How Does Life Insurance Work?

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Life insurance is a tricky topic. Not a whole lot of people love to talk about it, especially when they consider that using it means they're no longer here on this earth. But if we flip the topic from fear of death to love for our family, it becomes something else entirely.

You see, life insurance isn't about us; it's about providing for those we love and leave behind. If we keep that in mind while we talk about it, we'll have a whole different experience while we learn about it and when we buy it.

I have a great letter which I think sums up what having a life insurance policy does for us:

I AM YOUR LIFE INSURANCE POLICY!

You and I have similar purposes in this world.

It is your job to provide food, clothing, shelter, schooling, medicine, and other things for your loved ones. You do this while I lie in your strong box. I have faith and trust in you. Out of your earnings will come the cost of my upkeep. At times, I may appear to be worthless to you - but some day (and who knows WHEN), you and I will change places. When you are laid to rest, I will come alive and do your job. I will provide the food, clothing, shelter, schooling, medicine, and other things your family will continue to need - just as you are doing now. When your work and toil are done, mine will begin. Through me, your hands will carry on. Whenever you feel the price you are paying for my upkeep is burdensome, remember that I will do more for you and your family than you ever can do for me. If you do your part, I will do mine.

Sincerely, YOUR LIFE INSURANCE POLICY...

Does that change your perspective on the need for life insurance? I know it did for me.

So now that we know why having life insurance is important, how do we know we're buying the right amount and the right type of it to match our needs and the needs of our family? Well, that's where it can get complicated because each individual or family has different needs. While each case is different, I'll try to keep it simple and clear as I go over the basics.

What Kinds of Life Insurance are there?

Despite all the advertisements you might see or the articles written about the different kinds of life insurance on the market today, there are really only two types: Cash Value and Term. If you can wrap your head around how each of these two types work, then when you come across all the variations of the two that are out there, you'll be able to decipher what you're reading and how they work.

Cash Value: Bundled Insurance and Savings

With a Cash Value life insurance policy (a.k.a. Whole Life, Variable Life, Universal Life, etc.) you have a savings account (or investment account in some cases) and life insurance coverage bundled together into one product. When you pay your insurance premium, part of it goes towards the cost of the insurance and part goes into a savings account (the insurance company has control over the savings).

For the first 3-5 years (on average) there's no savings built up in the policy due to sales commissions and other fees to put the policy into place.
If you need to access the money in the policy, you need to borrow (with interest) against the savings.
If you die while insured, the insurance company keeps the savings and just pays the death benefit.
If you borrowed against the policy, the insurance company will deduct the amount of the loan from the money they pay your beneficiary.
The Bottom Line: You're paying for two things but only getting one of them.

Of all the life insurance policies sold, 8 out of 10 families have this kind of policy because insurance agents get paid a higher commission to sell them than for a Term policy. Also, they're almost always more expensive than a Term policy when it comes down to the price per unit of coverage.

Term Life: Insurance Separate from Savings

Term insurance is like your car insurance or your home owner's insurance; it's just plain insurance without any savings attached to it.

You're insured for a specific period of time.
When the term expires, your insurance expires (unless you renew)
The premiums per unit of coverage are almost always lower than for a Cash Value policy
Most economists recommend this type of insurance

Buy Term and Invest the Difference

Want a cost-effective way to buy insurance while growing your money? Take the difference between what you'd pay for a Cash Value policy and a Term Insurance Policy and invest it into a long-term, high-yield investment.

If you ever need the cash, you can get it from the investment without it affecting your insurance coverage.
If you
pass away, your family will get both the death benefit from the insurance policy as well as the cash in the investments.
The Bottom Line: You're paying for two things and you're getting two things.

Do I Need Life Insurance for my Whole Life?

A lot of people wonder if they need to keep paying for life insurance for their whole life. Well, the short answer is, not if they play their cards right. You see, the reason to get any kind of insurance is to offset risk. You get car insurance in case you get into an accident and don't have the money to buy a new car or cover the associated medical bills. You get home owner's insurance to pay for damage to your house caused by fires, floods, and other catastrophes which cost a whole lot more money than most people have on hand. Well, the same goes for your life insurance.

The Theory of Decreasing Responsibility is a way to explain when you need life insurance and when you don't. It says that financial responsibilities are temporary and insurance should be purchased to offset those responsibilities. When a person is younger, responsibilities include paying consumer debts, mortgages, funding children’s education and income replacement. With a proper plan, each of these responsibilities is temporary.

A person can pay off their debt and mortgage, owning their home outright. Children do grow up and leave home becoming independent of their parents’ support. Later in life a person should become financially independent having accumulated enough wealth to retire and no longer need to work. At this point they can discontinue the life insurance program, having more than enough money on hand to cover funeral and burial expenses.

How do I Know How Much Insurance I Need?

There's a simple formula you can use to figure out how much insurance you need to properly cover your family's needs should you pass away. It's called the D.I.M.E. Method and here's how it works.

To figure out the amount of Insurance needed there are four areas you need to cover:

D = Death, amount needed for final expenses and burial
I = Income, replacement of annual income (7-10 times this is recommended)
M = Mortgage, how much owed on your home
E = Education, the kids should still be able to go to college

Just add up these four amounts and that's the ideal amount of coverage you need. For example, say the cost for final expenses and burial are $25,000 (and the cost keeps going up each year by the way), you make $75,000, your mortgage is $150,000, and the cost to send your kids to college is around $50,000. Add these up and, if you were to die today, your family would need a minimum of around $900,000 to cover these items.

Another way to look at it is to just cover 7-10 times your annual income. If you were to pass away and your spouse were to invest the insurance money ($750,000) at an average rate of 7-10%, they could live off the investment returns indefinitely. It would be as if you were still alive and earning your normal salary. (In the above example you would need $750,000 in life insurance coverage – annual salary of $75,000 x 10.)

How Much Should I Spend on Life Insurance?

Ever hear of being “insurance poor”? That's when you're spending so much money on your different kinds of insurance that your lifestyle is suffering. When shopping for a Cash Value policy, you'll find that it's expensive and even a good Term policy for adequate coverage can put a dent in your finances. Unless you're wealthy, you may not be able to afford the 7-10 times your annual income which economists recommend. That's why an important factor in choosing a policy will be discovering how close you can get to your needed amount while still living within your monthly budget. Figure out how much money you need to cover your housing, transportation, debt payments, and savings. (You should always be saving and investing money each month). Then deduct what you normally spend on your daily living expenses. That should give you a fair estimate on what you can afford to spend on your life insurance premiums.

Get several quotes to compare.

I would recommend getting at least three quotes on each type of coverage and only from companies that carry an A+ rating with AM’s Best. You can check their ratings on the company's website. Although  Term life is very straight forward, you do need to ask what options are available at the end of the term. Most terms can be converted to Cash Value, but if you're following the Buy Term and Invest the Difference plan, you shouldn't need to. By the time the insurance policy matures in 20-30 years (i.e. the initial term is over), you should be financially set and not need to be paying for insurance at that time of your life. Chances are that if you do still need insurance, you may not need as much.

You also need to make sure you are getting a fixed-level term (meaning your payments will not go up for the duration of the term) for a long duration (20-30 years) and that it can be renewed no matter what your health is like.

The Reasons to Buy a Cash Value Policy

As far as getting a Whole Life or Cash Value policy, there are only two financially important reasons to get one:

First, you have health issues. One of the most important things an insurance company is going to consider when deciding whether or not to issue you a policy is your health. They'll ask a number of health questions to determine if they'll issue you a policy at a standard rate (i.e. you have average health), a preferred rate (i.e. your health is above average), rate you (i.e. you have below average health), or decline you (your health is so bad they don't want to touch you).

If you're declined due to bad health, that's what's called “uninsurable”. Some insurance companies will offer Guaranteed Issue Whole Life policies for a small amount of coverage (usually $25,000 or less) to people in this category It will be very expensive but if no one else will insure you, something is sometimes better than nothing.

Second, you have a lot of money and need a tax shelter for estate planning. When you have a lot of money (usually in the millions of dollars range), you're looking for some place where it won't be taxed as part of your estate when you pass away. You can purchase multiple Cash Value policies for large amounts (even in the million dollar range). They may be expensive but one good thing about life insurance is that you can name a family member or friend as the beneficiary of the policy and the proceeds will bypass probate court. They'll receive the money tax free!

What Happens When I Pass Away?

This can be very simple. Ideally, your family just notifies the insurance company of your passing, they submit a death certificate to the company, and the company quickly pays out the death benefit of the policy according to the payment terms you selected. That's how it works in a perfect world.

In the real world, it can sometimes be challenging. First, your family needs to find the policy (or policies) you own. These could be in a safe deposit box at your bank that they need to get access to, or be tucked away at home among your other paperwork.

Before they submit a claim to the insurance company, they'll need to obtain your death certificate. This can be as simple as heading down to the local health department, filling out some forms, and paying a fee but sometimes there are other hoops they'll need to jump through. It depends on your local government regulations. Just understand that the insurance company won't pay out on a policy without one.

The next possible complication is how long it takes for the insurance company to get the money to them. Some insurance companies are great and issue the money within a few days while others can take weeks to process the paperwork. With the funeral home and cemetery wanting their money A.S.A.P., the timing can make a huge impact on the stress level your family will be going through at this very emotional time.

The Bottom Line

Having a good life insurance policy should provide peace of mind at an affordable price and educating yourself on how life insurance works is the first step towards making that happen. Remember, you're making sure that your family is protected at one of the worst times of their lives. They should only need to deal with the emotional loss of your passing, not a financial one as well.