Twin Tier Financial

Life Insurance Basics – It’s Not As Bad As You Think

Life insurance is a contract between an insurer (a life  insurance company) and a policy owner to insure the life  of an individual. In many cases, the individual being  insured is also the policy owner (though this doesn't have to be the case).

The life insurance policy pays a death benefit to a  named beneficiary (which is stipulated in the contract by  the policy owner) upon the death of the insured.

Life insurance was originally designed as a way to help pay for burial costs. However, today, life insurance is used for a wide variety of purposes both personal and  business including insuring the life of business owners  (to keep the business operating after the owner's death),  key employees, supplemental retirement income, defined benefit plans, to protect an individual's pension benefits  (i.e. "pension max"), and traditional income replacement  (in the event of the death of either spouse).

Today's life insurance contracts also include suicide provisions to prevent insurance companies from having to pay claims on policies where the insured has committed  suicide within the first two years of the policy. Insurance companies also require that there be an "insurable  interest" between the policy owner and the insured (to help prevent a conflict of interest between the owner of a policy and the person being insured).

While not technically accurate, financial advisers and insurance agents tend to divide insurance contracts into the two different "types": term insurance (temporary) and cash value insurance  (permanent).

Term insurance is temporary or "pure" insurance. The  policy owner pays a defined amount of money for a specific  amount of death benefit. When payments stop, the insurance  ends. Term policies tend to be very inexpensive when the  insured is very young, and are guaranteed to get more  expensive as the insured becomes older. Due to expected mortality rates, term policies also tend to have a very low payout ratio which is estimated to be between 1% - 3%.

Cash value policies are often defined by insurance companies as "a death benefit with a savings component".  This "savings component" is actually a cash reserve that is designed to grow in value until the reserve equals the death benefit. In the beginning, the policy owner pays for the death benefit and an  additional amount of money is set aside in a cash value  account which is part of the insurance contract. With each premium payment, the costs associated with mortality and other expenses are either  guaranteed to decrease every year - in the case of whole life - or is expected to decrease every year - in the case of universal life (if the level death benefit option is elected).

A unique feature of cash value policies is that the cash value is allowed to grow income tax deferred. The  money can then be withdrawn or a loan can be taken against  the cash value if it is ever needed. The interest credited  (earned) to a cash value policy is normally comparable to  other competing savings instruments such as bonds, bank  CDs, or high yield savings accounts. The major difference  is that life insurance cash values grow tax deferred  inside the policy and can be accessed on a tax-free basis  unlike other savings options.

A Word About Buying Life Insurance

The amount and type of an insurance an individual  should consider buying largely depends the context of that  individual's life. Unless an individual has a good understanding of how life insurance works, and how to cover all of their financial responsibilities, a comprehensive financial review by an insurance agent will probably be necessary.

Many individuals attempt to use online calculators or  quoting software or simply pick an arbitrary amount of  life insurance that they "feel" is the right amount.  However, they could be purchasing too much or too little  insurance.

For example, such factors as personal financial goals, age, annual income, when an individual plans on retiring, total debt (including mortgage debt), number of children, the investment experience of the other spouse, expected pension benefits, expected social security benefits, and so on must all be taken into account when purchasing life insurance.

Even after all of this analyzing is done, the advice of a good financial professional can be invaluable in helping  you figure out how to comfortably afford your new  policy.

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One Comment so far ↓

  • Jay Walker

    Few people really understand the importance of Whole Life insurance as a part of their overall financial plan. This article is a plesant introduction without even mentioning the advantage W.L has for Disability, Liability, inflation, creditor protected, and income engineering. Good article, if more people understood the value of W.L in their plan they would be much better off.

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