Life insurance is a very common asset that figures into many people's long-term financial planning. Purchasing a life insurance policy is a way to protect your loved ones, providing them with the financial support they may need after you die. For example, you may purchase life insurance to help your spouse cover mortgage payments or everyday bills or fund your children's college education.
When purchasing life insurance, it's important to understand how it works and how your beneficiaries can receive the proceeds of your policy. This can help with choosing a payout option that works best for your estate planning goals.
- Life insurance is a contract between a policyholder and an insurance company that's designed to pay out a death benefit when the insured person passes away.
- A life insurance company should be contacted as soon as possible following the death of the insured to begin the claims and payout process.
- It's important to choose life insurance beneficiaries carefully to ensure that the right people are eligible to received proceeds from your policy.
- There are different ways a beneficiary may receive a life insurance payout, including lump sum payments, installment payments, annuities and retained asset accounts.
Life Insurance Basics
Life insurance is a type of insurance contract. When you purchase a life insurance policy, you agree to pay premiums to keep your coverage intact. If you pass away, the life insurance company can pay out a death benefit to the person or persons you named as beneficiaries to the policy.
Some life insurance policies can offer both death benefits and living benefits. A living benefit rider allows you to tap into your policy's death benefit while you're still alive. This type of rider can be beneficial in situations where you're terminally ill and need funds to pay for medical care.
"Some life insurance companies have designed policies that allow their policyholders to draw against the face value of the policy in the event of a terminal, chronic or critical illness. These policies enable the policyholder to be the beneficiary of their own life insurance policy," says Ted Bernstein, owner of Life Cycle Financial Planners LLC.
When purchasing life insurance, it's important to consider:
- How much coverage you need
- Whether a term life or permanent life policy makes more sense
- What you'll pay for premiums
- Which riders, if any, you'd like to include
In terms of coverage amounts, a life insurance calculator can be helpful in choosing a death benefit. Term life insurance covers you for a set term while a permanent life insurance policy covers you for life as long as premiums are paid. Between the two, term life tends to be cheaper but permanent life insurance can offer benefits such as cash value accumulation.
Life insurance premium costs can depend on the type of policy, the amount of the death benefit, the riders you include and your overall health. It's not uncommon to have to complete a paramedical exam as part of the underwriting process.
Hybrid life insurance policies allow you to combine life insurance coverage with long-term care insurance.
Choosing a Life Insurance Beneficiary
As part of the process when buying life insurance, you'll need to designate one or more beneficiaries. This is who you want to receive the death benefit from your policy when you pass away. A life insurance beneficiary can be:
- A spouse
- Adult child
- Business partner
- Charitable organization
- A trust
You can choose to name a single beneficiary or a primary beneficiary and one or more contingent beneficiaries. A contingent beneficiary would receive death benefits from your life insurance policy if the primary beneficiary passes away.
Minor children can't be named as beneficiaries to a life insurance policy.
Filing a Claim
Death benefits are not paid out automatically from a life insurance policy. The beneficiary must first file a claim with the life insurance company. Depending on the insurance company's policies, this may be done online or it may require a paper claims filing. No matter how you end up filing, the company normally requires paperwork and supporting evidence to process the claim and payout.
If you're the beneficiary of someone's life insurance policy, you may be required to provide a copy of the policy along with the claims form. You must also submit a certified copy of the death certificate, either through the county or municipality or through the hospital or nursing home in which the insured died.
“The death certificate has to be submitted to the insurance company address listed in the policy along with a statement of claim, which is sometimes called a request for benefits, signed by the beneficiary,” says retired insurance lawyer Luke Brown.
There's no set deadline for how long you have to file a life insurance claim but the sooner you do so, the better.
When Benefits Are Paid
Life insurance benefits are typically paid when the insured party dies. Beneficiaries file a death claim with the insurance company by submitting a certified copy of the death certificate. Many states allow insurers 30 days to review the claim, after which they can pay it out, deny it, or ask for additional information. If a company denies your claim, it generally provides a reason why.
Most insurance companies pay within 30 to 60 days of the date of the claim, according to Chris Huntley, founder of Huntley Wealth & Insurance Services.
“There is no set time frame," he adds. "But insurance companies are motivated to pay as soon as possible after receiving bona fide proof of death, to avoid steep interest charges for delaying payment of claims."
Life Insurance Policies: How Payouts Work
There are several possible situations that may result in a delay in payment. Beneficiaries may face delays of six to 12 months if the insured dies within the first two years of the issuance of the policy. The reason: the one- to two-year contestability clause.
"Most policies contain this clause, which allows the carrier to investigate the original application to ensure fraud was not committed. As long as the insurance company cannot prove the insured lied on the application, the benefit will normally be paid," says Huntley. Most policies also contain a suicide clause that allows the company to deny benefits if the insured commits suicide during the first two years of the policy.
Payments may also be delayed when homicide is listed on the insured's death certificate. In this case, a claims representative may communicate with the detective assigned to the case to rule out the beneficiary as a suspect. The payout is held until any suspicion about the beneficiary's involvement in the insured's death is clear. If there are charges, the insurance company can withhold the payout until charges are dropped or the beneficiary is acquitted of the crime.
Delays to payouts may also arise if:
- The insured party died during the course of illegal activity, such as driving under the influence.
- The insured party lied on the policy application.
- The insured omitted health issues or risky hobbies/activities like skydiving.
Insurance companies can delay payment for six to 12 months if the insured party dies within the first two years of the policy.
You can also help decide how your death benefit will be paid out after you die. Here are a few of the payout choices available to you and your beneficiaries.
Since the inception of the industry more than 200 years ago, beneficiaries have traditionally received lump-sum payments of the proceeds. The default payout option of most policies remains a lump sum, says Richard Reich, president of Intramark Insurance Services, Inc.
Installments and annuities
Modern life insurance policies have seen a monumental improvement in how payouts can be delivered to the policy's beneficiaries, says Bernstein. These include an installment-payout option, or an annuity option, in which the proceeds and accumulated interest are paid out regularly over the life of the beneficiary. These choices give the policy owner the opportunity to select a pre-determined, guaranteed income stream of between five and 40 years.
"For income-protection life insurance, most life insurance buyers prefer the installment option to guarantee the proceeds will last for the necessary number of years," says Bernstein.
Beneficiaries should remember that any interest income they receive is subject to taxation. You may end up better off with the lump sum rather than installments, as you'll end up paying more in taxes on the interest if the death benefit is fairly high.
Retained asset account
Some insurers offer beneficiaries of large policies a checkbook instead of a lump sum or regular installments. The insurance company, acting as a bank or financial institution, keeps the payout in an account, allowing you to write checks against the balance. Such an account would not allow deposits but would pay interest to the beneficiary.
The term for this is accelerated death benefit. (For related insight, take a closer look at accelerated benefit riders.) Traditionally, life insurance policies will only pay out at the time of the policyholder’s death. Talk with your insurance agent about whether this option makes sense for you.
Consider talking to your insurance agent and/or estate planning attorney about which payout option might work best.
The Bottom Line
Life insurance policies provide both policyholders and their loved ones peace of mind that financial difficulties may be avoided in the event of a person’s death. Understanding how the process works, from buying life insurance to filing a claim to receiving a payout, can help you proceed with your plans to purchase coverage confidently.