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Life Insurance 101

Life insurance is a contract binding a life insurance company to compensate a beneficiary for the death of a person insured. If the insured dies the company will provide a cash payment to the beneficiary. Life insurance is used to protect the economic value of a human life with regards to those who may be financially dependent upon it.

Uses of life insurance

Life insurance has many uses for both individuals and businesses. Some common uses include:

Funeral – Life insurance proceeds can ensure that there is enough money for proper funeral and burial expenses.
Debt – Personal bills, credit card debt, student loans, and personal notes can be covered by life insurance in the event of an individual’s death.
Mortgage Protection – The proceeds of a life insurance policy can pay off the balance of a mortgage or provide an income stream to pay monthly mortgage or rent payments.
Income Replacement – In the event of an individual’s death, life insurance proceeds can provide a supplemental income stream to ensure that the surviving family members are able to maintain the same standard of living.
Education – Life insurance proceeds can ensure that the education costs of the insured’s children are covered.
Taxes – Federal estate and state inheritance taxes can be pre-funded using life insurance to preserve the value of an estate.
Donations/Gifts – An individual can use a life insurance policy to fund a donation to a charity or leave a gift to a family member.

Key-Person – A life insurance policy can be used to protect a business from the loss of income and profits caused by the death of a key employee. For more information go to Key-Person Insurance in the advanced life section.
Business Continuation – Life insurance can be used to fund a buy/sell agreement or stock redemption plan to determine enable a partner or group of employees to buy the business interest of a deceased partner. For more information go to Business Continuation Planning in the advanced life section.
Business Loans – Life insurance protection on a key employee or business owner can be used to pay off the debts of a business in the event of that individual’s death.
Employee Benefits – Life insurance protection for employees is commonly included in company employee benefits plans.

Determining your needs

There is no magic formula to determine how much life insurance you should have; however, there are a number of factors that should be considered when estimating how much life insurance you should carry. They include:

Final Expenses – These could be unpaid hospital bills, funeral expenses, unpaid debts, probate costs, and estate and inheritance taxes.
Readjustment Fund – This may be used to cushion the immediate lifestyle adjustment that a family must make when a loved one dies. The family may be forced to move, or the surviving spouse might have to look for a new job. In addition, a working spouse may find it difficult to return to work immediately after the death of a partner. The readjustment fund allows for adequate bereavement due to loss.
Supplemental Income – After the readjustment period, there should be a consistent income stream to help pay for the family’s living expenses, such as mortgage payments, monthly bills, and daycare.
Educational Funds – Adequate funds should be available for the childrens’ education. This might include elementary school, high school, and college.
Retirement Fund – There should also be adequate funds available to ensure that the spouse can retire comfortably.

These are some factors that you should consider carefully when estimating how much life insurance you need. Everyone’s life insurance needs are different but, in general, an individual’s needs are greatest from the time they start their careers or a family until they reach retirement, at which time many individuals’ needs for life insurance diminish. It is important to remember that you should review your life insurance needs annually to account for changes in your family’s lifestyle. Use our life insurance needs calculator to help you estimate how much life insurance you require.

Types of life insurance

Whole life insurance policies are valuable because they provide permanent protection and accumulate cash values that can be used for emergencies or to meet specific objectives.

The policy can be surrendered at anytime for the cash surrender value.
The policy owner can take out a loan and use the cash value as collateral.
The policy can be changed to a reduced amount paid-up whole life policy.
The cash values may be used to pay premiums for a certain period of time.
The cash surrender value can be used to supplement retirement income.

Universal life insurance policies are valuable because they can provide permanent protection and accumulate cash values that can be used for emergencies or for meeting specific objectives. For those who prefer flexibility, universal life insurance provides more options than whole life insurance.

The policy can be surrendered at anytime for the cash surrender value.
The policy owner can take out a loan and use the cash value as collateral.
The cash values may be used to pay premiums for a certain period of time.
The cash surrender value can be used to supplement retirement income.

Variable life insurance policies are valuable because they provide permanent protection and may accumulate cash values; however, these policies carry more risk than traditional whole life insurance policies. Individuals considering purchasing a variable life insurance policy should be experienced investors in equity investments.

The policy can be surrendered at anytime for the cash surrender value.
The policy owner can take out a loan and use the cash value as collateral.
The cash values may be used to pay premiums for a certain period of time.
The cash surrender value can be used for retirement income.

Variable universal life insurance policies are valuable because they can provide permanent protection and may accumulate cash values; however, these policies carry more risk than traditional universal life insurance policies. Individuals considering purchasing a variable universal life insurance policy should be experienced investors in equity investments.

Beneficiary designations

A beneficiary is a person or entity named to receive a portion of the death benefit of a life insurance policy. The owner of a life insurance policy may name multiple beneficiaries, and most insurance companies permit the policy owner to change beneficiaries.

There are two types of beneficiaries: primary and contingent. A primary beneficiary has the first claim to the proceeds of a life insurance policy should the insured die. There may be more than one primary beneficiary and the proceeds do not have to be shared equally. The policy owner of a life insurance contract may also name a contingent or secondary beneficiary. The contingent beneficiary has claim to a portion of the death proceeds should the primary beneficiary(s) be removed or die prior to the death of the insured. There may also be more than one contingent beneficiary.

Many individuals designate a spouse as the primary beneficiary of their life insurance policy and the children as contingent beneficiaries. You should consult with an estate-planning attorney prior to making a minor child a beneficiary of a life insurance policy. In addition, anyone contemplating making their estate the beneficiary of their insurance policy should use extreme caution and consult with an estate planning attorney prior to doing so.

Settlement options

The life insurance policy owner may designate a specific settlement option to be paid upon his or her death. If the policy owner does not choose a specific option, the beneficiary(s) will be given a number of choices. These usually include:

Lump Sum Payment: The death proceeds of a life insurance policy are paid to the beneficiary(s) in one lump sum payment.
Fixed Period Payments: The death proceeds of a life insurance policy are paid to the beneficiary(s) for a fixed period.
Life Income with Installments Certain: The death proceeds of a life insurance policy are paid to the beneficiary(s) in installment payments through a certain period. After the certain period, payments will continue to be made throughout the beneficiary’s lifetime but the payment may vary from the payments during the certain period.
Interest Payments: The death proceeds of a life insurance policy remain with the insurance company and the company pays the beneficiary interest payments.
Fixed Installments: The death proceeds of a life insurance policy are paid to the beneficiary(s) in fixed installments until the proceeds and interest on the unpaid balance of the proceeds are exhausted.
Single Premium Annuity: The proceeds of a life insurance policy are used to purchase a single premium annuity from the insurance company.