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Life insurance basics

Read the Spanish version: Conceptos básicos sobre seguro de vida

Many of us buy life insurance because we want to make sure that our loved ones remain financially secure after we die. Income replacement is the No. 1 reason people buy life insurance.

life insurance basicsNon-earning caregivers also have an important — and often overlooked — economic value that should be covered by life insurance.

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Life insurance is also purchased by those interested in achieving specific business or estate-transfer goals.

There are many types of life insurance policies depending on your goals, and there are huge price differences among different companies offering identical coverage.

Here's an orderly way to go about shopping for life insurance:

Life insurance is a long-term proposition, so you should pay particular attention at time of purchase and throughout the life of the policy to the financial stability ratings of your life insurance company. Ratings indicate a company's ability to pay claims.

Assess your life insurance needs

The first step in life insurance planning is to analyze your life insurance needs — meaning the economic needs of dependents left behind:

  • Before purchasing a life insurance policy, consider your financial situation and the standard of living you want to maintain for your dependents or survivors. You might want to ask yourself who will be responsible for any outstanding medical bills and funeral costs. What would happen if your family had to relocate or otherwise change their standard of living once you've died? The assumption of immediate death is necessary to determine the current life insurance needs for a family or individual.
  • Add in the longer term financial needs of the remaining family members, such as: children's expenses, income for the surviving spouse, mortgage and other debt payoffs, college education funds and an additional emergency fund.

Because life insurance needs change over time, your life insurance amount should be reevaluated periodically. Insurance experts recommend revisiting the coverage of your policy once every five years or whenever you experience a major life event such as a change in income or assets, marriage, divorce, the birth or adoption of a child, or a major purchase such as a house or business.

In theory, you should have a declining need for life insurance as you age because fewer people remain dependent upon you for income support. Exceptions would be protecting a business entity or paying taxes on a large estate for heirs. If the purpose of buying life insurance is to pay estate taxes, then you’ll need permanent life insurance, which is in-force as long as you live and pay the premiums.

Policy choices

Life insurance policies are divided into two main types:

  • Term life insurance, which provides only a death benefit without any “cash value” (offering the least expensive cost per $1,000 of death coverage purchased).
  • Permanent life insurance, which has a “cash value” account in which a return-on-investment component becomes an often complex and expensive part of the policy (most expensive cost per $1,000 of coverage).

Term life insurance

Term life insurance is the easiest life insurance to understand: It provides death benefit protection without any savings, investment or “cash value” components.

Term life insurance is available for set periods of time such as 10, 15, 20 or 30 years. With "annual renewable term life," your policy automatically renews and premiums increase each year. Choose "level term insurance" if you want your premium to stay the same for the duration of the policy. Also available is "decreasing term insurance," where premiums remain level but your death benefit declines over time. This is useful if you want to cover only a specific debt that decreases, such as a mortgage or business loan.

As long as you pay your premiums, the company cannot cancel you.

Term life insurance is a popular choice because of the long rate-guarantee periods. However, if you get to the end of your policy term and still need life insurance, you'll need to shop for a new policy, which will then be priced based on your age and health status.

Choosing an initial rate-guarantee period is easy: Match the period of time your dependents need your income to the available rate-guarantee periods. For example, if your children are young and you have decades to go on your mortgage, look at 30-year term life. If your children are leaving the nest and your home is paid off or nearly paid off, 10-year term might fit the bill.

Other policy provisions that drive the popularity of term life insurance are guaranteed renewal and guaranteed convertibility.

  • Guaranteed Renewal. Before you buy a term life policy, ask the agent or company to confirm that the policy contains a guaranteed renewable option, which grants you the right to continue coverage beyond the initial rate-guarantee period without a life insurance medical exam. This feature, found in most term life policies sold today, is extremely important should you become sick and uninsurable toward the end of your rate-guarantee period.

    For example, say that you’ve been paying $800 per year on a $500,000, 20-year level term life policy and develop cancer near the end of the 20-year period, thus making you uninsurable. Assuming that you want to continue the coverage, a guaranteed renewable clause would allow you to continue the coverage beyond 20 years on an annual renewable basis without an exam, albeit at a much higher annual premium of, say, $8,000 in year 21, $11,000 in year 22, and so on.

  • Guaranteed Convertible. Another built-in feature of most term life policies is the right to convert your coverage to any permanent cash value policy that the company offers at current rates without having to take another medical exam. This feature may be useful in the future if you decide you want cash value life insurance.

If you'd like term insurance to cover you for a certain period of time but you're confident you'll outlive the policy, consider a "return of premium" (ROP) term life insurance policy. Under this type of policy, if no death benefit has been paid by the end of your insurance term, all your premiums are refunded (tax-free). Return of premium term life insurance generally costs 50 to 150 percent more than a comparable term policy but it provides a way to hedge your bets no matter what happens.

Cash value life insurance

If you want more than a death benefit from your life insurance policy and like the idea of a long-term savings account (not insured by any federal agency) or investment, you might consider cash value life insurance such as whole life insurance, universal life or variable life. But be prepared to pay much higher premiums per $1,000 of coverage because you are now funding a cash value account and paying fees and expenses.

In many cash value policies, the annual premium does not increase from year to year. Universal life policies allow you to fluctuate or even skip premium payments, which in turn adjusts your death benefit amounts.

Unlike term life insurance, which is easily compared online, cash value insurance is often marketed by agents and brokers in a face-to-face setting, where needs and strategies can be discussed.

Because of the complexity and dizzying array of possible outcomes for permanent life insurance, regulators insist that cash value insurance be sold using pre-approved illustration formats. These illustrations can run to 15 or more pages.

Pay particular attention to the guaranteed death benefit and premium-payment sections because these columns contain the actual company promises. If you don’t like what you see there, walk away.

Another caveat: Many cash value policies contain harsh penalties for surrendering the policies in the early years. Changing your mind within the first few years is an expensive decision.

For more on cash value and an example of a policy illustration, read about cash value in life insurance: What's it worth to you?.

Whole life insurance

Ordinary whole life insurance offers “permanent protection” with a cash value account that grows over time. Whole life provides a level death benefit and level premiums throughout your life and for as long as you continue to pay the premiums. For example, a healthy 40-year-old female might pay $4,200 per year for a $500,000 whole life policy. The premium remains level at $4,200 per year for the rest of her life and, in the event of death at any age, the policy will pay $500,000 to her beneficiary.

Whole life also contains a cash value account that builds over time, slowly at first and gaining steam after several years. You can withdraw your cash value or take out a loan against it, but remember, if you die before you pay back the loan, the death benefit paid to your beneficiaries will be reduced.

Understand what your beneficiaries will receive upon your death. If you have a traditional whole life policy, your beneficiaries receive only the death benefit no matter how much cash value you've built up. Other payout options available for higher premiums are:

  • Death benefit plus cash value
  • Death benefit plus return of premium

Whole life policies can be issued as "participating" or "nonparticipating." Participating policies typically cost more but may return annual dividends if the insurer has a good financial year. Dividends are never guaranteed. Nonparticipating whole life insurance offers no dividends.

Buyers of whole life insurance like the certainty of fixed premiums with a known death benefit for life. They also appreciate the "forced savings" component and watching their cash value account build up.

Universal life insurance

This kind of policy offers greater flexibility than whole or term life. Universal life has many moving parts to understand before you buy.

After your initial premium payment, you can reduce or increase the amount of your death benefit. Also, after your initial payment, you can pay premiums any time and in any amount, as long as you don’t miss a minimum payment level. In some cases, there are limits to how much extra you can pay in advance. If you choose to increase your death benefit, you may have to provide medical proof that your health has not deteriorated.

Some universal life policies perform like term life insurance: They can be configured at the time of purchase to provide both level death benefits and level premiums that are guaranteed for life as long as you pay the scheduled premium.

Variable life insurance

Variable life offers a death benefit with a side fund that operates like an investment account.

The insurance company invests your premiums and offers you a choice of funds in which your money will be invested. Returns are not guaranteed. The amount of money your beneficiaries will receive and the cash value of your policy depend on how well the underlying accounts perform. Theoretically, the cash value can go down to zero and, if so, the policy will terminate. Some variable life policies will guarantee a minimum death benefit.

Other permanent life insurance considerations

When your cash value account grows large enough, it can be used by the insurer to pay your premiums for the rest of your life. This is known as being "paid up." You can still withdraw your cash value, but you'll have to resume premium payments to keep the policy in force or settle for a reduced benefit that the remaining cash value can support. Your policy illustration will show you how long it may take for your whole life policy to be "paid up."

If you no longer want your whole life policy, you can surrender it to receive the current cash surrender value or convert it into an annuity, but keep in mind that cashing in a permanent policy after only a couple of years is an expensive way to get insurance coverage for a short time.

For more on permanent life insurance, see the basics of whole life insurance.

Riders add benefits

You can add riders to your life insurance policy that guard against a number of unpleasant situations. Your insurer will have its own list of available riders, but here are a few:

  • Accelerated death benefit rider (aka living benefits rider): Pays the benefit early if you become terminally ill.
  • Accidental death benefit rider: Pays an extra benefit if you die as the result of an accident.
  • Long-term care rider: Pays for long term care expenses should you not be able to do some of the "activities of daily living," such as dressing or toileting.
  • Waiver of premium rider: Waives premium payments should you become totally disabled.

How life insurance is priced

Life insurance rates are based on your life expectancy, the face amount you request and the length of the policy, whether it's the duration of your life (permanent life) or a specific period (term life).

Because your current and past health conditions impact your life expectancy, insurers want to know as much as possible about your health condition. Common conditions such as high blood pressure, heart disease, obesity, cancer and depression can all raise your premiums or even result in your being declined.

Based on your medical history, you'll be grouped into a category such as "preferred plus," "preferred," "standard" and "substandard." Your category ultimately determines your premiums. For more, read how life insurance companies view you: underwriting categories.

Insurance buyers with severe health conditions or a combination of conditions can find it hard or impossible to find life insurance. They are known as "impaired risks." Local agents may not be experienced enough to find a company that specializes in insuring people with certain medical conditions. Fortunately, impaired-risk specialists have expertise in knowing where to direct applications for folks with medical conditions. For more, read how impaired-risk specialists find life insurance for people with medical problems.

The life insurance buying process

The life insurance applications process is paper-intensive, can take 30 to 60 days and often seems intrusive for people who value their privacy. A face-to-face paramedical examination is generally required for policies in excess of $100,000, which means, at minimum, giving both blood and urine samples to a paramedical professional.

Tip: Send in payment with your application

When you send in your life insurance application, attach a check for your premium. This locks in coverage for you prior to the policy being issued.

Expect questions in detail regarding your lifestyle, intended foreign travel destinations, your family health history and your personal health history.

Sometimes multiple interviews are required in order to verify your information. The paramed examiner typically asks these questions face-to-face and often insurance companies will conduct follow-up telephone interviews so that you can verify the first set of answers. Regardless of the type of life insurance you buy, most policies require you to meet certain guidelines regarding your lifestyle and medical history.

If it sounds tempting to shortcut this process by withholding information or outright lying, don’t do it. Policies that were sold based on applications that contained misleading information can be voided at claim time. False information on insurance applications is fraud.

Insurers will likely report your medical exam results (reported as numbered codes) to MIB (formerly called the Medical Information Bureau), which maintains a database of those who have applied for life, health, disability and other insurance in the last seven years. If you've given different answers to medical questions in the past, it will raise a red flag with MIB. The goal of the MIB database is to reduce fraud.

All standard life insurance policies cover death by any cause at any time in any place, except for death by suicide within the first two policy years (one year in some states).

Additional Resources

Should you buy a term or permanent policy? Are you better off buying term and investing the rest? Here's the Consumer Federation of America's "Rate of Return" Service

Your state's department of insurance may also have life insurance buying guides online, such as California's Life Insurance Information Guide.

If you want to avoid the underwriting process, you have two other, more expensive, options:

  • Simplified issue term life insurance can be purchased after answering only a few medical questions. There is no medical exam required. However, if you report health problems, you will likely be declined. Also, if you are healthy, or even if you have some negative medical history, an underwritten policy is still going to be your least expensive choice.
  • Guaranteed issue life insurance, such as final expense insurance, is sold to anyone who applies (up to an age limit) and is by far the most expensive way to purchase life insurance. This should be considered only by those who are declined for everything else but still need life insurance. These policies have graded death benefits, meaning your beneficiaries won't receive the full death benefit until several years into the policy.

In naming a beneficiary, keep in mind that the life insurance company will want to see only the names of those who are financially dependent upon you. An acquaintance, friend or relative, absent of a financial relationship, will not do.

Working with a life insurance agent

After reviewing the various life insurance policies available, you might still be unsure about which best meets your needs. The American Council of Life Insurers recommends consulting an insurance agent.

Carefully study your agent's recommendations and ask for a point-by-point explanation. Make sure the agent explains items you don't understand. Because your policy is a legal document, it is important that you know what it provides.

ACLI suggests these tips when purchasing life insurance:

  • Ask for specifics of coverage so you can look at all your options.
  • Check financial strength ratings to determine if your potential insurer is financially stable.
  • Be wary of offers of "free" life insurance policies. Nothing is free. A good example is "stranger-originated life insurance" where the elderly are offered money from investors to buy their insurance policies.
  • Answer all application questions honestly. Do not omit information.
  • Make sure you get your policy within 60 days; if not, contact your insurance company to find out why.
  • Your state likely guarantees a "free look" period, which is often 10 to 30 days after the policy has been in effect. If you decide you don't want to keep the policy, you will be given a full refund.
  • Check the effective date on the policy.
  • Review your policy every year or when a major life event occurs, such as buying a new house, having a child or getting married or divorced.
  • If you have a complaint with an insurance company that isn't resolved after contacting a customer service representative, your state's department of insurance can help.

Insurance experts recommend these tips when deciding which type of life insurance to purchase:

If your agent recommends a term life policy, ask:

  • What are the Standard & Poor's, A.M. Best, Fitch and Moody’s ratings of this insurance company?
  • What is the initial rate-guarantee period? Is this term life  policy renewable past the initial rate-guarantee period without a physical exam? If so, what are the premiums?
  • Is this policy convertible to permanent insurance without a physical exam? If so, for what period of time do I have the right to convert?

If your agent recommends a cash value policy, ask:

  • What are the Standard & Poor's, A.M. Best, Fitch and Moody’s ratings of this insurance company?
  • Can you tell me, in writing, why you are recommending cash value insurance for me at this time?
  • Why should I combine my life insurance protection needs with my investment objectives?
  • Can you please prepare an analysis for me that shows the true cost of this cash value insurance policy over 5, 10, 15, 20, 25 and 30 years versus buying term life and investing the difference in long term bonds over those same time periods?
  • How much is your first-year commission on this proposed cash value policy versus your commission on an equivalent term life insurance policy?
  • Are these proposed annual premiums within my budget?
  • Why do you think that I can commit to paying these premiums over the long term, perhaps decades?
  • How much will I receive if I surrender the policy?

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