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What Is Life Insurance and How Does It Work?

Life Insurance can be defined as a contract between an insurance policy holder and an insurance company, where the insurer promises to pay a sum of money in exchange for a premium, upon the death of an insured person or after a set period, which can help cover lost income or pay off debt.

Originally designed to help cover burial costs and care for widows and orphans, life insurance is now a flexible and powerful financial product.

Life insurance can be issued as either an individual or group policy. We’ll be looking at individual policies, not the group life insurance commonly issued through work.

Life insurance is a contract between you and an insurance company. In exchange for premium payments, the insurance company pays a death benefit to your beneficiaries when you die. Life insurance typically covers natural and accidental deaths. Some policies also offer “living benefits,” which means they pay out a portion of the death benefit while you’re still alive, if you’re diagnosed with a covered chronic, critical or terminal illness.

What does life insurance cover?

The main purpose of life insurance is to provide money for your beneficiaries when you die. But how you die can determine whether the insurer pays out the death benefit. Depending on the type of policy you have, life insurance can cover:

  • Natural deaths. Dying from a heart attack, disease or old age are examples of natural deaths. 

  • Accidental deaths. Accidents may include car crashes, drowning or poisoning

  • Suicide. Most life insurance policies cover suicide, but only if it occurs after the policy's waiting period — typically the first two years of the policy.

  • Homicide. Life insurance often covers homicides, but the circumstances of the death can affect the payout. For example, if a beneficiary murders the insured person, the killer won’t receive the death benefit.

  • Illness or injuries. Some policies offer coverage for illness or injuries while you’re still alive. For example, a critical or chronic illness rider covers conditions like cancer, as well as conditions that permanently inhibit your daily activities. An accelerated death benefit rider provides access to your death benefit if you’re diagnosed with a terminal illness.

  • War or terrorism. Some life insurance policies may exclude death as a result of war or terrorism.

What does life insurance not cover?

  • Criminal activities. In general, if you die while committing a crime, your beneficiaries won’t receive the death benefit. This can apply to drug and alcohol abuse. For example, if you die while driving drunk — an illegal activity — the policy typically won’t cover the death.

  • High-risk hobbies. Some policies won’t pay out if you die while participating in a hazardous hobby, like skydiving. 

  • Misrepresentation. If you lie on your life insurance application, the insurer may cancel your policy. Make sure you're as honest and open as possible when applying for coverage. 

Common life insurance terminology

  • The insurer

Life insurance may only be offered by selected firms, which are governed by state insurance offices.

  • The policyholder

A person or groups like a family trust or a firm that owns (or “hosts”) the insurance. The policy might cover the holder or the other person.

  • The insured

The person whose life is protected.

  • The death benefit

The sum that the insurance company will pay if the insured dies.

  • The winners

The persons or entities who will get the death benefit. It may all go to one person or be shared in portions with many different persons and groups.

  • The policy’s duration

The time during which the insurer accepts to give a death payout. This may be a fixed term or permanent insurance that lasts for the insured’s entire life as long as payments are paid.

  • The premium

Monthly or annual payments are required to retain the coverage in force.

  • The monetary worth

Permanent life insurance products, like full life insurance, contain a cash value factor that grows over time and may be paid out or lent upon. The term policy has no financial worth.

Life Insurance Plans’ Advantages

Life insurance policies are long-term investing and security plans that offer a range of benefits. Some of the key perks of life insurance policies are:

Financial Safety

A key advantage of every life insurance policy is that it gives financial stability to your family. A death benefit is offered in most life insurance plans. If you die within the policy’s term, your family members get a predetermined sum known as the sum insured. This assures that your families are fiscally secure even when you are not around.

Forms a Savings Habit

To make your life insurance coverage valid, you must pay regular sums called premiums. Your coverage may be revoked if you do not pay your premiums. Thus, by saving regularly, you instil a savings habit that will benefit you in the long term.

Adds to Tax Savings

The government has made various investment products tax-deductible to encourage saving and investing. One such tool is life insurance. Under Section 80C of the Income Tax Act of 1961, you may claim a tax credit of up to Rs. 1.5 lakh for the premiums you make in a year. As a result, you may benefit from both investment and tax savings.

Reach Big Monetary Targets

Most life insurance plans gain monetary value as time passes. Life insurance plans, such as ULIPs, have an investing part too. Your premium is put in tradable assets and gets a return. They grow over time into a vast corpus that may be utilised to fulfil aims such as your kid’s schooling, marriage, and so on.

Wealth Safety and Sharing

Life insurance policies are among the most secure long-term investment prospects. Thus, having life insurance means you may protect your money from taxation and inflation for a long period. This aspect means that a life insurance policy is a good tool for retired people to create long-term pensions.

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