A guide to understanding your life insurance policy

Life insurance is a product that provides financial protection in the circumstance of your death. Although it is important, reading a life insurance policy is nobody’s idea of fun. Your life insurance policy will often be several pages long and contain complex terms. However, you must ensure that you carefully go through your life insurance policy to fully understand the coverage you have purchased.

This post explains the policy document sections and the common terms contained in those sections, so that you will not have any trouble when you sit down to read your life insurance policy.

What is a life insurance policy?

Life insurance is a contract in which the insurer promises to pay a death benefit upon the insured’s death in exchange for premium payments. Life insurance policies are either term or permanent. Within permanent life insurance, there are several subtypes, such as whole and universal life.

Different types of life insurance work best in different situations. For example, if you want a policy for income replacement until your children become financially independent, a term plan will suit you better. On the other hand, someone who wants a life insurance policy with an investment component will be better off buying a whole or universal life policy. Make sure you buy a policy that best addresses your needs.

Term Life Insurance

Term life insurance provides coverage for a specific period. That can be as short as one year or as long as 35 years. You can select the life insurance policy’s term when you apply. The insurer pays out only if the insured passes away during the life insurance policy term. When the policy reaches the end of the term, in most cases, the policy can be renewed without the policyholder having to take a medical exam - up to a certain age.

Term life has only one aim: to pay the death benefit. For this reason, it is often referred as the purest form of life insurance. Term life insurance policies do not build cash value, so you cannot use them as an investment tool.

Permanent life insurance

Permanent life offers life insurance protection that you cannot outlive. The coverage lasts your entire life, provided you pay the premiums.Because of this feature, a permanent policy is the nearest thing to “fill it, forget it” life insurance. Many permanent life insurance plans accumulate cash value, which grows tax-deferred over time.

Some of the most common types of permanent life insurance policies are:

Whole life insurance

Whole life provides lifelong coverage and accumulates cash value. A part of your premium goes into covering the cost of insurance and administrative fees, while the remaining is used for building cash value. Policyholders can borrow from or take a loan out against their cash value. Upon the insured’s death, the beneficiaries usually receive only the death benefit. Any remaining cash value reverts to the life insurance company.

Universal life insurance

Like whole life, universal life policies offer permanent life insurance and accumulate cash value. However, these policies usually offer more flexibility in regards to the death benefit and premium payments. You can increase or reduce the two within permissible limits, according to your needs. Universal life policies also offer you more control over how the funds in your cash value account are invested. On the downside, universal life insurance plans require closer monitoring and are more complex than whole life.

No-medical life insurance

Unlike traditional life policies, no-medical plans do not involve a paramedical exam. As such, they are easier to access. Individuals who do not qualify for a traditional life insurance policy — due to poor health or other reasons, like having a dangerous hobby — can get coverage through a no-medical policy. However, these policies are considerably more expensive than traditional life insurance.Also, the death benefit is usually limited.

No-medical policies are either simplified issue or guaranteed issue. With simplified issue life insurance, you do not have to undergo a medical test but must answer a few medical questions. The life insurance company will judge your risk level and set your premium rates on the basis of your answers. Generally, the death benefit amount is capped at$50,000, but some Canadian insurance carriers offer sizeable coverage with simplified issue plans, especially to applicants who are young and healthy.

Guaranteed issue plans do not involve any medical underwriting. You neither need to take a physical exam nor worry about invasive health questions. Almost everyone who applies receives approval, as long as they meet the age requirements. Typically, the maximum death benefit available is $25,000 to $50,000. 

Go through the declaration page

The first couple of pages of your life insurance policy provides a summary of your coverage and includes details such as:

• The name of the insured

• The name of the insurer

• The type of plan you have purchased

• The free look period

The free look period is a small period — usually 10-30 days— during which the policy owner can cancel the coverage without any penalty.

The cover page is followed by the declaration page, which can be several pages in length. Typically, it includes the following information:

• The names of the insured and policy owner

• The policy number

• The issue date

• The benefit amount

• The premium amount

• The policy type

• The risk class

• The attached riders (if any)

• The names of the beneficiaries

Pay attention to graphs and illustrations

Depending on the type of life insurance policy you have purchased, it may include tables showing how your cash value, and in some cases, death benefits and premium amounts may change over time. Carefully go through this section to ensure everything is as your agent told you.

Understanding the terms

Life insurance policies are full of legal terms, which can be a bit confusing at times. Thankfully, your life insurance policy document includes a definition section, which spells out what different terms mean.

Some of the common insurance terms that you should be aware of include:

The policy owner: The person who has submitted the life insurance application and is responsible for paying the premium dollars. Only the policy owner can access policy information and make changes to it as they deem fit.

The insured: The person whose life the policy covers. Upon the passing away of the insured, the insurance company will issue the death benefit to the designated beneficiaries. The policy owner and the insured are generally the same person, but they can be different. For example, a husband may purchase a policy on his wife’s behalf and designate himself as the policy’s beneficiary. In this situation, the husband will be the policy owner and the beneficiary, while the insured will be his spouse. It is legal to purchase a life insurance policy on someone else’s name, but you will have to prove insurable interest — meaning you will suffer financially if that person passes away — and need their consent.

The beneficiary: The person or entity that receives the death benefit upon the insured’s death. You can have more than one beneficiary, but in that case you must designate how the proceeds are to be distributed after the insured’s death. The policy owner is the only person who can designate and change beneficiaries.

Primary and contingent beneficiary: The primary beneficiary is the person who receives the proceeds from the life insurance policy upon the insured’s death. Whereas, the contingent beneficiary gets the death benefit if the primary beneficiary predeceases the insured. For example, say you take out a policy on your name and designate your husband as the primary beneficiary and your two daughters as the contingent beneficiaries. If your husband dies before you, upon your death the life insurance payout will go to your daughters.

Revocable and irrevocable beneficiary: A revocable beneficiary has no guaranteed rights to a life insurance policy’s payout. The policyholder is in complete control. They do not require a revocable beneficiary’s permission to update or change the designated beneficiary. By contrast, an irrevocable beneficiary enjoys certain rights when it comes to receiving the policy’s proceeds. The life insurance policy owner needs the former’s consent to change a named beneficiary.

Death benefit: The amount of money the beneficiaries will receive upon insured’s death.

Graded death benefit: This type of life insurance policy pays a lower amount if the insured passes on during the first few policy years. The full death benefit is paid only after the life insurance policy has been in force for a certain number of years.

Level death benefit: It means the death benefit will remain the same throughout the life of the policy. The insurer will issue the same payout whether the insured passes away shortly after taking out a policy or many years later.

Premiums: The amount of money you must pay periodically to keep the policy in force.

Level premiums:It means the premium amount will not change throughout the life of the policy. Most life insurance policies have level premiums.

Grace period: A short period of time after the premium is due in which the policy owner can make a premium payment without losing coverage. If you miss a premium payment and the grace period as well, your life insurance policy will lapse. Generally, the grace period is 30 days, but it can be shorter or longer depending on your insurer and insurance policy.

Riders: These are additional benefits or add-ons that the policyholder can buy to add to the original coverage to customize it according to their needs. The most common riders include accidental death benefit, accelerated death benefit, waiver of premium, child term, family income benefit, return of premium, and long-term care.

Contestability period: It is a short window — usually two years — during which the insurance carrier can review your application and contest a claim. If the provider finds out you willfully omitted, misrepresented, or lied on your application, they can reduce or even deny the claim.    

Suicide clause: Most life insurance policies do not cover suicide during the first two policy years.  

Exclusions: These are situations in which the provider will not pay out. Essentially, it means the insurance companies will not cover certain causes of death. Apart from suicide during the first two years, other common exclusions include dangerous activity, illegal activity, and substance abuse. If you die as a result of an illegal activity or due to substance abuse, or a risky activity, like rock climbing, the insurer will not issue the death benefit to your beneficiaries.

Guaranteed renewable:This clause pertains to term life insurance. It allows you to renew your term policy without any underwriting up to a certain age, which varies by insurer. In other words, if the policyholder wants to renew the life insurance policy and meets the age requirement, the insurer cannot turn down the request. Most term life policies have this clause.

Guaranteed convertible term: This clause is present in term life policies. It allows the policyholder to convert their term plan into a permanent one without taking a medical exam.

Policy loans: This pertains to whole or universal life insurance. The policy owner can borrow against their policy’s cash value once it has accumulated sufficient funds.

Surrender fee: The fee you will pay when you cancel a whole or universal life policy.

Cash surrender value: The amount of money you will receive when you cancel a whole or universal policy.It is equivalent of your cash value minus surrender charge and other fees.

Preferred Plus rating: This is the best rating an applicant can receive. To qualify, you must be in great shape and have a normal BMI. Insurance carriers reward these applicants with the lowest rates.

Preferred rating: People who receive this classification are in good health, have a normal BMI, and one or two minor health issues, like high cholesterol.

Standard rating: This rating goes to applicants who are in average health and have a higher BMI and potential health issues.

Substandard rating: This rating is reserved for high-risk applicants and comes with higher premiums.

Importance of reviewing your policy

Life insurance needs can change, and often do, as your life changes. For example, the small life insurance policy you bought to cover your student loan in your 20s is not likely to be enough when you start a family. Your insurance needs can reduce as well. As you approach retirement you are not likely to need as much protection as you did in your 30s and 40s. Therefore, it is important that you review your life insurance needs from time to time to ensure you have the level of protection that your present situation warrants.

Some key points in life when your life insurance needs are likely to change include:

• When you get married

• When you have children

• When you take out a mortgage to buy a house

• When you change jobs

• When you approach retirement

You should also review your coverage if you become healthier, quit smoking, or get off medications. If your health has improved for the better, you can request for a rate reduction through a process called reapplication or reconsideration.

Let’s say you received smoker’s rates when you took out a life insurance policy, but have now been tobacco-free for five years. In this case, you can apply for reconsideration. The insurer is likely to ask you to undergo a new medical test before readjusting your rates.Likewise, if you were considered overweight and have lost weight and been able to keep it off for 12 months, you may be eligible for better rates.

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Conclusion

Taking out a life insurance policy is an important step in securing the financial future of those who depend on you. However, your responsibility does not end with paying the first premium and receiving the policy documents. You should carefully read your life insurance policy to ensure that how much life insurance protection you have is the same as the amount you signed up for.