How does the life insurance work?

  

Life insurance is a very common asset that figures into many people's long-term financial planning. Purchasing a life insurance policy is a way to protect your loved ones, providing them with the financial support they may need after you die. For example, you may purchase life insurance to help your spouse cover mortgage payments or everyday bills or fund your children's college education.

When purchasing life insurance, it's important to understand how it works and how your beneficiaries can receive the proceeds of your policy. This can help with choosing a payout option that works best for your estate planning goals.

KEY TAKEAWAYS

Life insurance is a contract between a policyholder and an insurance company that's designed to pay out a death benefit when the insured person passes away. 

There are many kinds of life insurance from term to permanent.
A life insurance company should be contacted as soon as possible following the death of the insured to begin the claims and payout process.
It's important to always name life insurance beneficiaries, whether they are individuals or organizations.
There are different ways a beneficiary may receive a life insurance payout, including lump-sum payments, installment payments, annuities, and retained asset accounts.

Life Insurance Basics
 

Life insurance is a type of insurance contract. When you purchase a life insurance policy, you agree to pay premiums to keep your coverage intact. If you pass away, the life insurance company can pay out a death benefit to the person or persons you named as beneficiaries of the policy.

Some life insurance policies can offer both death and living benefits. A living benefit rider allows you to tap into your policy's death benefit while you're still alive. This type of rider can be beneficial in situations where you're terminally ill and need funds to pay for medical care.

"Some life insurance companies have designed policies that allow their policyholders to draw against the face value of the policy in the event of a terminal, chronic or critical illness," said Ted Bernstein, owner of Life Cycle Financial Planners LLC. "These policies enable the policyholder to be the beneficiary of their own life insurance policy."

When purchasing life insurance, it's important to consider:

How much coverage do you need
Whether a term life or permanent life policy makes more sense
What you'll pay for premiums
Which riders, if any, you'd like to include
The differences between life insurance quotes for each potential policy
In terms of coverage amounts, a life insurance calculator can be helpful in choosing a death benefit. Term life insurance covers you for a set term while a permanent life insurance policy covers you for life as long as premiums are paid. Between the two, term life tends to be cheaper, but permanent life insurance can offer benefits such as cash value accumulation.

Life insurance premium costs can depend on the type of policy, the amount of the death benefit, the riders you include, and your overall health. It's not uncommon to have to complete a paramedical exam as part of the underwriting process.


What Does Life Insurance Cover?

Depending on the life insurance you purchase, the death benefit can cover many expenses. After a partner or spouse, or parent dies, so does their annual income, so a life insurance policy can help fill in the gaps to pay financial obligations such as rent or mortgage costs, funeral and burial expenses, school tuition, personal debt such as student loans or credit cards, and even, supplement the lost income, to help pay for day-to-day expenses.

Of course, many individuals who purchase life insurance safeguard their beneficiaries against financial hardship.

It is possible to purchase an insurance policy to leave an inheritance to your grown children or grandchildren, an extended family member, or a nonprofit. Some policies, like whole or universal life insurance, allow you to access your life insurance funds while you are alive. You may be able to borrow against your policy as long as you continue to pay premiums to pay for a home or college for your children. While you run the risk of lowering the death benefit, if you cannot afford to pay back the loan, these life insurance policies can be helpful.

The policy itself usually covers natural and accidental causes of death and homicide. In some cases, it covers suicide, although it is wise to research the policy you want to purchase. There may be conditions attached that must be met before beneficiaries receive their death benefits in some instances.

Term Life Insurance vs. Permanent Life Insurance

Term life insurance provides coverage for a set amount of time, often in 15- 20- or 30-year policies, although timelines may vary, depending on the insurer. Term life's death benefit is not paid out after the term of the life insurance policy ends, even if all premiums on it have been made. However, premiums on term life policies are usually affordable compared to permanent life insurance.

Term life can be useful if you want coverage during prime working years or while your child or children are young to provide some financial protection to your partner, spouse, or children. Term life insurance does not contain a cash value, and you cannot borrow money against your death benefit. Some term life insurance policies can be converted into whole or universal life policies or extended, but the premiums will be much higher than the original cost.

There are two types of permanent life insurance, whole and universal. All permanent life insurance combines a death benefit with a cash value account. Permanent life insurance allows the insured to borrow against your life insurance policy. If you don't pay it back, your beneficiaries will receive a smaller payout. Some policies pay dividends on earnings, which can be used to pay much higher premiums than term life insurance.

Both whole and universal life insurance cover you until you die unless you stop paying the premiums, but your death benefit shrinks as you borrow from it.

How Much Does Life Insurance Cost?

The cost of life insurance depends on a few factors, among them, the type of insurance you purchase, the insurance company selling the policy, and your overall individual health, wellness, and family history, in some cases. For example, if you go with a 20-year term life policy, and you are a healthy adult, you could pay as little as $30 dollars a month for a half-million-dollar death benefit. Term life is less expensive than whole or universal life insurance, and all insurance gets more expensive as you grow older.

Whole or universal life insurance is considerably more expensive and could cost upwards of $125 to over $200 a month, depending on your age, health profile, and the amount of death benefit.

Choosing a Life Insurance Beneficiary

As part of the process when buying life insurance, you'll need to designate one or more beneficiaries. This is who you want to receive the death benefit from your policy when you pass away. A life insurance beneficiary can be:

A spouse
Parent
Sibling
Adult child
Business partner
Charitable organization
A trust

You can choose to name a single beneficiary or a primary beneficiary and one or more contingent beneficiaries. A contingent beneficiary would receive death benefits from your life insurance policy if the primary beneficiary passes away.

Filing a Claim

Death benefits are not paid out automatically from a life insurance policy. The beneficiary must first file a claim with the life insurance company. Depending on the insurance company's policies, this may be done online or it may require a paper claims filing. No matter how you end up filing, the company normally requires paperwork and supporting evidence to process the claim and payout.

Your beneficiaries may be required to provide a copy of the policy, along with the claims form. They must also submit a certified copy of the death certificate, either through the county or municipality or through the hospital or nursing home in which the insured died.

Policies owned by revocable or irrevocable trusts must ensure that the insurance company has a copy of the trust document identifying the owner and the beneficiary, added Bernstein.

When Benefits Are Paid

Life insurance benefits are typically paid when the insured party dies. Beneficiaries file a death claim with the insurance company by submitting a certified copy of the death certificate. Many states allow insurers 30 days to review the claim, after which they can pay it out, deny it, or ask for additional information. If a company denies your claim, it generally provides a reason why.

Most insurance companies pay within 30 to 60 days of the date of the claim, according to Chris Huntley, founder of Huntley Wealth & Insurance Services.

“There is no set time frame," he adds. "But insurance companies are motivated to pay as soon as possible after receiving bona fide proof of death, to avoid steep interest charges for delaying payment of claims."

Payout Delays

There are several possible situations that may result in a delay in payment. Beneficiaries may face delays of six to 12 months if the insured dies within the first two years of the issuance of the policy. The reason: the one- to two-year contestability clause.

"Most policies contain this clause, which allows the carrier to investigate the original application to ensure fraud was not committed. As long as the insurance company cannot prove the insured lied on the application, the benefit will normally be paid," said Huntley. Most policies also contain a suicide clause that allows the company to deny benefits if the insured dies by suicide during the first two years of the policy.

Payments may also be delayed when homicide is listed on the insured's death certificate. In this case, a claims representative may communicate with the detective assigned to the case to rule out the beneficiary as a suspect. The payout is held until any suspicion about the beneficiary's involvement in the insured's death is clear. If there are charges, the insurance company can withhold the payout until charges are dropped or the beneficiary is acquitted of the crime.

Delays to payouts may also arise if:

The insured party died during the course of illegal activity, such as driving under the influence.
The insured party lied on the policy application.
The insured omitted health issues or risky hobbies or activities like skydiving.

Payout Options

You can also help decide how your death benefit will be paid out after you die. Here are a few of the payout choices available to you and your beneficiaries.

Lump-Sum Payments

Since the inception of the industry more than 200 years ago, beneficiaries have traditionally received lump-sum payments of the proceeds. The default payout option of most policies remains a lump sum, said Richard Reich, president of Intramark Insurance Services, Inc.

Installments and Annuities

Modern life insurance policies have seen a monumental improvement in how payouts can be delivered to the policy's beneficiaries, said Bernstein. These include an installment-payout option, or an annuity option, in which the proceeds and accumulated interest are paid out regularly over the life of the beneficiary. These choices give the policy owner the opportunity to select a pre-determined, guaranteed income stream of between five and 40 years.

"For income-protection life insurance, most life insurance buyers prefer the installment option to guarantee the proceeds will last for the necessary number of years," added Bernstein.

Beneficiaries should remember that any interest income they receive is subject to taxation. You may end up better off with the lump sum rather than installments, as you'll end up paying more in taxes on the interest if the death benefit is fairly high.

Retained Asset Account
Some insurers offer beneficiaries of significant policies a checkbook instead of a lump sum or regular installments. The insurance company, acting as a bank or financial institution, keeps the payout in an account, allowing you to write checks against the balance. Such an account would not allow deposits but pay interest to the beneficiary.

The term for this is accelerated death benefit. (For related insight, take a closer look at accelerated benefit riders.) Traditionally, life insurance policies will only payout at the policyholder’s death. Talk with your insurance agent about whether this option makes sense for you.

How Does Term Life Insurance Work?

Term life insurance is often the most accessible type of insurance to purchase. Depending on the type of policy, you may or may not need a medical exam, and the policy will last for an agreed-upon number of years, often 20- or 30-year terms. You pay monthly premiums on your death benefit, and if you die before the term is up, the insurance company pays your beneficiaries. If you reach your term limit, your policy ends.

How Does Whole Life Insurance Work?

Unlike term, whole life insurance is a permanent form of insurance, allowing fixed death benefit coverage over the policyholder's life. The life insurance premiums for whole life insurance are higher than what you pay for a term life policy. Whole life contains a cash-value account, which can accumulate as interest accrues on a fixed rate and a tax-deferred basis.

You can borrow against your whole life policy, but the benefit acts as the collateral, so your benefit shrinks if you don't pay it back. If you don't pay the premiums or the loan back, your policy will be canceled. Any money you borrowed may be considered income and subject to taxation.

How Does Universal Life Insurance Work?

Universal life insurance, like whole life, is another form of permanent life insurance. These policies offer a death benefit and a cash value account. Universal life insurance stays with you until the end if you pay your monthly premiums. There are three kinds of universal life insurance⁠—variable, guaranteed, and indexed⁠—but with all three, you have the flexibility (unlike other policies) to change your death benefit or lower your premiums. Your cash value account's earnings can help pay the premiums on your account.

Can You Get Life Insurance With a Pre-Exisiting Condition?

If you have pre-existing conditions, you may find it difficult, but not impossible, to purchase life insurance. Coverage will depend on various factors, primarily your individual health situation. Depending on the life insurance company, some pre-existing conditions like diabetes, high blood pressure, and anxiety may be covered but with higher premiums.

How Long do You Have to Pay Into a Life Insurance Policy Before It Pays Out?

Life insurance will pay out upon the death of the insured as soon as it is in force. This usually counts as the first premium payment. Some life applications, however, come with the option of binding a certain amount of coverage while the underwriting process takes place in case the applicant dies before the policy is issued (known as a binder). The binder usually requires payment up-front when the application is taken and will either be returned or credited toward the first premium once approved.

The Bottom Line

Life insurance policies provide both policyholders and their loved ones peace of mind that financial difficulties may be avoided in the event of a person’s death. Understanding how the process works, from buying life insurance to filing a claim to receiving a payout, can help you proceed with your plans to purchase coverage confidently.