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Life Insurance 101: Understanding Your Life Insurance Policy

Understanding your life insurance policy means knowing the parts of a policy as well as the type of policy and how death benefits work. Life insurance costs as little as $12.70/per month, but the rate depends on several factors, including your age and health.

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Leslie Kasperowicz holds a BA in Social Sciences from the University of Winnipeg. She spent several years as a Farmers Insurance CSR, gaining a solid understanding of insurance products including home, life, auto, and commercial and working directly with insurance customers to understand their needs. She has since used that knowledge in her more than ten years as a writer...

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UPDATED: Jun 29, 2020

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Your life insurance policy is a contract. Like any contract, understanding your policy is the key to getting the most out of it, and making sure it fully protects your family when you need it to.

Understanding your life insurance policy isn’t as complicated as it might sound. We wrote this article to give you a basic overview of the key parts of a life insurance policy, and where to find the information.

Shopping for life insurance doesn’t have to be hard. Once you understand a typical life insurance policy, you can use our free tool above to get instant quotes from multiple companies at once, allowing you to comparison shop for the perfect coverage.

Parts of a Life Insurance Policy

Life insurance has some basic components that can vary between policy types. Those key parts and some of their variations are covered here.

Life Insurance Premiums

Premium is just a fancy word for payment. Your life insurance premium is the price you pay for coverage. Premiums are typically paid monthly or annually (though the rare low-value policy will let you pay for the entirety of coverage in a single payment).

Your premiums vary based on the type of coverage you choose. Here’s a quick comparison of sample rates for the three policy types. First up, a 20-year term policy:

Average Monthly 20-Year Term Life Insurance Rates by Age & Gender for Non-Smokers
Policyholder AgeRates for Male with $100,000 CoverageRates for Female with $100,000 CoverageRates for Male with $250,000 CoverageRates for Female with $250,000 CoverageRates for Male with $500,000 CoverageRates for Female with $500,000 Coverage
25$14.53$12.70$23.27$18.72$34.79$27.39
30$14.96$13.22$24.59$20.44$37.39$29.59
35$17.57$15.40$26.09$22.19$40.04$32.19
40$21.40$18.62$33.72$28.49$54.79$45.69
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Next, let’s look at permanent life insurance with the same face values.

Average Monthly Whole Life Insurance Rates by Age & Gender for Non-Smokers
Policyholder AgeRates for Male with $100,000 CoverageRates for Female with $100,000 CoverageRates for Male with $250,000 CoverageRates for Female with $250,000 CoverageRates for Male with $500,000 CoverageRates for Female with $500,000 Coverage
25$93.70$84.91$201.90$179.97$396.07$352.22
30$107.71$97.35$238.33$211.60$468.50$415.25
35$128.24$112.93$289.26$251.86$569.70$495.33
40$153.90$132.15$350.98$299.62$692.47$590.19
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Finally, take a look at the monthly cost of a typical $10,000 final expense policy (typical because the average funeral costs around $7,500).

Average Monthly Final Expense Life Insurance Rates – $10,000 Coverage
Policyholder Age$10,000 – Male$10,000 – Female
40$24.02$20.43
45$27.16$22.65
50$43.20$32.91
55$50.06$38.89
60$57.86$45.98
65$71.02$55.60
70$88.55$69.69
75$114.80$91.51
80$163.18$126.89
85$230.74$181.52
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You’ll notice that, in all cases, women pay lower premiums than men. That’s because women have a longer life expectancy, and therefore represent less of a risk.

You pay your life insurance like any other bill. Most insurers allow you to have your payments automatically debited from your checking account every month by filling out an authorization form. Many will also let you pay them directly online or by mail.

Death Benefit

The death benefit is the money paid to your beneficiary when you die. Death benefit claims are typically processed within 30 days of filing and the money is paid in a single lump sum.

Every life insurance policy has a face value (the total amount of coverage you’re purchasing). When you die, the life insurer pays that total face value. For a term policy, that’s the amount your beneficiaries receive. A whole policy has two components: the face value and the cash value. In those cases, the total death benefit is a combination of both.

There are three main types of benefits: fixed, increasing, or decreasing.

Fixed:

For a term policy, a fixed (or level) benefit means that the premiums never increase, and the amount of the death benefit remains the same throughout the entire term.

For a whole policy, it means that the policy premiums decrease over time as the cash value increases so that the payout is always equal to the initial face value. Excess cash value is used to lower your cost rather than being tacked onto your face value after you die.

Increasing:

For a term policy, the death benefit increases each year you have the policy within a certain limit, usually between 2–10 percent. As the death benefit goes up, so will your premium.

For a whole policy, the premiums and face value remain the same over time. As the cash value increases, the overall death benefit increases.

Decreasing:

Decreasing benefits only apply to term insurance. Decreasing term insurance is sometimes called mortgage protection insurance. The benefit decreases every year of the term. In this scenario, you would be paying down the balance on whatever debt you intend the insurance to cover during the term (typically a mortgage). As that balance shrinks, so does the amount of coverage you need.

The premiums don’t decrease with the benefit. Instead, these policies offer a much lower premium from the start that you pay continually throughout the term.

Cash Value

Most whole life policies also include a cash value component. A portion of your premiums is set aside every month into an interest building account. Any money that you earn is either added onto the death benefit or used to pay your premiums depending on your policy type.

You can also take out loans against the cash value during your lifetime. You have to pay back the loans with interest before you die or the balance will be deducted from the benefit.

Depending on the type of policy you choose, your cash value either grows at a fixed interest rate in a savings account or according to market factors (indexes and mutual funds) like a 401k.

Dividends

Some policies also pay annual dividends. Many whole life insurers are mutual companies, meaning that policyholders are partial owners of the company, and therefore entitled to profit sharing. Those dividends are often added to the cash account or used to pay policy premiums.

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Basic Life Insurance Policy Details

Now that we’ve explained the important parts of a life insurance policy, you need to understand just how coverage works.

What are the three types of life insurance?

One of the first questions people ask when shopping for life insurance is: What is a good life insurance policy?

There’s no universal answer to that question. Everyone’s situation is different. The best policy is the one that meets your specific financial needs at a price you can afford. That said, your options fall into one of three basic categories: term life insurance, whole life insurance, and final expense insurance:

  • Term life insurance provides temporary coverage for a set period.
  • Whole life insurance provides permanent coverage for as long as you live. Most also include a cash value account similar to retirement savings. A portion of your premiums is set aside to accrue interest.
  • Final expense insurance (sometimes called burial insurance) is a special type of whole life policy with small face values meant only to cover funeral costs (usually $2,000–$25,000).

Each has several variations so you can customize the policy to fit your specific needs.

Term Life Insurance vs Whole Life Insurance

Watch this video that explains why you would want to get final expense insurance.

For more info on each, you can read one of our complete guides to buying term life insurance, buying whole life, and how much final expense life insurance costs.

How does a life insurance policy work?

A life insurance policy is a contract between you and the insurer. You pay a regular fee and, in exchange, the insurance company promises to pay a lump-sum payment to your loved ones upon your death.

To understand your life insurance policy contract, you’ll need to familiarize yourself with some common terms. Here is a quick glossary of the most common:

Common Life Insurance Terms and Definitions
Life Insurance TermsDefinitions
AgentAn authorized insurance representative who sells and services policies
BeneficiaryThe person designated by the policyholder to receive the proceeds from a life insurance policy
Death BenefitA tax-free lump sum of money paid to the beneficiary upon the death of the insured
Face AmountThe amount of coverage provided by a life insurance policy
Final ExpensesExpenses incurred at the time of a person's death such as funeral costs, current liabilities, and taxes
PolicyThe legal document stating the terms of the life insurance contract
PolicyholderThe owner of the policy, typically the insured
PremiumThe money paid to the insurance company in exchange for coverage
Risk ClassificationThe process which determines the risk associated with an applicant,
which decides how much the insured’s premiums differ from the standard
UnderwriterThe person who reviews the life insurance application, assigns a risk classification,
decides if the applicant is acceptable, and determines the premium rate
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Watch the following video for a brief overview of life insurance.

The basic life insurance process consists of the following steps:

  • The customer fills out a life insurance application and a medical questionnaire.
  • The insurer sends the application to an underwriter.
  • The underwriter reviews the application to determine the risk of insuring the customer.
  • The underwriter may request the customer complete a full medical exam.
  • The underwriter either approves or denies the applications.
  • If approved, the underwriter assigns a risk classification, which determines the premium rate.
  • The policy goes into effect and the customer begins making regular premium payments.
  • If the premiums are current when the customer dies, the life insurer pays out the guaranteed face value of the policy.

That payout can be the difference between financial security and hardship for your family once you’re gone.

Life Insurance Policy Exclusions

For the most part, the death benefit is guaranteed as long as your policy is active and your payments current. However, there are a few exclusions. Here is a brief look at the most common:

  • Suicide Clause – Many policies have a clause stating that they will not pay the death benefit if the cause of death is a suicide (or if the suicide occurs within a specific time frame). In those cases, most insurers will refund the premiums paid on the policy.
  • Alcohol and Drug Use – Some policies state that the insurer will not pay if the death was due to alcohol or drug abuse.
  • Illegal Activity – Some insurers won’t pay a benefit if the death occurred while committing or engaging in some other illegal activity.
  • Dangerous Activity – Some policies have a list of excluded activities (such as skydiving or mountain climbing) that they deem exceptionally dangerous. If you die during one of them, they won’t pay.
  • Acts of War – Some policies don’t cover deaths that result from acts of war. This is a rare occurrence, but it could affect people who travel overseas to unstable regions.

The key to avoiding all of these exclusions is to know which applies to you, which is why it’s so important to understand your policy. You can’t avoid excluded dangerous activities if you don’t know what they are. Some insurers will also remove exclusions for a higher premium. So, if you do have a penchant for skydiving, you would need to inform your insurer and pay a little more for coverage.

Tax Implications of Life Insurance

Life insurance benefits are non-taxable, according to IRS rules, when they are paid directly to a beneficiary, such as a spouse or a child. However, if you name your estate as the beneficiary, the benefits become a part of the estate and are then subject to estate taxes.

If you have a whole policy with a cash-value account, you will have to pay deferred taxes on the interest earned (just like you would with any retirement account).

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How do I access my life insurance policy?

When you purchase life insurance, either your agent or the insurance company will provide you with a paper copy of the policy. Nearly all will also allow you online access to those life insurance policy details at any time via an online portal.

Your policy will include a few different sections, each of which outlines your specific information in all of the categories discussed above. Here’s what you can expect.

Life Insurance Declaration Page

The declaration page gives a brief, general overview of the policy. A quick internet search can return a life insurance declaration page sample; but for now, all you really need to know is that it includes the following information:

  • Name of the insurance company
  • Type of policy (term, whole, etc.)
  • Free-look period info (how much time you have to cancel without penalty)
  • Signature of an insurance company officer

Schedule of Benefits

The schedule of benefits answers two of the most common questions people have about their policy:

  • In what part of an insurance policy are policy benefits found?
  • What is included in a life insurance policy summary?

This section includes all of the key financial details of your coverage:

  • Benefit amount
  • Premium payments
  • Name of the insured
  • Policy issue date
  • Policy number
  • Rate class (assigned based on a health and risk assessment)

Additional Details

Depending on your insurer and policy type, the final section of your policy you will some or all of the following:

  • Tables or graphs illustrating potential cash value growth and future premium payments
  • Definitions of insurance terms
  • Riders (additional coverages added to the policy)
  • Life insurance contestability period (time the insurer has to look mistakes in your application; after the period, they can’t cancel your policy over these errors)
  • Grace period (how much time you have after a missed payment before your policy lapses)
  • Information on how to make a claim
  • Your original application

If you have a whole life policy with a cash-value account, you will also receive a monthly schedule of benefits statement detailing your performance.

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Understanding Your Life Insurance Policy: The Bottom Line

Purchasing life insurance to protect your family is one of the most important decisions you can make. It’s also important to have a thorough understanding of the coverage you just bought.

You’ll get the most out of your life insurance when you know all of your obligations to the life insurer and their obligations to you. You’ll know exactly how much coverage will cost you, how much of a benefit your family can expect, how to ensure your policy doesn’t lapse, and important exclusions to avoid.

We wrote this guide to make understanding life insurance a little easier. Are you still looking for more information? If so, be sure to read one of our many guides that cover all of the information touched on here.

Once you’re done reading about the importance of understanding your life insurance policy, you can use our free tool below to instantly compare quotes from multiple insurers at once. Get started now.

References:

  1. https://content.naic.org/consumer_glossary.htm
  2. https://www.irs.gov/faqs/interest-dividends-other-types-of-income/life-insurance-disability-insurance-proceeds
  3. http://www.nfda.org/news/statistics
  4. https://www.who.int/publications-detail/world-health-statistics-2019-monitoring-health-for-the-sdgs-sustainable-development-goals

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