Life insurance has been around for centuries, but what exactly is it and how does it work? Simply put, it’s a legal contract designed to protect the financial interests of an individual in the event of his or her death.
There are three main parties to an insurance contract: the policyholder, the insurer, and the beneficiary. The policyholder is an individual that purchases an insurance policy and pays a monthly premium to the insurer for the policy; an insurer is the company that guarantees payment in the event of the policyholder’s death; and a beneficiary is an individual designated by the policyholder to receive a lump-sump payment from the insurer upon the policyholder’s death.
There are several reasons why individuals purchase insurance. For many policyholders, the purchase of a policy is to help compensate for lost income for a beneficiary, usually a spouse, in the event of the policyholder’s death. Insurance benefits can help meet the financial needs of individuals and families by paying mortgages, educational expenses, or even to keep a business running. Wealthy individuals may also purchase insurance to help protect their assets and ensure their estates are properly transferred to beneficiaries.
The three main types of insurance policies are term life, whole life, and universal life:
Term – A policy that typically covers a set period in time, usually 10-20 years, and is designed to replace income during a policyholder’s working years;
Whole – A policy that covers the policyholder for an entire lifetime, tends to costs more in monthly premiums, and develops a cash value as a policyholder pays into it over time;
Universal – A policy with a flexible term period and is also designed to preserve wealth and tax benefits.
Before purchasing a life insurance policy, a potential policyholder is “rated” by an insurance company to determine if there are any risk factors associated with issuing a policy, such as health and lifestyle factors such as smoking, and a family medical history. Individuals deemed to have greater health risks may have to pay a higher policy premium.