Welcome back, I hope everyone had a wonderful Thanksgiving holiday!
Now that we have a good solid understanding of the importance of life insurance to end-of-life planning and how to go about getting the right policy with the right death benefit for you and your family, it’s time to get into the mechanics of life insurance and some ways to make your policy work even harder for you.
How Life Insurance Works
As we discussed in our first blog in this series, a life insurance policy has two main components—a death benefit and a premium. Term life insurance has these two components, but permanent or whole life insurance policies also have cash value components. The death benefit or face value is the amount of money the insurance company guarantees to the beneficiaries identified in the policy when the insured dies. The insured might be a parent, and the beneficiaries might be their children, for example. The insured will choose the desired death benefit amount based on the beneficiaries’ estimated future needs. The NAIC or National Association of Insurance Carriers says that the insurance company will determine whether there is an insurable interest and if the proposed insured qualifies for the coverage based on the company’s underwriting requirements related to age, health, and any hazardous activities in which the proposed insured participates.1
Premiums are the money the policyholder pays for insurance.The insurer must pay the death benefit when the insured dies if the policyholder pays the premiums as required, and premiums are determined in part by how likely it is that the insurer will have to pay the policy’s death benefit based on the insured’s life expectancy. The NAIC states that actors that influence life expectancy include the insured’s age, gender, medical history, occupational hazards, and high-risk hobbies.1 Part of the premium also goes toward the insurance company’s operating expenses, and of course, premiums are higher on policies with larger death benefits, individuals who are at higher risk, and permanent policies that accumulate cash value.
The cash value of permanent life insurance serves two purposes. For one, it is a savings account that you can use during your life; the cash accumulates on a tax-deferred basis. Some policies may have restrictions on withdrawals depending on how the money is to be used. For example, the policyholder might take out a loan against the policy’s cash value and have to pay interest on the loan principal. Secondly, you can also use the cash value to pay premiums or purchase additional insurance. The cash value is a living benefit that remains with the insurance company when the insured dies. Any outstanding loans against the cash value will reduce the policy’s death benefit, so keep those two points in mind.
Life Insurance Riders and Policy Changes
Many insurance companies offer policyholders the option to customize their policies to accommodate their needs. Riders are the most common way to modify or change your policy. There are many riders, but availability depends on the provider, and you’ll typically pay an additional premium for each rider or a fee to exercise the rider, though some policies include certain riders in their base premium. Here are some of the more common riders available.
- The accidental death benefit rider provides additional life insurance coverage in the event the insured’s death is accidental.
- The waiver of premium rider relieves the policyholder of making premium payments if the insured becomes disabled and unable to work.
- The disability income rider pays a monthly income in the event the policyholder becomes unable to work for several months or longer due to a serious illness or injury.
- Upon diagnosis of terminal illness, the accelerated death benefit rider allows the insured to collect a portion or all of the death benefit.
- The long-term care rider is a type of accelerated death benefit that can be used to pay for a nursing home, assisted living, or in-home care when the insured requires help with activities of daily living, such as bathing, eating, and using the toilet.
- A guaranteed insurability rider lets the policyholder buy additional insurance at a later date without a medical review.
- A term conversion rider should allow you to convert to any permanent policy the insurance company offers with no restrictions. The primary features of the rider are maintaining the original health rating of the term policy upon conversion, even if you later have health issues or become uninsurable, and deciding when and how much of the coverage to convert. The basis for the premium of the new permanent policy is your age at conversion.
Of course, overall premiums will increase significantly since whole life insurance is more expensive than term life insurance. The advantage is the guaranteed approval without a medical exam. Medical conditions that develop during the term life period cannot adjust premiums upward. However, the company may require limited or full underwriting if you want to add additional riders to the new policy, such as a long-term care rider.
Certain types of insurance come with built-in features like the ability to borrow money from your policy or ways to fund retirement. Most permanent life insurance accumulates cash value that the policyholder can borrow against. Technically, you are borrowing money from the insurance company and using your cash value as collateral. Unlike with other types of loans, the policyholder’s credit score is not a factor. Repayment terms can be flexible, and the loan interest goes back into the policyholder’s cash value account. Policy loans can reduce the policy’s death benefit, however.
Policies with a cash value or investment component can provide a source of retirement income. This opportunity can come with high fees and a lower death benefit, so it may only be a good option for individuals who have maxed out other tax-advantaged savings and investment accounts. The pension maximization strategy described earlier is another way life insurance can fund retirement.
In next month’s blog series, we will continue our discussion of end-of-life planning with a focus on estate planning, specifically the ins and outs of wills.
Until next time…
One last thought, I believe an educated investor is an empowered investor. If you like what you’ve read and think your friends and family can benefit as well, please share.
1 NAIC. "Life Insurance." Accessed October 19, 2022.
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