What Is Life Insurance and How Does It Work?

Mar 31, 2022

5

min read

L

ife is full of uncertainties, and we don't know what will happen next. But, we are confident of one thing, we will die someday.

We don't know when but death can be quite the burden to our loved ones who are emotionally and financially dependent on us.

In ancient times, people used to pass the hat to collect money for the family who had lost their loved ones on whom they were financially dependent. The loss of a breadwinner meant that the family had no one to rely on financially.

Thus, the people collected small sums of money to give the family enough money to sustain themselves for a while. This practice developed the concept of life insurance.

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What Is Life Insurance?

Life Insurance is financial coverage promised by the insurer to your loved ones after your death or any unfortunate events mentioned.

In other words, it is a legal contract between an insurer and insured where the insurer pays the contract amount to the nominee upon the insured's death.

It's like buying peace of mind knowing that your family will be financially secured after your death.

Initially, life insurance was tied to financial security after the insured's death. But, modern life insurance is beyond that and is more of risk protection with an investment.

Terminologies Of Insurance

Policyholder: The policyholder is the one who purchases the insurance and pays the premiums regularly.

Life Assured/ Insured: Life assured/ Insured is the person who has insurance coverage. The policyholder is the one who purchases the insurance, but they can be different from the insured.

For instance, if you buy life insurance for your parents, you will be the policyholder, whereas your parents will be the insured.

Insurer: The insurer is the insurance company that provides you the insurance coverage.

Insured amount/ Sum guaranteed: This is an amount agreed upon by the insured and insurer in the insurance contract where the insurer promises to pay the amount to the nominee upon the insured's death.

For instance, you purchase a term life insurance policy for yourself and name your wife as the beneficiary. Upon purchase, you will be requested to set a sum assured.

Let's suppose the money promised is one million. Your wife will now get the amount of 1 million from the insurance firm in the tragic event of your death within the policy's term.

Nominee/ Beneficiary: The nominee/ beneficiary is the person who inherits the insured amount when the insured dies within the policy's term. This is frequently a family member or a close relative picked by the policyholder.

Policy Term: This is when the insurance policy is in effect. This term may last anywhere from a year to a lifetime.

For instance, an insurance policy has a 50-year policy term. If the policy's life guaranteed dies within this time, the insurance company would be responsible for paying the amount promised to the nominee.

However, if the insured dies after the policy term is over, the insurance company is not liable to pay any amount.

Premium: The policyholder pays a certain amount to the insurance company for coverage. Various payment options include monthly, quarterly, and yearly payments. It is a crucial part of insurance, and your insurance may be void if you fail to pay premiums on time.

Claim: If the insured passes away during the policy's term, the insurance company does not immediately pay the money promised to the nominee. You must first make a claim, and the company will verify several things before paying you the insured amount.

Types Of Life Insurance

Term Life Insurance

Term Life Insurance is the life insurance policy for a specified period. The coverage period is generally between one to thirty years, and the coverage plan depends on the policy.

It is the most popular life insurance policy as it is cheaper and more relevant. If the insured dies within the insured period, the nominees are paid the contract amount.

However, the main disadvantage of this policy is that if you outlive the insured period, your nominees won't get a payout.

Universal Life Insurance

Universal Life Insurance is a flexible life insurance policy that provides the policyholder with both investment and insurance options.

While some of the premiums are used to pay for insurance, the rest is invested in various market investing alternatives such as stocks and mutual funds.

The significant advantage of the insurance policy is that you can access the cash value, which grows over time. Your benefits are high when the stock market increases. On the same note, there is a risk that you may lose the benefits if the stock market crashes.

Endowment Life Insurance

Endowment life insurance is the combination of insurance and savings plans. Usually, you won't get any payout if you outlive the insured period in term insurance.

But, with endowment plans, the amount is returned to the insured after maturity though no claim has been filed.

The maturity is usually ten to twenty years, and the policyholders have to pay monthly premiums up to the maturity.

Whole Life Insurance

Whole life insurance is a long-term insurance policy that lasts until the covered person passes away. The person has to pay the premium for his entire life, and the benefit will be delivered to the beneficiaries once the insured person is dead.

The main advantage of the policy is that it offers lifelong coverage, and the payout is vast since the premiums encompass a life term.

How Does Life Insurance Work?

When you apply for life insurance, you need to fill out the form stating your details, including your financial condition, medical condition, and family condition.

The insurance company may even require you to submit medical documents to ensure that you are not suffering from any life-threatening diseases.

Your age, income, and medical condition play a huge role in deciding the insurance coverage. The higher your age is, the lower your insurance coverage would be. It's because you are a risky customer to the insurance company.

The higher the risk, the higher premiums you have to pay to the insurance company. After you come up with an agreement with the company, you will sign a contract with them.

The contract binds you to pay the regular premiums. Similarly, the insurance company has to pay out the insured amount upon the insured's death or upon the maturity as mentioned in the contract.

However, if you fail to pay the premium, the contract will be void, and you won't receive any benefits.

Conclusion

Life insurance is like an umbrella to protect you and your loved ones from unfortunate events. It helps protect your beneficiaries against the financial loss in income through premature death or other tragic events.

Though initially, life insurance typically meant the financial benefits after the death of the insured, modern life insurance also pays you the guaranteed amount after maturity even though no claims have been made.

Thus, life insurance is now risk protection with investment and has become an essential tool to manage the financial risk of the individual.