How Does Life Insurance Work?

Life insurance is a contract between an insurer and a policyholder. In exchange for premium payments, the life insurance company promises to pay The Death Benefit to the policyholder’s beneficiaries in the event of the policyholder’s death.

March 10, 2021

There are two types of life insurance — Term life insurance and permanent life insurance. Term life insurance provides coverage for a predetermined period, and Permanent life insurance provides coverage until your death.

Generally speaking, Term life insurance is significantly cheaper. However, most Permanent life insurance policies accumulate cash value, which you can access while you are still alive.  

Life insurance basics

Originally created to pay for funeral costs and lend financial support to families of the deceased, life insurance is now considered a robust financial product. According to a LIMRA study, 12.6 million Canadian households own a life insurance policy.

So how does life insurance work? Continue reading to find out.

Life insurance terminology

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There are different types of life insurance policies. There is life insurance for couples, families, high-risk individuals, and other classes of buyers.  Here are some terms that are common across the board.

  • Policyholder: The person who owns the policy. Usually, the policyholder and the insured are the same people.
  • Insured: The person whose life is insured.
  • Insurer: The insurance company that provides the insurance cover.
  • Premium: The amount of money you pay the insurance company for life insurance coverage.
  • Beneficiary: The person who will receive The Death Benefit after the death of the insured. You can name anyone as your beneficiaries, like your spouse, children, aunt, or even pet.
  • Death Benefit: The amount the insurer will pay to the policy beneficiary when the insured passes away. This money is paid out on a tax-deferred basis. So, if you purchase a policy with a two-million-dollar death benefit, the insurer will pay your beneficiary two-million-dollars when you die.
  • Cash Value: Some Permanent life insurance policies include a savings component — called Cash Value — that grows on a tax-deferred basis. A part of your monthly premium pays for the cost of insurance while the other part is funnelled into a savings component. You can withdraw money from your cash value or borrow against it in the form of a policy loan. Term policies do not build any cash value.
  • Policy Term: The period for which a term life policy will last. For instance, a ten-year term policy will expire after ten years from the date of issue unless you renew it.
  • Riders: These are extra benefits you can add to your life insurance policy to tailor it to your unique needs. Some riders are free, like the Term Conversion rider. But others, like the Waiver for Premium, require an extra payment.

Who needs life insurance?

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If someone depends on you financially, you need life insurance. If you were to die prematurely, life insurance will protect your family, ensuring they are still able to make mortgage repayments or pay for school fees.

Even if nobody depends on you financially in the day-to-day, your loved ones will still have to pay for funeral costs and other end-of-life expenses. These can quickly amass to a large sum of money, leaving your loved ones in debt.  A life insurance policy can set aside funds for your funeral before the need arises. It ensures your family will not be burdened with the funeral costs and other expenses after you pass away.

If you have no dependents and your funeral expenses will not affect your loved ones, then you do not require life insurance. However, if someone will be negatively impacted financially when you die — whether in the near or long term — you should consider taking out a life insurance policy.

How does Term life insurance work?

Term life insurance is exactly what it sounds like — a life insurance product that lasts for a specific term.

The coverage usually lasts for five, ten, twenty, or thirty years or until you reach a certain age, like 65. Term life insurance is popular as it is easier to understand and affordable. The premiums can be cheaper than a cup of coffee a day!

If you die while the policy is in effect, the insurer pays The Death Benefit to your beneficiaries. If you outlive the policy, you will not receive a payout.

When your policy is near the end of its term, you can renew it to continue coverage. The renewal premium is likely to cost more as the cost of insurance increases as we age. The upside is that you will not have to take a medical exam again, nor can the insurer factor in any change in your health status into the renewal premium. For most people, renewing a Term life policy is cheaper than buying a new one.

Most Term life insurance policies also let you convert your Term policy into a Permanent one without any underwriting. Naturally, the new premium will be higher, in part because you are now older, and in part, because Permanent life insurance is more expensive.

Young couple cooking in their kitchen

Reasons to buy a Term life policy include:

  • You want to secure your family’s future.
  • You want to ensure your children can finish college even if you die before you expect to.
  • You do not want to pass on debt to your loved ones.
  • You want coverage but are on a tight budget.

How does Permanent life insurance work?

Permanent life insurance provides coverage that lasts your entire life, assuming you pay premiums. There are different types of permanent life policies, with Whole life and Universal being the most popular ones.

Most Permanent life insurance policies give you a chance to build cash value. Often, the cash value is a key selling point for Permanent life insurance.

So how does cash value work? It is an account within your policy that accumulates overtime on a tax-deferred basis. Your monthly premiums get divided into two parts — one pays for the cost of insuring you, while the other fuels the cash value.

In the early years of your policy, the cash value grows much more quickly. This is because the younger you are, the lower the cost of insuring you. Consequently, a bigger portion of your premiums gets funnelled toward the cash value in the initial years.

Whole life policies accumulate cash value at a predetermined rate. By contrast, Universal policies do not grow at a fixed rate. Instead, the growth rate fluctuates with the market.

The Death Benefit amount is for your beneficiary, but the cash value is for you. This money is there for you to use while you are alive.  Your beneficiary will not receive any accrued cash value if you pass away, only The Death Benefit.

You can borrow against your cash value or make withdrawals. You can also use the cash value to pay future premiums or surrender the policy for its cash value. When you cancel the policy, you forego The Death Benefit and, in return, the insurer pays you the cash value less any fees.  

Whole life insurance could make sense for you if:

  • You have a lifelong dependent.
  • You want to leave an inheritance to your heirs.
  • You want your life insurance policy to include an investment component.
  • You want life insurance to cover your end-of-life expenses.

Whole Life Insurance

Whole life insurance lasts until your death and builds cash value. However, useful as these aspects are, they come at a price. Generally, a Whole life insurance policy can cost five to ten times more than a comparable term life insurance policy.

A Whole life insurance policy has an investment component, but the rate of return is lower and administrative fees are higher than other traditional options. Therefore, a Whole life insurance policy can not be considered simply an investment tool.

Universal Life Insurance

Universal life insurance covers you for life and accumulates cash value. However, unlike Whole life insurance, it offers more flexibility. You can adjust the premium payments and the Death Benefit according to your needs.

Also, the cash value in Universal policies does not grow at a steady rate. Rather, it is tied to investment options picked by you. This means that your returns will fluctuate according to the investment choices you make.

Choosing a beneficiary for your policy

When you buy a life insurance policy, you can name one or more persons as beneficiaries. A beneficiary is an individual or an entity you name in your policy to receive The Death Benefit.

If you are naming more than one beneficiary, you need to specify how you want the policy proceeds to be distributed. You can also name one or more contingent beneficiaries. A contingent beneficiary is entitled to receive the payout only if the primary beneficiary dies before the insured.

Young Couple with a Baby Indoors at Home.

You can name anyone as your beneficiary, such as:

  • A spouse or partner.
  • Adult child.
  • Charitable organization.
  • Business partner.
  • A trust.

Minor children cannot receive The Death Benefit directly. Instead of naming a minor as a beneficiary, consider choosing an adult or designating a trust as your beneficiary to ensure your child’s financial wellbeing.

How do life insurance payouts work?

Life insurers pay The Death Benefit amount to a policyholder’s beneficiaries when the insured dies. The recipients usually need to file a death claim by filling the appropriate form and attaching a copy of the death certificate. The life insurance company then reviews the claim and releases the payout.

Payout Options

A life insurance beneficiary can choose to receive The Death Benefit in different ways, such as the following:

  • Lump-sum

You can receive the entire Death Benefit at once. This is the most popular payout option as it gives the beneficiary more flexibility. You have complete control over the money and can use it any way you like.

  • Lifetime income

You can opt to convert a life insurance payout to an annuity. The insurer will then pay guaranteed payments until you die. The amount of payment will depend on The Death Benefit amount and your age.

  • Fixed amount

You can choose to receive a fixed amount each month or year. Once The Death Benefit is exhausted, payments stop.

  • Interest income

You may have the option to leave The Death Benefit with the insurer in an interest-bearing account. The insurer, in return, will pay out interest earnings to you. The original Death Benefit can be paid to a secondary beneficiary after your death.

  • Life income with a certain period

You can choose to receive payments for life or over a certain period, whichever is longer. If you die within the specified period, beneficiaries designated by you will receive the remaining payments.

Filing a claim

To receive a life insurance payout, you need to file a claim with the insurance company. You can initiate the process by calling the insurer or agent to find out what you need to do. In most cases, you will need to fill in a claim form and submit a certified copy of the death certificate.

Some insurance companies pay The Death Benefit only in a lump sum. Others, however, may offer multiple options. You will have to specify how you want to receive the payout. If there are multiple beneficiaries, each one may have to file a separate form.

When are benefits paid?

Life insurance companies usually have 30 days to review the claim. After that, they must pay The Death Benefit, deny it, or request additional information.

If everything is in order, most insurers process the claim rather quickly after receiving the paperwork — in one or two weeks. An insurance company can face hefty interest charges if the claim gets delayed too long, so it is in their best interest to process the payout quickly.

However, certain situations may warrant extra scrutiny. For instance, if the insured dies within two years of buying the policy, the insurance company may investigate the matter further. Suicide, homicide or death during an illegal activity may also lead to a lower payout.

If the insurance company denies the claim, which happens only rarely, they will tell you to know the reason. You will then receive the premium dollars paid into the policy, but not The Death Benefit.  

How does life insurance work if you do not die?

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The purpose of life insurance is to financially protect your loved ones after your death. But what happens if you outlive your term policy?

Here are the possible scenarios:

  • You can let the policy expire.
  • You can renew it.
  • You may be able to convert it into a permanent life policy.

If you bought a return-of-premium Term life policy, the insurance company will refund you the amount you paid as premiums after its term ends.

A Permanent life insurance policy, however, does not give you a chance to outlive it. The coverage lasts until your death, as long as you pay your premiums. After you die, the insurance company will pay The Death Benefit to your beneficiary.

Conclusion

Life insurance provides your loved ones with a financial safety net by replacing part or all your income after you pass away. You can secure your family’s financial future by buying either a Term or Permanent life insurance policy, depending on your needs. Term life insurance provides coverage for a limited period but is simpler, easier to understand, and cheaper. Permanent life insurance, by contrast, lasts a lifetime and builds cash value while you are alive.

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