Most people have a vague idea of how life insurance works but generally they don’t understand the fundamentals of a life insurance contract and how the insurance company can make a profit when they are frequently paying out more than they’re taking in.
To understand how life insurance companies profit from insurance contracts, you have to consider the spread of the risk versus a single insured risk.
To make money on life insurance, the insurance companies simply invest the premiums they collect in the market where they earn interest on their investments, and as long as the investments perform as expected, the insurance company will realize a profit based on the entire group of risks they are insuring.
Consumers should take into consideration that life insurance has been around since the 18th century and between then and now, the insurance companies have figured out how to be competitive with one another and still make a profit.
Instead of reciting the history of life insurance and the intricate parts that keep the profit engine running, in this article, we’re going to discuss how life insurance works for the policyholder.
How does Term Life Insurance Work?
Term life insurance is the least expensive of all life insurance products (excluding accidental death insurance). Term insurance is purchased in blocks of time called “the term” like 1, 5, 10, 15, 20, 25, and 30-year terms. If the insured dies during the term of the policy, the insurance company is obligated to pay the death benefit that is specified in the insurance contract.
Term life insurance policies have certain guarantees that are similar to other insurance products like a guaranteed death benefit and level premiums for the life (term) of the policy. In most cases, shortly before a term policy is going to expire, the insurance company will offer a renewal of the policy but with a different term (usually 1 or 5 years) and a new rate that is based on the insured’s age at the time of the renewal.
Many term life insurance policies also have a “conversion privilege” which allows the policyholder to convert their term insurance policy to a permanent policy like whole life or universal life (sold by the same insurance company) without having to prove insurability (they’re health condition).
Term life insurance is remarkably cheaper than permanent insurance products for the following reasons:
- Term insurance is temporary and lasts only for the term that an applicant has selected.
- Most term insurance policyholders outlive their coverage and thus the insurer will pay substantially fewer claims than if the policy coverage was for a lifetime.
- Your premium amount for term life insurance covers only the cost of life insurance and a policy fee charged by the insurer. There is no cash value component and no living benefits unless optional insurance riders are purchased by the applicant.
- Many policyholders do not keep their policy for the entire term. This means if you purchase a 10-year term life insurance policy and then cancel it in year seven, the insurer has made a 100% profit on that policy. This scenario happens much more than most people think.
Here is an example of how cheap term insurance is for a 30-year old healthy male or female non-smoker who is purchasing a 10-year $1,000,000 policy:
As you can see from the rate chart, a 30-year old healthy male or female non-smoker can buy $1 million in life insurance coverage for 10 years for about the cost of 2 large pizzas.
It’s important to note that term insurance rates take three primary aspects into consideration for determining the cost of term life insurance:
- The applicant’s age
- The applicant’s health
- The applicant’s requested death benefit
Finally, it’s important to know that a term life insurance policy can provide more than just a death benefit if the applicant purchases additional optional insurance riders like the accelerated death benefit and return of premium rider.
How does Whole Life Insurance Work?
Whole life insurance is the oldest type of insurance product yet continues to gain momentum even though it is typically the most expensive kind of insurance to purchase. Where term insurance is temporary and does offer a cash value component, whole life insurance covers you for your whole life and contains a cash value component that will accumulate money over time.
Most policyholders have purchased their whole life insurance because of the cash component and not the death benefit. With whole life insurance, the insurer will charge a level premium that is sufficient to pay the cost of life insurance for the life of the policy. In the early years of a policy, the policyholder is actually paying more than the cost of insurance. where a portion of the premium is used to purchase life insurance and the balance of the premium is deposited into the cash value account.
The money in the cash account is invested by the insurance company so that they can earn interest on the money and then credit the policy’s cash account with a guaranteed interest amount that is specified in the policy contract. As the cash account grows over time, the policyholder can access the cash using policy loans, withdrawals, or complete surrender of the policy.
How does Universal Life Insurance Work?
Commonly referred to as UL, universal life insurance is kind of a mixture of term insurance and whole life insurance, in fact, it is typically priced somewhere between these two very different insurance products.
UL offers a guaranteed death benefit like term and whole life insurance and it has a cash value component like whole life. UL policies can be purchased with a fixed crediting process, an indexed crediting process, or a variable crediting process. In an attempt to stay out of the weeds, here, we’ll talk a little about UL. Here are the most common selling points that attract consumers to universal life insurance:
- Guaranteed death benefit – As long as your UL is properly funded, the policy will provide a guaranteed death benefit for a lifetime. Even the cost of life insurance is not guaranteed in a UL policy, if a sufficient amount of premium is paid each month, the policy will earn enough interest to safely afford the increasing cost of life insurance in the later years of the policy.
- Most insurance companies pay a higher amount of interest than a whole life policy will earn.
- Universal life insurance has the flexibility to allow a policyholder to change premium payments or even skip some premium payments as long as there is sufficient cash value to support the policy.
- A UL also has the flexibility to allow a policyholder to change the death benefit to accommodate life events over the policyholder’s lifetime. The policy can choose to reduce or increase the death benefit according to their needs, however, an increased death benefit will likely trigger medical underwriting before the increase is approved.
- Policy loans – Once the universal life policy’s cash value has grown to a substantial value, the policyholder can withdraw funds using tax-free policy loans. If the insured dies while a loan is outstanding, the company will simply deduct the amount of the loan from the death benefit that is to be paid to a beneficiary.
Which kind of Insurance will Work Best for Me?
Simply put, the insurance policy that will best for you is based on your need for insurance. There are many reasons that individuals and families need the financial protection that is provided by life insurance, so the type of policy you buy will not likely work for someone else with different needs.
Here are common reasons why people by life insurance with the best product to meet those needs:
|Need for Life Insurance||Best Product Solution|
|Replace income and cover debts, mortgage, college expenses, and retirement plan funding.||Term Life Insurance|
|Funds to pay for final expenses like funeral and burial, unpaid medical expenses, unpaid nursing home expenses.||Whole Life Insurance (Final Expense Insurance)|
|Wealth accumulation for retirement planning||Universal Life or Indexed Universal Life|
|Funding your “Becoming Your Own Banker” Plan||Whole Life Insurance from a Mutual Company|
|Consumers who have severe or multiple health issues.||Whole Life Insurance (Guaranteed Issue)|
It’s always a good thing to understand how life insurance works and the different types of policies that are available to you. It’s even more important to use an experienced and reputable independent insurance professional who is not beholden to any one company and can shop your life insurance with multiple companies to deliver an insurance solution to best meet your needs.