Do you really understand life insurance?

Many Americans have at least a basic understanding of life insurance, recognizing its primary function as a financial safety net in the event of a loved one's passing. However, numerous surveys and studies have consistently shown that the depth of understanding varies widely and, in many instances, is inadequate.

A recent study by the Life Insurance Marketing and Research Association (LIMRA) found more than half of Americans surveyed admit they are unsure what product they would need or how much coverage to purchase. The study also found that 47% report they have put off purchasing a policy, and 36% believe they simply would not qualify for coverage.

The lack of understanding about life insurance can have serious consequences. For example, if you don't have enough life insurance, your loved ones may not be able to afford to pay for your funeral or other expenses. Or, if you have the wrong type of life insurance, it may not provide the coverage you need.

There are a number of reasons why Americans have a lack of understanding of life insurance. One reason is that life insurance is a complex product. There are many different types of life insurance, and each type has its own benefits and drawbacks. It can be difficult to understand all of the different options available.

Another reason is that life insurance is often seen as a necessary evil. People don't want to think about their own death, so they avoid thinking about life insurance.

If you're considering buying life insurance, it's important to do your research and understand the different options available. You should also talk to a financial professional who can help you choose the right policy for your needs.

Why is life insurance misunderstood?

While most Americans are familiar with the concept of life insurance, many are unaware of the specifics. This includes understanding the differences between term and permanent policies, the advantages of each and how to determine appropriate coverage amounts.

One problem is the underestimation of the value of life insurance. There's a common misconception that life insurance is just for breadwinners or primary earners. This overlooks the substantial economic value of roles like stay-at-home parents, whose replacement costs (child care, home management, etc.) can be significant.

Another issue is widespread misconceptions about the cost of life insurance. Studies have shown that many people overestimate the cost of life insurance, particularly term policies. This misconception can discourage some from even researching or inquiring about a policy.

Americans also tend to have an over-reliance on employer-provided coverage. Many workers believe that the life insurance provided by their employers is sufficient. While group policies are a valuable benefit, they often don't offer the level of coverage a family needs. Additionally, these policies may not be portable if an individual changes jobs.

Those who do have life insurance sometimes neglect to revisit and update their policies after significant life events like marriages, births, home purchases or changes in health. This can lead to under-insurance or misaligned beneficiary designations.

Procrastination is another factor that leads to a lack of adequate coverage. The notion of "I'll get to it later" is widespread. Many individuals, especially younger ones, perceive life insurance as something for the distant future, not recognizing the cost advantages of securing a policy when they are young and healthy.

There also is a tendency to overlook the benefits that life insurance offers the policyholder during their lifetime. Some modern life insurance policies offer benefits that can be accessed while they are alive, such as riders for chronic illnesses or the ability to tap into the policy's cash value. Many Americans aren't aware of these features or don't understand their potential value.

Then, of course, there is the issue of complexity and intimidation. Life insurance can be complex, and the array of choices can be intimidating. Without guidance or adequate education, potential policyholders can feel overwhelmed.

Efforts are ongoing within the insurance industry to better educate the public about life insurance. Financial professionals, insurance agents and public awareness campaigns all play roles in enhancing understanding. Still, there's undoubtedly room for improvement to ensure that more Americans are adequately covered and informed.

What is life insurance?

Life insurance is a contractual agreement between an individual (policyholder) and an insurance company in which the insurer promises to pay a specified sum of money (death benefit) to designated beneficiaries upon the death of the insured person. In return, the policyholder agrees to pay premiums, either regularly or as a lump sum, for the duration stipulated in the policy. The primary purpose of life insurance is to provide financial protection and security to the insured's beneficiaries, helping them cover costs and maintain their standard of living after the insured's demise. When applying for life insurance, individuals usually undergo an underwriting process. This might include answering health questions, undergoing a medical exam or providing medical records. The insurer uses this information to assess the risk and determine the premium rates. There are several types of life insurance policies, each designed to cater to specific needs.

How does term life insurance work?

Term life insurance provides coverage for a specified "term" or period (for example, 10, 20 or 30 years). If the insured dies during this term, the death benefit is paid tax-free to the beneficiaries. This can be used to cover end-of-life expenses, pay off debts, replace lost income or any other financial needs of the beneficiaries. If the insured outlives the term, the policy expires with no cash value.

Term life insurance is considered to be a temporary, cost-effective solution designed to provide financial protection for a specific period. It's especially suitable for those who need significant coverage during specific life stages but might not require lifelong insurance. Some term policies do allow for conversion to a permanent life insurance policy without requiring a new medical exam. This can be advantageous if the policyholder's health has declined over the term. However, it's essential to choose the term wisely, considering future needs and potential changes in health or financial situations.

Premiums are the amounts policyholders pay to maintain their coverage. With term life insurance, premiums are typically fixed and remain the same throughout the duration of the term. The amount is determined based on several factors, including the individual's age, health, the chosen term length and the coverage amount.

How does whole life insurance work?

Whole life insurance (also known as permanent life insurance) provides coverage for the insured's entire life, as long as premiums are paid. These policies typically have a cash value component that grows over time, which the policyholder can borrow against or cash out. Whole life insurance offers both a guaranteed death benefit and a cash value component, providing both life long coverage and a financial resource that can be accessed during the policyholder's lifetime. A portion of your premiums goes into a tax-deferred savings component, which accumulates over time and builds what is called “policy equity.”

While whole life insurance premiums can be higher than term life insurance, the lifelong coverage and savings component can make it an attractive option for those seeking both protection and an avenue for savings or investment in retirement. Also, premiums are typically fixed, meaning they remain the same throughout the life of the policy.

Some policies allow you to make withdrawals from the cash value. Withdrawals up to the amount you've paid in premiums can be made tax-free, but amounts exceeding this will be taxable. If you decide to give up the policy, you can receive the accumulated cash value. However, surrendering the policy in the early years can result in surrender charges, and there might be tax implications. If you decide to give up the policy, you can receive the accumulated cash value.

In addition, some whole life policies, especially those offered by mutual insurance companies, may pay dividends. Dividends aren't guaranteed, but if paid, policyholders can use them in several ways: receive them as cash, reduce premium payments, purchase additional coverage or allow them to accumulate interest. Some whole life policies offer flexibility with premium payments once the cash value has reached a certain amount. For example, the cash value might be used to cover premium payments if you're in a tight financial situation.

What is universal life insurance?

Universal life insurance is a type of permanent life insurance that offers both a death benefit and a cash value component, much like whole life insurance. However, universal life insurance distinguishes itself through its flexibility, allowing policyholders to adjust premiums and death benefits to fit their needs and financial circumstances. One of the most significant features of universal life insurance is its flexible premiums. After the first premium payment is made, the policyholder has the option to increase or decrease their premium payments, as long as the policy has enough cash value to cover monthly deductions.

The policy's cash value earns interest based on rates set by the insurance company, which might be tied to a specific benchmark or index. Some policies guarantee a minimum interest rate, ensuring that the cash value grows over time. As the cash value accumulates, it can be used to cover premium payments if needed, or borrowed against. Universal life policies typically provide two death benefit options. One option pays a level death benefit (the policy's face amount). The other option pays the face amount plus the cash value. The choice between these options can influence the policy's cost and cash value growth.

Policyholders can take loans or make withdrawals from the cash value of their universal life policy. However, these actions can reduce the death benefit and potentially result in tax implications. If loans and interest on them are not repaid, they will reduce the death benefit. Based on the policy's performance and the needs of the insured, the death benefit can be adjusted. However, increasing the death benefit might require proof of good health, and decreasing it might be subject to certain conditions or fees. Universal life policies typically come with monthly charges. These can include the cost of insurance, administrative fees and other associated costs. These charges are deducted from the cash value.

What is variable life insurance?

Variable life insurance is a type of permanent life insurance that combines the features of traditional life insurance with the potential for investment growth, similar to mutual funds. It offers both a death benefit and a cash value component, but with a unique twist: The policyholder can invest the cash value into a variety of different investment options. This means that the policy’s performance is directly tied to the performance of the underlying investments.

The most distinguishing feature of variable life insurance is the ability to invest the policy's cash value. The insurance company typically offers a selection of investment options, ranging from stocks and bonds to money market funds. The policyholder decides how to allocate the cash value among these investment choices.

Given the investment component, there's potential for significant growth in the cash value. If the chosen investments perform well, the cash value and potentially the death benefit can increase. But with the potential for higher rewards comes greater risk. If the investments perform poorly, the cash value and possibly the death benefit can decrease. However, some policies may have certain guarantees to ensure the death benefit doesn't fall below a specified amount.

Variable life insurance policies often have a variety of fees and charges. These can include mortality and expense risk charges, administrative fees, fund expense charges and possibly surrender charges. It's essential to be aware of and understand these charges as they can significantly impact the policy's cash value.

The growth in the policy's cash value is tax-deferred, meaning policyholders won't pay taxes on earnings until they withdraw funds. Also, if managed correctly, beneficiaries can receive the death benefit without it being subject to income taxes. Because of the investment component, variable life insurance is regulated as a security product. This means that the agents selling it must be registered with the Financial Industry Regulatory Authority (FINRA) and provide a prospectus detailing the policy's investment options and associated risks.

What is indexed universal life insurance?

Indexed universal life (IUL) insurance is a type of permanent life insurance that blends aspects of both universal life insurance and investment potential tied to a financial index, most commonly the S&P 500. It's designed to offer policyholders the chance to earn market-linked returns on their cash values, while also providing a death benefit. Like other types of universal life insurance, IUL allows for flexible premium payments and offers tax-deferred growth of cash value. Also, once the initial premium is paid, the policyholder can adjust the amount and frequency of their premium payments, as long as the policy has enough cash value to cover monthly deductions.

IULs are generally designed as a long-term financial product. Their potential benefits, especially the protection from negative market returns, tend to become more pronounced over an extended period. It might not be suitable for those seeking short-term financial solutions.

Summary

The right type of life insurance for an individual depends on their needs, financial goals, age, health and other factors. Life insurance serves not just as a death benefit but, in certain policies, as a savings or investment tool as well. Plus, having life insurance means you can rest easier, knowing that your loved ones will be financially protected should anything happen to you.

Life insurance is a crucial financial tool for many individuals and families and it can serve as a way to leave an inheritance to your heirs, even if you don't have substantial assets to pass on. You can name family members or loved ones as beneficiaries.

Perhaps the most compelling reason is to ensure that your loved ones maintain their standard of living in your absence. The death benefit can replace lost income and help family members manage expenses such as mortgage payments, utilities and daily living costs. Life insurance can help clear any outstanding obligations you leave behind, such as mortgages, college tuition, child care costs, car loans, credit card debts and other bills, preventing these financial burdens from falling on your loved ones.

Another potential burden on loved ones is the significant cost of a funeral and burial. A life insurance policy ensures that these expenses are covered, sparing your family additional financial stress during an already challenging time.

Some other potential uses of life insurance are for business continuation or charitable contributions. It can fund a buy-sell agreement, ensuring the business continues running smoothly in your absence, or act as a protective measure for business loans or key personnel. Or, if you have a cause that you're passionate about, you can name a charity as the beneficiary of your life insurance policy, ensuring that your philanthropic goals continue to be realized even after you're gone.

In short, life insurance offers a range of benefits beyond merely providing a death benefit. It's a versatile financial tool that brings assurance in an uncertain world, ensuring that those you care about most are shielded from potential financial hardships.