The Truth On How a Life Insurance Policy Works

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You have probably heard about life insurance, but do you know how it works? What are the different types and what does it cover?

Well, most people’s understanding of life insurance is that; it is a cover that takes care of your family just in case you die, but there is more about it than that.

For instance, there is the issue of the scope – what it covers – who is entitled to the payouts and how they are priced. In this post, we are going to explain what life insurance entails and how it works.



But first off;

What is life insurance

A Life insurance policy is a contractual agreement between a policyholder or a legal entity, where, a certain amount of money is to be paid to your next of kin or nominee if you pass on before the policy duration ends.

All you are required to do is to purchase the policy which you can pay in installments (monthly) or as a lump sum. The money will also be paid out if you contract a terminal illness and you have less than 12 months to live.

The main purpose of a life insurance policy is basically to offer financial support to your family or beloveds after you pass on. This monetary benefit can help your family settle debts, pay for their day to expenses, cater to your kids’ school fees, and generally help them maintain a certain standard of living.


Types of life insurance policy

There are two main types of Life insurance i.e., permanent and term life insurance.

A permanent life insurance policy as the name implies is a type of life policy that offers you protection for the rest of your life. The key difference between permanent and term life insurance policy is the cash value.

Permanent life insurance has a cash value feature making the policy last for as long as the policyholder is alive and the premiums are paid. You are entitled to the financial benefits gained from the policy by the insurer.

A certain percentage of your premiums are invested and the cash value increases tax-free over a certain period of time. The total death benefits are payable right from the day your policy is effected but the cash value takes a couple of years for it to grow to a substantial amount.

Permanent life insurance is further categorized into Universal and Whole life insurance. Universal life insurance is usually relatively cheaper but the cash value, death benefits, and premiums growth rate are unpredictable making it a bit complex.

Whole life insurance, on the other hand, is way simpler as the premium, remains constant for as long as the agreement is valid, the cash value continues to increase at a stipulated rate, and the death payouts are assured.

As for the term life insurance policy, the coverage has a specific time period ranging from 10 to 30 years. It is also referred to as pure life insurance coverage mainly because it offers no cash value as is the case with permanent life insurance.


How term life policy works

As stated earlier, a term life policy is set for a specific period of time that is normally selected when the policyholder purchases the policy. The common policy periods are 10, 20, and 30-year terms.

If you pass on during the policy coverage period, the insurer will pay out the benefits to your beneficiaries as stated in the policy. No payment is made when you are a life.

One of the things that makes term life more appealing in relation to Permanent life policy is the fact that the payouts are more and the investment is relatively low. It also offers a temporary and an alternative option to the expensive permanent life cover.


How permanent life covers works

Permanent life cover is valid for life provided you faithfully pay your premiums. The most popular permanent cover is whole life followed by universal and lastly variable life cover.

The beauty of permanent life policy is that they grow in cash value as time as time goes. A proportion of the premiums is set aside for the cash account, which is then invested so as to earn interest.

It is advisable to purchase permanent life insurance when you are young and inexpensive to insure as the policy tends to grow faster during its early stages. Whole life policy, unlike universal cover whose growth fluctuates depending on the market forces, has a constant growth rate.

Note that it takes a number of years to grow a significant cash value so it is more of a long-term investment.

Another thing with permanent life insurance is that you can access the cash value while you are still alive. You can choose to withdraw some amount or use the interest or even borrow to pay for the premiums later in life.

You can also choose to trade the policy for its current market value at a cost.


Whole life insurance

Whole life insurance cover with its constant premiums, possible cash value, and guaranteed payout may appear pretty attractive, but as you’ve guessed it – it comes at a price.

The premiums for a whole life cover is way expensive compared to term life insurance cover. For instance, a $500,000 whole life cover for a 30-year-old woman goes for approximately $3750 per year.

The same cover for a term life policy with a term length of 30 years will cost you around $300 per year.


Universal life policy

Universal life policy has both life time cover and flexibility. It enables you to make either large or small payments based on your capabilities or the investment performance.

If things are looking good, you may opt to stop payments, however, if the performance is poor, you may have to pay a little extra to cater for the shortfall.

So, it generally depends on the insurer’s investment performance. Any wrong moves by the insurer will cost you more than what you had planned for.


How are life insurances priced

One of the main things that are considered when calculating your life insurance premium is your health. Young and Healthy individuals have a lower probability of dying soon and therefore, life insurance companies usually charge them a lower rate.

Individuals without chronic medical issues live longer, non-smokers, women, people who keep fit, and so on are highly likely to live longer. The people who fall under this category usually receive preferential pricing.

Most life insurance companies have medical examinations as part of the registration process. Your cholesterol level, weight, blood pressure, and blood sugars are some of the factors that are examined in an effort to establish your general health.

There are some companies that don’t require a medical examination, however, their premiums are relatively higher. They may also offer limited coverage than what you expect, with some companies offering a maximum of $50,000 for a no medical exam policy.