What is a life insurance policy?

What is a life insurance policy?

Life insurance provides financial protection for your family in the event of your passing. Your beneficiaries will receive money to use as they see fit, ensuring security in a difficult time.
When to get life insurance

Anytime is a good time, but these life events are especially important.

    If you were just married
    You bought a new home
    You’re expecting a new baby

We all must face the inevitability of death and the economic hardship that others might face when we die. Buying life insurance is one way to ease the burden of that economic risk. We can safeguard surviving family members by paying a relatively small amount, called the expense, to an insurance company. Then, the insurance company will pay a relatively large sum of money to the beneficiaries of the strategy when the insured person dies.

In other words, the risk of a large financial loss that may result from the death of an individual can be transferred to the insuring organization — the insurance company. Life insurance is a means of giving an instant estate to the survivors at the death of an insured person. While the basic idea of insurance is quite simple, many of the details of life insurance can seem perplexing.
(opens in new window) Protection with life insurance

Because families rely upon cash for day-to-day survival, there is a real requirement for insurance from financial disaster if the source of cash is eliminated. Life insurance is one way to provide security if part or all of the family's income is cut off because of death. It can also provide funds to replace the services that a member of the family provides — child care, for example.
(opens in new window) Protection and savings?

The major purpose of life insurance is security — the instant estate to address survivor issues. Some policies incorporate a savings feature, yet there are many other ways to save money and make investments. When buying life insurance, your primary concern should give adequate security; the possible savings feature is a secondary consideration.

In any event, when security needs have been met, it is a decent practice to consider other forms of saving and investment plans for a family. Whether to save or invest through life insurance or other saving or investment media is a family decision, based on needs, preferences, and ability to manage finances. It is a saving/investment decision, not an insurance decision.

You may help a superior profit from your money through other saving or investment vehicles. In addition, a variety of saving and investment opportunities are available that don't need paying any commission, or require a commission that is lower than that for saving through life insurance.

Earnings on the saving or investment component of life insurance are tax-conceded; however there are a variety of other saving/investment media that also provide deferral of taxes on earnings. However, earnings in a life insurance strategy that are part of the proceeds paid to a beneficiary after the death of the insured are not subject to income tax at all.
 Assessing needs

Families should consider total financial needs and other resources available when deciding their requirement for life insurance. Needs rely on:

    The number and ages of dependents (wife, children, parents, and so forth.);
    The standard of living desired for dependents if the income earner should die;
    The amount of other financial resources a family has (Social Security, savings, investments, dependents' earning capacity, and so forth.).

Considerations when buying

The financial needs of surviving family members may include:

    Expenses regarding the death (funeral expenses, final medical expenses not covered by health insurance, expenses for estate settlement, and possibly readjustment expenses such as relocation of the family, and so on.)
    Day-to-day everyday costs of surviving dependents (food, clothing, and so forth.).
    Payments on debts (a mortgaged home or farm obligation, car loan, and so forth.).
    Special needs (securing a loan, assuring children's educational expenses, gifts to family, friends or organizations).
    Retirement income for the surviving spouse, and perhaps for other dependents.

Principles for buying

    When buying life insurance, a family should foster a plan and select policies that fit their particular financial needs. They should use life insurance to provide for financial needs that are not met in other ways.
    This plan should fit the family's ability to pay for the insurance, because premiums must be paid to keep the insurance in force.
    A family should select the top notch period that provides the most economical rate (usually annually). This takes planning and must be incorporated as an item in the month to month financial plan.
    Families should read each strategy carefully. Strategy owners should assure themselves they are making the best use of their insurance dollars for the financial security of survivors of the insured person.
    The family insurance program should be reviewed periodically and revised to address changing issues.

Basic policies
Pure protection (term) and cash valueTerm insurance

Term insurance is a type of life insurance that provides pure protection only. It insures an individual against the risk of financial loss in case of death. It does not include a savings plan; it is strictly an insurance protection contract, similar to auto, home, or health insurance. The owner buys a certain amount of coverage and pays an annual premium based on the insured's age. As the name suggests, this policy covers the insured for a certain term or period of time. At the end of the term, the coverage stops, unless the policy is renewed. The simplest form of life insurance protection is annually renewable term insurance. The owner of a term life insurance policy can continue protection for additional terms, but as he or she grows older, the premium per unit ($1,000) of coverage will increase for each new term.

Some term policies are for five, ten or twenty years. The annual premium remains the same over the term. It is also possible to buy a term policy that will cover the insured for the same annual premium from the time of the purchase to age 65. The actual cost of protection increases each year, but this cost is averaged out to provide a level premium during the term of the policy. This is known as level premium term insurance.

Another form of term insurance is decreasing term. In this form, the amount of protection declines as the insured grows older, so the annual premium can stay level.

Because term insurance provides pure protection, it provides the most coverage for the premium dollar spent.
Cash value insurance

Cash value life insurance policies consist of two elements — a decreasing amount of actual insurance protection over time, combined with a savings component that increases over time — which is funded by premium payments and earnings on the saving element in the policy (Figures 1 and 2).

There are two basic types of cash value life insurance policies. They are designed to provide coverage throughout life (whole life policies) — straight life and limited payment.

Straight life insurance

This strategy provides a certain amount of coverage over the course of life. It combines a decreasing amount of security with an increasing amount of savings. Be that as it may, the total coverage provided by the arrangement (the face value of the strategy) — including both the security and the savings elements — remains the same.

Because the proprietor is developing savings as well as buying security through this plan, the charge is higher than the expense for term insurance. As with all life insurance policies, the expense is based on the age of the insured when the strategy is purchased. The expense for straight life insurance then remains the same through the life of the strategy. This is because the policyholder is paying more than the cost of unadulterated assurance during the early years of the approach. The excess portion of the premiums, above the cost of unadulterated assurance, is what builds up the savings component of the strategy. Because the security component decreases after some time as the savings component increases, the level premium continues to be adequate to take care of the expense of the strategy as the insured grows more seasoned.

The face value is the amount payable at the death of the insured. It includes both the security and the savings value of the strategy, if there is any. The cash surrender value is the amount of savings that has developed within the strategy. This amount increases during the time the approach is in force. The insured may reclaim the approach for its cash value at any time, yet this terminates the strategy. Or, the insured may borrow the cash value from the company; however, this reduces the total coverage until the strategy loan is repaid. Interest is charged on the loan until it is repaid.

If the insured continues premium payments to age 100, the individual in question has made sufficient premium payments to develop the cash value to make it equal to face value at that point. Therefore, as of that date, the strategy consists completely of the savings component, and there is no actual insurance security component remaining. As with a savings account in a bank or elsewhere, the insured can at that point gather the face value of the strategy while he/she is alive, because the whole approach value currently consists of his/her savings component.
Limited payment life insurance

This strategy is similar to the straight life strategy, then again, actually the policyholder pays the total premiums on the approach in a limited number of years, usually 20 to 30, or by age 65. After that, the strategy remains in force for the rest of the insured's life unless the cash value is withdrawn, when coverage stops.

The top notch on limited payment life insurance is higher than for a straight life strategy because you pay all the premiums into the arrangement in a given number of years. This means the policyholder is actually developing saving (cash value) within the strategy at a considerably faster rate than would be valid with the straight life insurance strategy, and thus decreasing the security component in the arrangement faster.

This strategy has limited use with the exception of families that have extremely big time salaries in their early years (for example, a professional athlete whose income may be decreased in later years). The typical family has more stress on its financial plan in the early years and, because of the greater payments, will probably track down it impossible to afford sufficient coverage with limited payment life insurance. And having sufficient security to provide for decided needs in occasion of death of the insured is the most important consideration in buying life insurance.

The cost per $1,000 of actual life insurance security rises as the insured gets more established, in a cash value type strategy as in a term strategy. In a cash value strategy, the increasing cost of security is not obvious, because as the savings component created by the higher charge increases, the amount of the actual insurance security component decreases.
Tax treatment

Cash value policies are habitually marketed as a tax sheltered form of saving. While this is a consideration, the advantages of the tax shelter are habitually overstated. The shelter of a cash value strategy is that the interest earned on the cash value (savings portion) is tax-conceded as lengthy as the approach is in force. If the arrangement is surrendered to obtain the cash value, income tax is paid exclusively on the portion of the cash value that exceeds the total premiums paid on that strategy. And, as indicated above, if the face value of the strategy is paid to a beneficiary at death of the insured, the earnings on the savings component are not taxed at all.

The tax treatment, however, is a minor factor to consider when deciding the kind of insurance to purchase. It is a far less important consideration than the security provided by the strategy (the instant estate created at death of the insured).
Policy selection considerations

Cash value life insurance is often advanced as an avenue for saving because the exceptional payments incorporate a saving component. However, there are several factors and hazards that must be taken into account when considering cash value policies. The first, and most important, is that families sometimes purchase higher-premium policies with a savings component and provide inadequate security to address their issues. So if the insured dies, they have spent their superior dollars on too little security and their financial needs are not adequately covered. A second factor is that when families commit to high-premium contracts, if they face increased everyday costs or a financial crisis, the insurance premiums may put too much stress on their income, and they drop the pollicy — thus leaving them without life insurance. In this case, they are without security, however have a further loss because of the greater commissions paid to acquire this kind of strategy. Finally, if the family considers a cash value life insurance strategy as a saving medium, it should compare the rate of return earned on the saving component, the commission to acquire the strategy, and other factors, with alternative avenues for saving and investing.

It is important to remember that there are a variety of media for saving, yet the security feature of life insurance is the main mechanism for creating an instant estate at the death of the insured. If a man age 25 saves $150 one day and dies the following, that $150 will be part of his estate. However, if he is healthy, for that $150 he can purchase a one-year renewable term life insurance strategy that will provide about $100,000 to his beneficiaries or estate if he dies the following day. This illustrates the instant estate idea, and the difference between a savings plan, in which the principal is yours whether you live or die, and an insurance security plan, in which you are paying a modest-size charge to provide a large dollar amount of insurance which will be paid exclusively in occasion of your death. The security idea is similar to the insurance you purchase for a characterized time span to cover your home or automobile.

Life insurance provides financial security for survivors of the insured, and may meet other financial objectives, as well (a gift to charity, for example). Families should survey their life insurance program and policies regularly and make adjustments to meet changes in circumstances and needs.
Definition of terms

    Beneficiary
    The person named in the approach to get the insurance proceeds at the death of the insured.
    Cash surrender value
    The amount of money payable to a policyholder who purchased insurance with a savings component in it, when the person stops paying premiums before the maturity date of the strategy.
    Face value
    The amount stated on the face of the strategy that will be paid in case of death of the insured or at the maturity of the contract. Profit additions or additional amounts payable under accidental death or other special provisions are above the face value.
    Insured
    The person on whose life an insurance strategy is issued.
    Life insurance
    A risk-sharing plan to cover the financial loss, and other financial needs, experienced by dependents upon the death of an individual.
    Limited payment life insurance
    Entire life insurance on which premiums are payable for a specified number of years or til' the very end if death occurs before the finish of the specified period.
    Strategy
    The printed record stating terms of the insurance contract issued to the policyholder by the company.
    Strategy loan
    A loan made by an insurance company to a policyholder on the security of the strategy's cash value.
    Premium
    The payment, or an intermittent payment, a policyholder makes for an insurance strategy.
    Straight life insurance
    Entire life insurance on which premiums are payable for the life of the insured, at whose death the face value is paid to the dependents.
    Term insurance
    Insurance payable to a beneficiary at the death of the insured while the strategy is in force