Life Insurance 101
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. You can take steps to stay in good financial health when unexpected events bring sudden expenses by buying insurance coverage for various risks, including your own death.
Life insurance can help you protect your loved ones’ financial well-being when you pass away, which can help reduce their feelings of stress during a difficult time. And it 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 a loss. It pays a death benefit1 to the persons named as beneficiaries in the policy upon the death of the insured.
When you purchase a life insurance policy, you pay premiums to the insurance company. Then, in exchange, you get the promise that your chosen beneficiaries will receive a payment that can help them meet their financial obligations if you, the insured person, passes away.
What are the different types of life insurance?
There are two basic types of life insurance: term and permanent. Term life insurance is coverage intended for a specific time period, known as the term. If you as the insured pass away during the term, your named beneficiaries will receive the death benefit, but if you outlive the term, they won't receive it.
With term life insurance, you choose the exact term length and coverage amount, and you only pay for the insurance you need. Term life insurance tends to more affordable because of its simplicity and set timeframe.
In contrast, permanent life insurance provides coverage for your entire lifetime, if all required premiums are paid. As a result, it can provide your beneficiaries with a death benefit regardless of when you pass away. 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 and those who are comfortable with the higher premiums.
What are the benefits of life insurance?
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 pay debts you leave behind, make mortgage payments, and meet obligations like caring for elderly relatives or paying for a child's education.
Finally, 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 health care.
How does life insurance work?
An application for a life insurance policy must go through underwriting. This is the process that insurers use to figure out how risky you are to insure. For example, young and healthy non-smokers may pay less for life insurance policies 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.
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 you would have to renew it, perhaps with a riskier health outlook that could increase the cost or even disqualify you.
When you pass away, the death benefit is then paid out to your named beneficiaries, assuming you have sufficiently paid your premiums and the policy is still active. The death benefit can vary in size and structure depending on the type of life insurance. You determine the exact coverage when you buy the policy.
The bottom line
Life insurance can be a powerful tool in a broader financial strategy that aims to lower risks. Finding the right coverage can offer significant benefits for your loved ones, helping safeguard their financial health and plan for their future.