What Is Life Insurance & How Does It Work?

Life insurance provides people who are dependant on you with financial support if you die and so can no longer provide for them. Life insurance is therefore not needed for single people who do not have children, but only for people with a family or with dependents.

How much life insurance you need really depends on how many people would have to be supported if you were to die, and how much money you have saved away. If for example, you have a wife and two kids, then you would probably need to take out more life insurance than someone who is married but has no children.

As a general guideline, it is recommended that you take out a coverage policy for five to eight times the amount of your current salary. However, if you have a lot of money saved away in a bank or in investment funds, then you may need to take out less coverage as your family will already have some money to support themselves with after your passing.

Another factor which can determine how much life insurance you need is if your spouse has an income of their own. If they do, then you may require a smaller policy. If they do not work, then you are likely to need a larger policy.

As explained shortly, there are different types of policies that you can take out and the type of policy you have largely depends on your current level of income. For those who are young, starting with a basic policy is usually a good idea as this will allow you to gradually save up money over time whilst still ensuring that your dependents are covered.

What you want to try and avoid doing is to get the most expensive policy straight away. This is because unless you have the income to support such a policy, you may then find it difficult to keep up with your monthly payments. In the worst case scenario, this could result in you losing all that you have saved up for.

If you start small and gradually however, you will help to ensure that you maintain your policy for as long as possible whilst also ensuring that you have money left over to pay for other expenses. More information about how much life insurance you should take out and the different factors that can affect your coverage limit can be found here.

How Much Coverage Do You Need?

A good way to get a more accurate determination as to the amount of coverage that you are likely to need, is to keep a record of all your families expenses for one year. This can be done by keeping receipts for all the items that you buy and all the bills that you pay. Then, at the end of the year, you will be able to see exactly how much money your family would require each year if you were to die.

It is advisable to carry out this exercise over the course of a year, rather than just a few months, because your family’s monthly expenses are likely to vary throughout the year.

In the winter months for example, when it remains darker for longer and when it is cooler, electricity bills are going to be much higher than during the summer months. An exception to this is if you have air conditioning, as this can push up your electricity bills in the summer also.

Another seasonal expense to take into consideration is holiday periods, as there are usually additional expenses associated with Easter and Christmas periods for example. If you do manage to keep track of all these expenses for a year, then you should have a pretty good idea as to how much life insurance you need to take out for your family.

Thinking About Lifestyles

The type of lifestyle that you want to provide your dependents with can also affect the amount of coverage that you need to take out.

If you currently live quite an expensive lifestyle and have a high standard of living, then you are likely to need a greater amount of coverage to continue providing your dependents with security and the standard of living that they are used to. Conversely, if your standard of living is low or moderate, then you will probably require less in your life insurance policy for your family to maintain that standard.

This is something that is definitely worth thinking about, because even though you may have money set aside, such as savings in a bank or if your spouse has a retirement plan, you may not be happy with this amount because it will mean that they will have to change the way they live in order to survive on a lower income.

In addition, whilst you may expect your families living costs to fall if you were to pass, they may in fact increase as your spouse may have to hire someone to help with the children or to maintain the house. For this reason, it is always a safe bet to put more in your insurance policy than you think you will need, and, to take out a policy for a slightly longer duration than you think would be sufficient.

Length Of Insured Coverage Period

Different types of life insurance policies will provide your dependents with money for different periods of time. Generally, the longer the coverage period, the more expensive a policy is going to be. As a result, you want to have a rough idea as to how long your coverage policy should provide for your dependents.

This is important because you want your death benefit, which is the amount of money paid out upon your death, to last your wife or children long enough until they are able to secure another source of income to support themselves with. In addition, you also want your policy to be affordable for you to maintain. So even though you may want to provide for a certain amount of years, you may not currently be able to afford such a policy.

Protecting Important Stages Of Life

It should be noted however, that you are not necessarily aiming to provide your family with money for the rest of their lives so that they never have to work again. This is not the purpose of a life insurance policy. Rather, you should be looking to provide for them during specific periods of their life when they are likely to need it the most.

For example, if you have children who will one day be going into higher education, then that would be a good time to provide for them. In such a case, a 10 or 15 year coverage period may be all that you need to see them through their college or university years.

How close your spouse is to retirement can also affect the length of your policy’s coverage. If your spouse has a retirement plan for example, then that may be sufficient to provide your spouse with enough money to live on. In which case, a 5 or 10 year plan may be enough to provide adequate coverage.

What Types Of Life Insurance Are There?

After you have decided how much life insurance you need and how long you want it to last for, the next step is to determine what type of coverage you want to take out.

There are two basic types of life insurance that you can take out: temporary and permanent.

1) Term Life Insurance

Temporary or term life insurance is the least expensive type of life insurance, and if you are young, then this is probably the best option as it will allow you to build up your policy at a rate which you can afford. The amount that you pay towards your policy each year is called an annual premium.

As long as you pay your premium each year, your beneficiaries will receive a pre-determined amount of money if you die during the term in which you are insured. Death outside this period however, will not result in your dependents receiving any money. Hence why this type of policy is known as “term” life insurance.

The “catch” is that this annual premium will gradually increase as you get older, and may eventually become too expensive for you to maintain. The reason it becomes more expensive, is because as you get older, the chances of you dying increase. Therefore, there is a greater risk of your insurer having to pay out a death benefit, and so to compensate for this added risk, the insurance company charges you more money.

Term life insurance is therefore best suited for young families who are looking to provide their dependants with a source of income during a certain period of life, such as when their children go to school or when their teenagers go to college. It can also be useful for families who want to cover major expenses such as a long term loan like a mortgage, so that their children won’t be put at risk of losing their home if one parent were to die.

Looking For Something More Permanent?

As a term policy can become prohibitively expensive to maintain as you get older, term life policies should not be seen as long term policies past 10-20 years. This of course, largely depends upon your age when you first take out the policy. As younger adults can generally stay with a term policy for longer than older adults can before it starts to become too expensive to maintain.

But regardless of your age, once a term life policy begins to cost you as much as a permanent life insurance policy would, it is time to consider switching to a permanent policy as that will provide additional benefits for your dependents and reduced cost for you throughout the rest of your life.

To find out more information about term policies and the different types of coverage options it can provide you with please see this article.

2) Permanent Life Insurance

Cash value reserve, also known as permanent life insurance, is generally taken out by wealthy people or older people. This type of policy involves a combination of permanent life insurance, meaning that your dependents will receive a death benefit regardless of when you die, and a type of savings account known as a cash value reserve.

Your cash value reserve can be added to throughout the course of your policy (usually via interest and a portion of your premiums), and will therefore accumulate in value over time providing you with an extra lump sum of money when you retire, if you decide to end your policy or to your dependents upon your death.

There are three main types of cash value reserve policies that you can take out; whole life, universal life and variable life.

i) Whole Life

A whole life policy offers you a stable rate of interest on your cash value reserve. This means that you will always know exactly how much your rate of return will be each year. Although this is a safe option, sometimes the interest that you are getting might be lower than that offered at a commercial bank.

ii) Universal Life

With a universal life policy, your rate of interest on your cash value reserve is not fixed. As a result, sometimes you will be getting a high rate of interest, whilst at other times, you might be getting a low rate of interest. The rate of interest that you do get is largely dependent upon current economic conditions. So there is inherently more risk with this type of policy.

iii) Variable Life

A variable life policy gives you the option to invest a portion of your cash value reserve into an investment vehicle, such as the stock market or a mutual fund. Although this does provide you with the potential for greater returns, it could also result in you losing money. For example, if you invest in the stock market and your investments do poorly, then the value of your cash value reserve will decline as a result of that bad investment.

Greater Expense

Although permanent life insurance offers greater benefits and more options than a term life policy, it is important to remember that it is also a lot more expensive. This is why only wealthy or elderly adults then to have this type of policy.

Agents who sell life insurance will try to sell you this type of policy if they can, because they make a much higher commission on it.

Usually they will tell you that your policy will be paid up in 10-20 years, and so you won’t have to make any more payments after that period. Whilst this may be true, the fact that a cash value life insurance policy can be up to eight times more expensive, means that you would be better off going with term life insurance if you are still young.

Making The Most Of Your Policy

Although permanent life insurance is considerably more expensive than a term policy, especially during the first few years, they do offer one significant advantage; you are not limited to when your death benefit will be paid out.

With a term life policy, you take out insurance for a specified period of time. The insurance industry calls this period a term. Your dependents will only receive money from that policy if you die within that term. The problem is, that since you can’t predict when you are going to die, having a term policy could mean that your dependents receive no death benefit if you die outside of the term that you have been insured for.

As a result, your life insurance policy will essentially be wasted if your dependents don’t benefit from it at all. This can cause a policy holder unnecessary worry, especially if they would like to leave their spouse or children with some money after their passing.

The main advantage of having a permanent life policy is that your dependents will receive a death benefit whenever you die. This way, you will know that when you do die, your dependents will be well looked after as a result of you having taken out a permanent policy.

As a result, permanent policies give policy owners much greater peace of mind by helping to secure the financial future of their loved ones.

Getting An Upgrade

Even though most new families will not be able to afford a permanent life insurance policy, the good news is that if you do take out a term policy, you will usually have the option to upgrade it to a permanent policy at the end of your term. By this point, your income has likely increased and your overall expenses have decreased, thereby making a policy upgrade a much more affordable option.

If you want to learn more about the different types of cash value policies and the advantages and disadvantages of each, please see this article.

Or, if you would like to know more about the main differences between term and permanent life insurance, please see this article.

Note: Because permanent policies are more expensive to take out, some insurance advisers do not recommend getting a permanent policy. Instead, they argue that you can receive greater benefit by investing the money which you would have spent on a permanent policy.

So, What Is Life Insurance?

Life insurance is taken out by people who want to provide family members with money after they die. The people who receive this money are called beneficiaries, and the payout they receive is called a death benefit. There are different types of policies that a person can be insured for, and different death benefits their beneficiaries can receive.

The two main types of life insurance are term life, which only pays out if you die within the term that you are insured for, and permanent life, which pay out regardless of when you die and also offer a savings account option called a cash value reserve.

Premiums

The older you are and the worse your state of health is, the more expensive it will be to insure yourself. Policies are paid for via premiums.

Term policies tend to have the lowest premium rates at the start of the policy, but the highest rates as the policy ages. Permanent policies have the highest rates at the start of the policy, but the long term cost of maintaining a permanent policy throughout the course of your life is lower. In addition, some permanent policies, such as whole life, will offer you level premiums throughout the life of your policy.

Stage Of Life

Most people start with term life insurance when they are young, as this can be built up slowly over time whilst still leaving money that can be used to support their family while the insurance holder is alive. Once this term expires, and if a person’s income has improved, some people choose to convert their term policy to a permanent policy to guarantee that their spouse or children receive a death benefit.