What is life insurance & how does it work?

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Life insurance is a type of insurance policy that can provide the policyholder with the reassurance that loved ones will have the financial support they need after the holder of the policy passes away.

A working spouse, for example, might take out a life insurance policy naming a non-working spouse as the beneficiary; parents can name their children as beneficiaries; and so forth.

Related: How to buy life insurance

How Life Insurance Works

This type of policy can be compared to buying car insurance to cover the costs associated with an accident and any associated injuries — except, in this case, the ramifications of not having coverage can be much larger and longer-lasting.

After someone dies, they can leave behind a mortgage loan, student loans and so forth. Funds from a life insurance policy can help those left behind to meet debt obligations. Without it, they may be burdened with debt obligations they can’t meet.

In the cases when the policyholder is the sole or main source of income for a household, funds paid out from a life insurance policy can provide a financial safety net to beneficiaries. Without it, financial circumstances can be challenging.

A person can get a quote for a life insurance policy from a qualified agent. The policy would be taken out for a certain dollar amount under predetermined terms. The policyholder would then make regular payments, known as premiums, on the policy to keep it active.

The person would also name one or more beneficiaries, who are people who would receive a payout at the time of their death. In general, payouts are given in a lump sum, usually in full, and are typically tax-free.

Usually, the total amount of premiums paid into a policy is less in sum than what the ultimate payout will be. Beneficiaries usually have plenty of flexibility in how to use the funds. Depending upon the specifics of the financial situation and of policy payout, someone might choose to pay off a mortgage loan, for example, or make monthly payments to stay current.

Payouts can be used for child care or college expenses, to pay for funeral expenses, estate taxes and so forth.

Applying for Life Insurance

After selecting a life insurance company, the next step is to fill out that carrier’s application as completely as possible. The application will be reviewed as part of what’s called the underwriting process.

If more information is needed, the applicant will be contacted. Some life insurance companies routinely conduct a phone interview at this point, while others only do so if more information is needed to complete the application.

During the underwriting phase of the process, the carrier will look at the application through the lens of potential risk. In other words, they will review the application to determine how risky it would be to issue a life insurance policy to that particular applicant and then price it accordingly.

As part of analyzing risk, underwriters will use actuarial tables. Using the body mass table, for example, they can consider the applicant’s height and weight to determine what health-related category the person belongs in.

Another table looks at a person’s expected mortality. By looking at the applicant’s age and gender, the underwriters can get a sense of how long a person would, on average, be expected to live.

Each insurance company will have policies about who does and doesn’t need a medical exam as part of the application process.

As part of this exam, applicants are often asked the same types of questions that were on the application. That often includes information about family health history, personal health and lifestyle, prescriptions being taken, surgeries performed, and so forth. A medical tech will compare answers to ensure they match.

The physical exam may be like an annual physician given by a doctor. This can include a height and weight check, taking of blood pressure, urine samples and blood samples. Some applicants may need to have an EKG performed, which measures the electrical activity of the heart. Some men, especially those over age 50, may need a PSA test to check prostate health.

It’s crucial to be transparently honest when filling out a life insurance application. Deliberately providing false information is a form of fraud. Plus, when information on the application doesn’t match up what is found during the underwriting process, the application will likely be rejected.

Plus, if a policyholder dies within two years of getting a policy, the insurance company can investigate. This could lead to beneficiaries not receiving any payout.

Term Life Insurance Versus Whole Life Insurance

While considering how life insurance works, it’s important to note that people have two broad choices to consider: term life versus whole life. Here are the specifics of each:

Term Insurance

  • This type of policy is designed to cover the policyholder for a designated amount of time.
  • Regular payments must be made to keep the policy active.
  • Payments on term life insurance policies are typically fixed.
  • If the policyholder dies within that time frame and the policy is paid up, then beneficiaries can receive the appropriate payout.

People often choose this option because of one or more of these reasons:

  • They expect to have saved up enough money by the time this policy would expire and would therefore not need to have their income replaced.
  • They believe their beneficiaries will be financially independent by the time the policy expires.
  • The policy is more affordable and, therefore, easier to fit within their budget.

Whole life policies typically have premiums that are three to ten times the cost of term life, and some people may prefer to purchase term life and then personally invest the difference between a term life premium and a whole life one.

Whole Life Insurance

  • This type of insurance is designed to be in force throughout the policy holder’s life.
  • Regular payments must be made to keep the policy active.
  • This insurance type has a cash value component, as well, with the policyholder able to borrow against the value at a predetermined interest rate.
  • When the policyholder dies and the policy is paid up, then beneficiaries can receive the appropriate payout.

People often choose this option because of one or both of these reasons:

  • The policyholder can be insured throughout their entire lifetime, eliminating the need to seek another policy (as they would when a term one expires).
  • When payments are made, part of them goes toward the cash value of the policy, which can be considered a type of retirement investment.

Some people may like having the ability to surrender their whole life policy during their lifetime and receive the cash value of it. Doing so can have tax implications that can be discussed with a tax professional.

How Much Life Insurance is Needed

Circumstances are unique for each person, with the DIME formula providing some guidance. The acronym stands for Debts, Income, Mortgage, and Education. Here’s how to use this formula.

Debts

Gather together debt information, from car loans to personal loans and from student loans to credit card balances. In other words, add up everything that’s owed outside of mortgages.

Income

Take the household’s annual income and multiply it by 10. This will provide a ballpark estimate of what it would take to replace lost income during that period of time.

If the life insurance policy would be needed to provide financial support for more than ten years (perhaps because there are young children in the household), use a higher multiplier.

Mortgage

Home loans are usually the largest debt of a household and often have the longest term. As part of calculating the amount of life insurance to take out, include the payoff on mortgages.

Doing so can help to prevent loved ones from taking on the burden of the house payment expenses and/or from potentially being foreclosed upon.

Education

If there are outstanding student loans, they can be incorporated into the life insurance amount. Also, consider children who might have future tuition expenses at college, along with their housing costs, textbooks and so forth.

U.S. News & World Report lists the following average annual tuition costs for the 2020-2021 academic year:

  • Private college: $35,087
  • Public, out-of-state university: $21,184
  • Public, in-state university: $9,687

When adding up debts, income, mortgage and education (DIME), what is the total dollar amount? This can be a benchmark for the coverage amount of a life insurance policy.

Note that this figure would not include funeral or cemetery expenses. The National Funeral Directors Association shows the national median cost of an adult funeral with viewing and burial to be $9,135 (although some costs are not included). The national median cost of an adult funeral with viewing and cremation is $6,645, again with some related costs not included in this figure.

Life insurance provides a safety net for beneficiaries after a loved one dies. Choices exist between term life and whole life policies, and the DIME formula can help an applicant determine the optimal dollar amount. Applying for life insurance involves an application, an underwriting process and perhaps a medical exam.

Now, here are answers to other questions that people may have.

When is the right time to apply for a policy?

In general, if a person’s passing would have a detrimental financial impact on loved ones left behind, it makes sense to consider getting a policy. As far as premiums, people can typically get the best rates when they are young and healthy.

That’s because insurance companies usually price policies on the risk factors associated with them. With some insurance companies, the price of the premium can be locked in. In those cases, applying when young and healthy can help to ensure many years of the best pricing available.

What if someone gets an insurance policy and later wants to change the amount of coverage?

The answer to this can vary by the insurance company. Some carriers provide flexibility in their policies that allow a policyholder to change the coverage amount. If considering a particular insurance company and this flexibility is important, ask that question before taking out the policy.

Can a person have more than one life insurance policy?

Yes, they can. For example, some employees receive life insurance through the workplace. That amount can be relatively small, perhaps one to two year’s worth of the person’s salary.

Compare this to the DIME formula that uses 10 years’ worth in calculations. That person can also independently buy a life insurance policy to increase their protection and provide more peace of mind to the family.

Pros and Cons of Using an Agent

If someone has questions about how life insurance works, then an agent can provide helpful information. This can be useful if buying life insurance is new to you. Agents often work on commission, which adds to the cost of policies. This can be especially true with whole life policies, which are more expensive overall than term life options.

Some insurance companies don’t use commissioned agents. So, determine how much help you need and the cost of that help, and then make a decision about the use of an agent.

Learn more:

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

Ladder Life term life insurance policy made available through Ladder Insurance Services, LLC (Ladder) and underwritten by Fidelity Security Life Insurance Company, Kansas City, MO. Product availability and features may vary by state. Not available in New York. The California license number for Ladder is OK22568. Policy Form No. ICC17-1069, M01069, Policy No. TL-146.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

Image Credit: Bychykhin_Olexandr/ iStock.

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