Here’s What’s Actually in the Fine Print of Your Life Insurance Policy

It’s fun to contemplate your life — who you will become, where it will take you, what you will do. 

The flip side of that conversation, though? Not so much. 

Still, it’s important to prepare yourself and your family for the (un)expected. Part of that preparation may include working with life insurance.

About 60% of Americans are covered by some form of life insurance. And the payments can range anywhere from a couple hundred to a couple thousand dollars a year, depending on several factors.

But what does life insurance cover? We’re going to review the basics so you can determine if it’s right for you.

What Is Life Insurance?

Life insurance is a contract between an insurer and a policyholder. In exchange for a premium, life insurance companies provide a sum of money to the designated beneficiary after the insured person’s death.

In layman’s terms? Life insurance helps support your family after you die. It’s a financial cushion your family can turn to after the loss of your salary or income.

Whether you need to purchase life insurance depends on your personal situation — if you don’t have dependents, the expense might not be worth it. However, if you have several dependents and are the family breadwinner, you’ll want to seriously consider it.

Before we dive into the nitty-gritty of life insurance, here are a couple of terms to familiarize yourself with:

• Death benefit. This is the payout that goes to the named beneficiary after the policyholder dies. Lump-sum death benefits are not subject to income tax.
• Beneficiary. The person or entity receiving the death benefit. You can name one or more people, a trustee, a charity or your estate. A policyholder can designate one or multiple beneficiaries, but if no beneficiary is named, the death benefit will be paid to the deceased’s estate. It’s essential to keep your choices up to date — for example, if you get divorced, have another child who’s not named on your plan, etc., you’ll need to update your policy.
• Cash value. A component of permanent life insurance policies (more on that in a bit) that’s in addition to a death benefit. An insurer puts your regular premium payment toward two parts: basic insurance policy costs and an internal investment or savings account that accumulates cash value. This account grows throughout the policy, and a policyholder can borrow against it, invest it or use it to supplement their income. If an owner cancels their policy, they’ll receive the accumulated cash value, save for any incurred penalties.

You’ll see these terms pop up a lot when you discuss life insurance.

What Does Life Insurance Cover?

The life insurance payout, or death benefit, is frequently used toward mortgage payments, funeral costs, everyday expenses and debts.

Here are five common ways of using life insurance payouts:

1. Replace your income. The payout can be used to help replace your lost income after death. Whether it goes to a spouse, small children or dependent adults, the money can be used to help support the named beneficiaries who rely on you financially. The money can also help protect a surviving spouse whose government- or employer-sponsored benefits will be reduced after your death, and future-proof financial needs, like providing for a child’s higher education.
2. Create an inheritance. You can buy a life insurance policy, name your heirs as beneficiaries and effectively create an inheritance for them.
3. Make a charitable contribution. You can assign a charity as the beneficiary and make a larger donation instead of giving the cash equivalent of your policy premiums.
4. Create another source of savings. If you have a policy with cash value, you can borrow or withdraw it. The interest in this plan is also tax-deferred. And if the money is paid as a death claim, it’s tax-exempt.
5. Pay for final expenses. Life insurance funds can be used to pay for funeral, burial, probate (the judicial process of settling an estate if there’s no will) and administration costs, debts (such as credit cards or a mortgage) and medical expenses health insurance didn’t cover.

How much life insurance you need depends on your unique situation. You’ll want to shop around — you can get quotes online pretty easily — and find the best policy for you and your family.

Types of Life Insurance

The two primary types of life insurance are term and permanent. 

Whole life insurance is the most popular form of permanent insurance, and you’ll often see “whole life” and “permanent” used interchangeably. Whole life falls under the umbrella of permanent life insurance policies, which we’ll expand on further in the article.

For now, we’ll look at the differences between term and whole life insurance, as well as some pros and cons of each.

Term Life Insurance

The simplest form of life insurance is term life insurance. This type of insurance only pays if your death occurs during the policy’s term — typically between five and 30 years — and most term policies offer no other benefits.

Here are some additional things to know about term life insurance:

Pros:

• It’s the easiest and most affordable life insurance to purchase.
• It can provide temporary additional coverage along with a permanent life insurance policy.
• It can typically be changed over to whole life insurance.

Cons:

• You secure it for a specific time period or “term,” such as five, 10, 15 or 30 years, and the policy only pays out if your death occurs during that period.
• It becomes pricier the older you get, specifically after age 50.
• You must renew the term if you want to extend coverage beyond the term length, and you’ll lose coverage if you don’t pay your premiums.

There are two basic forms of term life insurance: level term and decreasing term. There’s one major difference between them.

Level term: The death benefit remains the same throughout the policy term

Decreasing term: The death benefit drops, typically in yearly increments, throughout the policy term

Level term is the more popular option because the premiums and death benefits don’t fluctuate. It’s also the most common life insurance policy offered.

Permanent Life Insurance

Unlike term life, permanent life insurance pays a death benefit at any age. In other words, you’re covered for life.

Pros:

• Provides death benefits no matter when you die.
• Accumulates a cash value during the policy (though it usually takes 12 to 15 years to develop a good cash value), and a portion of it can be withdrawn or borrowed against within the lifetime of the policy.
• If your policy lapses, you might be able to reinstate it.

Cons:

• Permanent life insurance premiums are typically more expensive than term life insurance premiums.
• You’ll lose coverage if you don’t pay your premiums, but some of the money you’ve paid (the cash value) will be yours to keep — but again, remember, it will take a pretty significant time to develop into a good value.
• Permanent life is more complex than term life, and cash value growth, fees and other factors can vary greatly depending on the company.

Here are the major types of permanent life insurance policies.

Traditional Whole Life Insurance 

Also known as “ordinary life,” traditional whole life insurance is the most common form of permanent life insurance. 

It provides a death benefit, plus a savings account. Your premiums stay the same throughout the policy, and you receive a specified death benefit. The savings portion grows based on the company-paid dividends.

Universal Life Insurance

Also known as “adjustable life,” universal life insurance offers more flexibility than whole life. If you pass a medical exam, you may be able to increase the death benefit. 

Once you’ve accumulated funds in that account, you’ll have the option to change your premium payments if needed. However, you’ll want to coordinate with an agent to make sure you don’t use up the savings and cause a lapse in your policy. 

Universal life premiums are usually less expensive than whole life premiums but more expensive than term life premiums.

Variable Life Insurance

This policy merges your death benefit with a cash value component that you can invest in stocks, bonds and money market mutual funds, but if your investments don’t do well, you could lose money. Having said that, some policies won’t let the death benefit fall below a certain amount.

Variable-Universal Life Insurance

You’ll get the features of both variable and universal life policies with this one. If you purchase this policy, you’ll experience investment risks and wins, and you’ll be able to adjust your premiums and death benefit.

Other Types of Life Insurance

Here are five other types of life insurance policies you can purchase, depending on your situation.

Survivorship Life Insurance

Married couples have the option to purchase an individual or a joint life insurance policy. The latter covers both spouses.

Survivorship life insurance, also known as a “second-to-die life,” is a joint life policy. It doesn’t pay out the death benefit until after the second insured partner dies. 

This type of life insurance is usually cheaper than single-insured plans since there is no payout until both parties die. Because of this, it’s sometimes easier to qualify for a policy, too.

A survivorship life insurance policy might make sense for a couple whose heirs would owe large estate taxes, or parents with special needs children who would need financial support after they pass away.

Key Man Insurance

This insurance covers “key” employees, such as a business owner. 

Key man is life and disability insurance rolled into one. The business owns the policy and pays the premiums; if an insured key person dies or becomes disabled, the business then receives the payout.

Group Life Insurance

Group life insurance is offered by groups and employers to their members and workers. You should approach it as supplemental to individual life insurance, versus a replacement, since your employer owns the policy.

Unlike other life insurance policies, coverage is guaranteed and there are no health questions. (The premium is based on the group as a whole.) Group insurance is typically offered as part of an employee’s benefits package.

Accidental Death and Dismemberment Insurance (AD&D)

Accidental death and dismemberment insurance is a limited form of life insurance that covers you or your beneficiaries if you’re killed or dismembered in an accident. AD&D shouldn’t be considered a replacement for life or disability insurance. Because of its specificity, it might not be worth purchasing for most people.

Deaths resulting from the following are typically NOT covered:

• Death during surgery
• Death resulting from a mental or physical illness
• Bacterial infection
• Hernia
• Drug overdose
• Skydiving
• Car racing
• Drunk driving
• War

Final Expense Life Insurance

This type of policy is also known as burial or funeral insurance. 

Final expense life insurance is generally a lower-value policy that beneficiaries put toward your final wishes. A reminder: Any life insurance policy can be used to pay for funeral costs.

Frequently Asked Questions About Life Insurance

Life insurance is a complex topic. So, we’ve rounded up some popular questions people have regarding these policies.

Do I Need a Medical Exam to Qualify for Life Insurance?

Not necessarily.

It’s possible to get a life insurance policy without undergoing a physical. However, you may have to pay a higher premium and/or supply supplemental health reports — it will be harder for insurance companies to evaluate your health and lifestyle, after all. 

Regardless, be truthful on your survey responses or run the risk of having your policy voided.

What’s the Qualifying Exam Like?

It’s typically conducted by a health care professional, such as a nurse. The exam usually consists of a verbal questionnaire and a blood and urine sample. It can be done in your home, too.

What Types of Death Are Covered?

Life insurance policies typically cover any cause of death, except for suicide within the first two years of the policy. After the two-year window, the policy will usually pay out for suicide unless there’s another provision in place. 

That said, each policy is different. Some may have recreational-drug or alcohol-related death clauses, for example. People in certain occupations might not be covered, either. Your best bet is to thoroughly review a potential policy and consult with a professional if needed.

What Happens if You Outlive Your Policy?

If your term life insurance policy is about to expire and your age or health might make it difficult to renew, you have options. You can purchase a new policy (though, most likely at a higher rate), convert it to permanent life insurance or drop it altogether.

How Does a Life Insurance Payout Work After the Policy Owner Dies?

When a policyholder dies, here’s what you’ll do to start the claims process:

• Get copies of the death certificate.
• Contact the insurance agent or company to fill out any necessary paperwork and navigate next steps.
• Send a certified copy of the death certificate from the funeral director along with the policy claim. 

Once the claim has been made, the funds should be issued to the beneficiaries. Payments are usually issued within 30 days.

Kathleen Garvin (@itskgarvin) is a writer and editor whose work has appeared in U.S. News, Clark.com and Well Kept Wallet.

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