Life Insurance 101
E*TRADE from Morgan Stanley08/29/23
Summary: Understanding exactly what life insurance is, how it works, and what it can do for you and your family will help you decide what kind of policy and coverage you may need.
Life is unpredictable. Life insurance can help you protect your loved ones’ financial well-being, and can help make a difficult time slightly less stressful. Life insurance has several other financial upsides to consider as well.
What is life insurance?
Life insurance, like other forms of insurance, is a contract between an insurer and policyholder that provides financial protection against loss. It pays a death benefit1 to the people named as beneficiaries in the policy when the insured person dies.
When you purchase a life insurance policy, you pay premiums to the insurance company. In exchange, you get the promise that your chosen beneficiaries will receive a payment to help them meet their financial obligations and possibly reach their financial goals.
What are the different types of life insurance?
There are two basic types of life insurance: term and permanent.
Term life insurance
With term life insurance, you choose the exact term length, which is typically 10 to 30 years, and coverage amount, and only pay for the insurance you need for as long as you need it. Term life insurance tends to be more affordable because of its simplicity. Most life insurance policies available through employers are term life insurance, but they often have coverage limits that may not provide what you need. In addition, if you have a workplace plan and you move to another job, you typically lose this coverage.
There are two types of term life insurance: level and decreasing.
- With a level policy, you purchase a set amount of coverage, which does not change over the course of the term.
- With a decreasing-term policy, you also purchase insurance for a set period, but the coverage amount diminishes over the term. It’s intended to cover financial obligations that decrease over time, like a business loan or mortgage.
Permanent life insurance
As the name implies, permanent life insurance provides coverage for your entire lifetime, as long as you continue to pay premiums. However, permanent life insurance is often more expensive and more complex. Most types of permanent life insurance also have a savings-like cash value that grows over time, which can provide additional financial benefits during your lifetime—like the ability to take loans.2
Permanent policies may be a good fit for individuals with lifelong dependents, such as family members with special needs, and those who are comfortable with the higher premiums, or those who want to leave a financial legacy to their heirs.
What are the benefits of life insurance and how much should I have?
Life insurance’s primary advantage is that it offers your named beneficiaries a measure of financial protection with income replacement. If you were to pass away, they could use the death benefit to help them better manage their finances without your income.
The death benefit can help your loved ones in other ways as well. It can help them cover the cost of a funeral, pay debts you leave behind, make mortgage payments, and meet obligations like caring for elderly relatives or paying for a child's education.
The amount of coverage you should have depends on whether your heirs will use the proceeds for specific expenses like those outlined above or if you have dependents for whom you’re hoping to replace your income.
With permanent life insurance, you can often access money in the policy during your lifetime once its cash value reaches a certain amount.2 You could use this money for your own financial needs, like supplementing retirement income or paying for your care
How does life insurance work?
When you apply for life insurance, you must go through an underwriting process, which insurers use to figure out how risky you are to insure—and how much to charge for your policy. Young and healthy non-smokers typically pay less for life insurance policies than others because they are viewed as a lower risk. As you get older or if you have health complications, life insurance policies can become more expensive.
Many life insurance policies require a medical exam as part of the underwriting process. While it’s possible to get a policy without such an exam, you’ll typically have to pay a higher premium for that kind of policy.
After you buy a life insurance policy, you can usually expect your rates to stay the same during your policy period, even if you are diagnosed with a health condition during that time. Keep in mind that term life insurance does expire, so if you still need insurance at that time, you may need to reapply, perhaps with a riskier health outlook that could increase the cost or even disqualify you.
The bottom line
Life insurance can be a powerful tool in a broader financial strategy that aims to lower risks for you and your family. Finding the right coverage can offer significant benefits for your loved ones, helping safeguard their financial health and plan for their future.