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What is Life Insurance and How Does It Work

Russell Cain Fact Checked Updated: 19 November 2020

When you move out of your parents’ house and become financially independent, buying insurance is often seen as the ‘grown-up’ thing to do. You know it’ important and that you’re supposed to have it, but you’re not entirely sure why or what’s the benefit.

Life insurance is a way to protect your loved ones from financial strain should you die or be diagnosed with a terminal illness. However, other insurance types fall under this umbrella term, and these might protect you should you suffer an illness or injury, depending on the type you choose — for example, TPD insurance, Critical Illness cover, and Income Protection insurance.

Use the below life insurance guide to help you understand what life insurance is, how it works, whether it will benefit you and how to buy a policy suited to your requirements.

Life insurance definition

Life insurance pays your nominated beneficiaries a lump sum amount, generally referred to as a death benefit, when you pass away or get diagnosed with a terminal illness and die within 12 to 24 months, depending on your insurer. In Australia, the death benefit will pay out should you die within a defined term, usually up to your age 100, and is referred to as a term life insurance policy.

What are the benefits of life insurance?

Life insurance generally benefits people that have outstanding debts and ongoing financial obligations. Investing in a life insurance policy provides your loved ones with a more secure financial future. When you pass away, the lump sum benefit pay-out can be used to cover the mortgage/rent, outstanding debt and medical expenses, as well as your funeral costs.

Life insurance companies generally pay the death benefit after receiving a valid death certificate and completed claim forms. However, the company is usually not obliged to pay the death benefit when:

Why should you buy life insurance?

The most obvious reason people typically buy life insurance cover is to safeguard your family against the possible financial constraints that might occur because of your untimely death, supporting them in maintaining the lifestyle they’ve grown accustomed to. Essentially, you’re paying for the peace of mind that your beneficiaries could use the lump sum pay-out to:

How does life insurance work?

Life insurance is a legal contract between the policy owner and the insurer, wherein you pay the insurer a premium in exchange for a death benefit to be paid to your nominated beneficiaries when the insured person dies or gets diagnosed with a terminal illness. Generally, it provides cover 24/7 worldwide for all types of death, excluding suicide within the first 13-months.

  • Policy owner: The person that owns and pays for the policy.
  • Insured person: The person receiving the protection/coverage.
  • Beneficiary: The person(s) nominated to receive the lump sum benefit should the insured person pass away.
  • Premium: How much the policy will cost you. Generally, you’ll have the option between stepped and level premiums.
  • Death benefit: The lump sum life insurance payout your beneficiaries will receive when the insured person dies. When you purchase the policy, you usually determine the amount you want to be covered for.

There are many things to consider when purchasing a life insurance policy, but thethree most important decisions are usually the type of life insurance you buy, the cover amount you need and the premium you can afford.

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What are the different types of life insurance?

There are different types of personal insurance types you should consider depending on your stage of life and specific requirements:

Term life insurance

Pays out a lump sum to your beneficiaries if you die or become diagnosed with terminal illness. Coverage will generally cease at the end of the predetermined term.

TPD cover

Total and permanent disablement insurance pays you a lump sum benefit in the event you are totally and permanently disabled because of a sickness or accident, as per your selected TPD definition.

Trauma Insurance

Pays you a lump sum benefit should you be diagnosed with one of the critical illnesses listed in your product disclosure statement (PDS).

Income protection insurance

Generally, provides you up to 75% of your regular income when an illness or injury leaves you unable to work for longer than your waiting period.

How much life insurance do you need?

The amount of coverage that’s enough for you depends on various factors, for example, the type of personal insurance you want, whether you have people depending on you financially, the amount of outstanding debt you have and the stage of life you’re in; single, couple, family or nearing retirement. Most people generally need at least an amount equal to 10 times their annual salary.

What’s the average cost of life insurance?

What you’ll pay for life insurance cover largely depends on how the company evaluates your risk factors, including your age, gender, health, smoking status, location, and your lifestyle. The amount of cover you purchase and your style of premium (stepped or level) will also contribute to how affordable your life insurance policy will be.

How do you buy life insurance?

You can typically complete the purchasing process in just a few steps:

  1. Gather free quotes online: Comparing premiums, benefits and features from a variety of companies allows you to make a better-informed decision.
  2. Choose your policy: Assess your needs and budget. When in doubt request guidance from an insurance broker.
  3. Apply for a policy: You can generally fill out an application online. The insurer will typically require that you provide some personal, financial and health-related information.
  4. Telephonic interview: In some cases, an insurance representative will give you a call to complete your medical questionnaire and/or request that you sign a medical authorization letter so they may contact your Doctors to request your relevant medical history.
  5. Underwriting process: The insurer’s underwriting team complete your risk assessment based on the information provided to determine your acceptance status and the premium you’ll pay.
  6. Your acceptance status revealed: You’re informed on whether your policy has been approved or not and on which terms and conditions.
  7. Policy commences: Your product disclosure statement (PDS) and policy documents are delivered, and your first premium payment gets deducted.

How long does the purchasing process take?

How long the life insurance application process will take usually depends on the type and level of insurance coverage you’re purchasing, as well as your medical history. If you have a pre-existing medical condition, the buying process may take longer as the insurer usually needs to gather information from your medical practitioners to accurately assess your risk factors.

When should you review your policy?

Ideally, you should review your policy annually or at least every time a significant life event occurs, for example, you’ve changed careers, bought a house, gotten married and started a family. The reason you need to review your policy is to ensure it’s still providing you value for money. As your life changes, so should your insurance.

Frequently asked questions

  • Is life insurance an investment?

    No, in Australia whole life insurance, that has both an insurance and investment component, is no longer available. Only term life cover, which has no cash-value element, can be purchased. However, term life insurance is generally a lot cheaper than whole life cover.
  • What is ‘advised’ life insurance?

    Advised life insurance is generally defined as life cover you obtain via the guidance of a financial adviser that provides you with specific recommendations tailored to suit your needs and circumstances, this form of advice is referred to as personal advice and should only be delivered by an adviser with an AFS license.

    Not to be confused with a life insurance broker, who offers general advice based on your unique requirements so that you can make a better-informed decision. General advisers do not take your personal needs into account but instead empowers you to confidently make insurance decisions for yourself, usually by providing you with educational material.

  • What is the best age to get life insurance?

    Generally, the best time to buy life insurance is when it’s most affordable, which is usually between the ages of 18 and 35, depending on your specific requirements. Typically, when you are young, you are still healthy and thus a lower risk to the insurer and might, therefore, get better rates. You might want to consider buying life cover when you have outstanding debts, a mortgage or loved ones depending on you financially.
  • Does it cover funeral costs?

    Depending on your insurer, your life insurance policy might have a funeral advancement benefit, which generally pays a percentage of your lump sum death benefit in advance after receipt of a valid death certificate and claims forms. This benefit can then be used to cover the cost of your final expenses, including your funeral.
  • How does life insurance work when you die?

    Generally, your life insurance benefit is paid to your nominated beneficiaries when they completed the claims process and provided the insurer with a copy of your death certificate. Once the claim has been approved, the lump sum death benefit is usually paid tax-free to beneficiaries that are financial dependents.
  • What happens to your cover when everyone dies?

    Should the life insured, and all their listed beneficiaries die, then the benefit will usually be paid to the policy owner’s estate, upon which the executor of the estate will divide the benefit as per the policy holder’s Will.

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  • Protect your family
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