Many people wonder to themselves, "Just how does life insurance work, anyway?" Life insurance has been shrouded in mystery ever since its inception. Partially this is due to the way life insurance has traditionally been sold, which is through specially trained commission-earning agents. But other factors include the fact that life insurance is perhaps the most intangible product that one can buy, and the fact that it is developed in strange and mysterious ways through the employment of secretive statisticians called actuaries.
Actuaries are professional statisticians with strong business educations or experiences who use data including gender, age, occupational risk, and medical exams to calculate the likelihood of a given person's death. Using these data and actuarial calculations, they advise an insurance company on how much a given policy for a given applicant should cost (I.E. what his premiums should be). From this advice, a life insurance company sets its premiums by coming up with "cost per thousand" tables.
After a person has applied for a life insurance policy and taken a medical exam, the life insurance company, assuming the person is insurable, tells him how much he will have to pay per month (or per year or every six months) to pay for the coverage based on the risk range into which he falls. Factors of youth, being female, non-smoker status, and general health based on the medical exam all contribute to lowering the premium, while their opposites contribute to raising the premiums. Having a hazardous occupation may also raise your premiums depending on the insurance company's underwriting standards.
DIFFERENT TYPES OF POLICIES
There are different basic types of life insurance policies. It is important to know about them so that you can make an informed decision about what type of coverage is best for you.
First comes the very first type of life insurance ever devised: Term. A term policy is very simple: you pay premiums to have death benefit coverage for a specific term, or time period. If you die during that term, your beneficiary receives the payout. If you are still alive when the term is up, you can renew the policy (in some cases) for another term (with premiums based on your new age status) or you can lose coverage. There are different kinds of Term Life for different purposes. You do not receive back any of the premiums you paid during the term. However, Term Life is the cheapest form of life insurance and many financial advisors and planners recommend it.
(Recently the life insurance industry has devised a new kind of Term Life called Return of Premium Life Insurance (ROP) where you can get all your premiums back if you survive the term. However, this kind of Term Life is significantly more expensive. The life insurer uses the extra money to invest and make a profit as a hedge against possible ROP.)
Later on, the life insurance industry developed Whole Life Insurance. The idea here was to give people an incentive to hold a policy for their "whole life" or until a very advanced age (at which time they would receive the death benefit payout to themselves, if still alive) and be able to build up cash value within the life insurance policy which could be drawn upon if needed and eventually even be used to pay the policy premiums. And it is true that, if a Whole Life policy is held long enough, it returns the same as a decent corporate bond. The problems, however, are: Whole Life insurance costs way more than Term Life; many people could get far better returns on their money by investing the money they save with Term; and life insurance was actually never intended to be kept for one's whole life.
As a response, life insurance companies about 20 years ago began developing Universal Life and Variable Universal Life insurance. These polices are really Term Life with a tax-free investment account bundled together with them; this account is partly customized by the policy holder. Variable Universal policies allow for greater investment returns but, hence, exposure to greater risk, including possible losses; they also allow extra money to be paid into them with premium payments to increase their cash value. These policies' premiums are usually in between Term and Whole Life for the same amount of coverage for the same person.
APPLICATION BASICS
As a rule of thumb, when you apply for life insurance you want to be covered for 8 to 10 times your annual salary. (There may also be other considerations of what amount you want if you are in a business situation or if you are using life insurance for a specialized need such as mortgage payoff in case of untimely death). So, if you earn $50,000 a year, you want to have a death benefit of $400,000 to $500,000. This is to allow for your beneficiary to be able to pay off all your debts and still have money left over to invest into an account and use as income.
Beneficiaries need to be chosen with some care, because your choice is investigated by the underwriters when your application is turned in. Technically you can name anyone you want, but a "strange" naming such as a very distant cousin may get your policy denied due to suspicions about your motives. If you are married you should name your spouse and/or your children, though you do not have to; but once again, if you don't that fact may be viewed with suspicion, although if you can justify it to the agent and underwriters you'll get the policy. You can change your named beneficiary(s) at any time while the policy is in force.
Most life insurance policies will not pay out if you commit suicide or are murdered by a named beneficiary within the first two years of having the policy and there will be a written clause stating such in your policy. Also, if a death benefit claim is made and it turns out you as policy holder lied on your application (such as you said you don't smoke but autopsy proves you did), life insurance companies won't pay out.
When you apply for life insurance you must be prepared to answer some sensitive personal questions about financial matters and health matters. The agents are trained as objective-minded professionals and there are strict industry regulations about confidentiality.
Some people prefer applying for life insurance over the Internet. This can be a good idea if you know what you're doing, but the usual person would benefit from meeting in person with agents representing different life insurance companies or meeting with an insurance broker or financial planner to be advised on the best options.
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