How an Insurance Policy Works

There’s no question that some policies contain investment-type attributes, but how are they any good investments? Understanding how an insurance policy works before attempting to evaluate life insurance as a potential investment option is a must. One key caveat, life insurance is always complex. Understanding what types of risks are involved in insuring one’s life is absolutely essential.

The typical insurance policy features two parts: a death benefit and a cash value. The death benefit is essentially the lump sum paid out to the beneficiaries upon the policy holder’s death. The cash value is what is invested by the insurance provider in order to create an interest income for the company. Understanding how these two parts come together is critical to understanding how they are both viable investments.

A life insurance policy will pay out a death benefit when a policy holder dies. The amount of this death benefit is determined by the insurance provider. Most often, the insured pays a fixed rate of return on the death benefit in return for the death benefit being tax free. Some life insurance policies provide a variable return, meaning that the insured may choose a pre-determined percentage in which to invest the death benefit.

A cash value life policy is one in which you pay a fixed rate of return regardless of how well the insured’s financial circumstances change. While you don’t need insurance during your golden years, you do need it while you are older. How does this differ from a permanent or term policy? Term insurance only pays out if the policyholder dies during the term. A cash value policy provides a way to benefit your family today while building cash value over time with little effort. You don’t need to liquidate all your cash in order to pay your premiums; you simply give the policy to the beneficiaries and they in turn pay the premiums.

Another major difference between a term insurance policy and a permanent life insurance policy is that the former provides you with an opportunity to borrow against the cash value. With a term policy, if you were to have an accident your policy would end up being worthless. With a permanent life insurance policy, however, you can borrow against the policy’s value. If you need to borrow more money than you paid in initially, you simply pay more money as premiums and the borrowing will continue until you’ve paid back the loan. With a permanent life insurance policy, however, there is no guarantee as to how much money the policy holder will have available at any one point in time.

As you can see, both permanent and term life insurance are important investments. However, you need to know which one you’re going for. Before you choose a particular type of policy, it’s wise to consult a professional who can guide you in the right direction. The Internet is full of helpful information on both types of policies, so before you invest in anything, be sure to read up on the matter.

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