoking rates.

Your goals are to provide for your family’s needs and future children’s education – both while alive and if you unexpectedly pass. First, you decide you need the policy to cover living expenses/education expenses while you are working and raising your future kids.

Then, by age 50 or 55, your financial plan says you will have enough in savings to let go of this insurance safety net. However, by this time, you have other needs arising. These needs include tax-advantaged ways to access cash in retirement and a need for long-term care funds.

What Insurance Do You Need?

In this case study, as the financially savvy 30-year-old, there are a few ways you could meet your insurance needs.

Let’s look at one effective plan. (As a disclaimer, this is just an example, and not a recommendation for everyone.)

Assuming you believe your income will grow modestly each year, we would research insurance companies that have term policies with conversion options. On top of that, we would research companies that offer Long-Term Care Riders on their products.

Here is Our Insurance Solution:

  • Death Benefit: After deciding how much cash your family would need upon your death (typically 25x your annual income), we would take out a 30-year term policy that has conversion privileges (that usually extend for the first 20 years of the policy.)
  • Retirement Income: At age 40, we would convert part of the term policy to an IUL (Indexed Universal Life) policy with a Long-Term Care Rider. After paying the premiums for at least 15 years (20 would be better), then you could use the cash value in the policy as a source of tax advantaged income in retirement.
  • Long-Term Care: On top of that, the Long-Term Care Rider would allow you to use the death benefit value for long-term care needs or for chronic illnesses.
  • Legacy: As a bonus, if you did not deplete the face value (death benefit) of the policy for long-term care needs, then you would have money to leave your family or your causes as a legacy.

What is Life Insurance to You?

Now that you know the basics of life insurance and how it works, you need to decide – what is life insurance to you?

Considering your life goals and needs, you can now make more informed decisions on how to use life insurance to protect you and your loved ones, both now and in the future.

You can get started by comparing quotes with one of the best online life insurance aggregators on the market right now!

PolicyGenius With PolicyGenius, you can compare life insurance policies and quotes from 12+ top rated insurers all from the comfort of your home! Compare Rates Now! PolicyGenius

Carly Cummings

Carly Cummings

Carly is an “Elder Millennial” on the path to early retirement with the help of two strategic passive incomes. She is a licensed insurance agent and former FINRA licensed financial advisor. Carly is the Creator of MedicareLifeHealth.com where she helps her readers (of all ages) find the best health care and create the best cash flow in retirement.
Carly Cummings

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