Life insurance is a contract between an insurance company and a policyholder where the insurer agrees to pay a lump sum of money if the insured person dies during a covered period in exchange for premium payments. If you have people who depend on you financially, you probably need life insurance.
In this article, we’ll cover the types of life insurance policies, the benefits of life insurance and how to get coverage. But first, to understand how life insurance works, you need to understand a few key terms.
Life insurance policy: The agreement between the insurance company and the policyholder to insure someone’s life.
Policyholder or policy owner: The person who owns the life insurance policy. Typically, this is the person whose life is insured.
Death benefit: The sum of money the insurer pays out when the covered person dies.
Beneficiary: The individual who receives the death benefit payout when the insured person passes. You can have a single beneficiary or multiple beneficiaries.
Premiums: The monthly or annual payments the policyholder pays to keep the policy in force.
Policy riders: Optional add-ons to a life insurance policy that are available for an extra cost.
Types of life insurance policies
There are two basic types of life insurance policies: term life insurance and permanent life insurance. The key difference is that term insurance only covers you for a specified period of time, whereas permanent life insurance covers you for your entire life. Also, permanent life insurance policies have a savings component called cash value, whereas term policies don’t.
Term life insurance
A term life policy pays a death benefit only if you die within a certain period, i.e., 20 years or 30 years. If you don’t die during the term, the policy expires without paying out money. Term life insurance policies don’t accumulate cash value. However, premiums are much cheaper than permanent life insurance premiums.
Whole life insurance
Whole life insurance is the most common type of permanent life insurance. Also referred to as ordinary life insurance, these policies offer a guaranteed death benefit, plus cash value that grows at a rate guaranteed by your insurer. If you choose what’s called a participating policy, the insurer may also pay dividends. For all these benefits, you’ll pay a higher premium.
Universal life insurance
Universal life insurance is a type of permanent coverage that’s more flexible than whole life coverage. You can adjust the premiums (within limits) and your death benefit as your financial situation and needs change. The insurer guarantees a minimum cash value growth, but the interest you earn will vary based on money market rates.
Variable life insurance
Like universal life insurance, variable life insurance offers flexible premium payments and death benefits, but you’re allowed to invest the policy’s cash value in underlying sub-accounts similar to mutual funds. Because the cash value is linked to financial market performance, variable life policies are riskier than other life insurance options.
How life insurance works
When you apply for a policy, the life insurance company will review your medical records and often require a physical exam to determine how risky of an applicant you are. Essentially, they’re assessing the likelihood that you’ll die during the covered period. The underwriting process determines how much coverage you qualify for and how much you’ll pay.
You’ll pay your premiums at regular intervals, i.e., monthly, quarterly or annually. If you miss premium payments, your policy could eventually lapse. Your premiums go toward:
Insurer expenses: The portion that goes toward the insurer’s business expenses and profits.
Cost of insurance: The amount that’s used to pay for death benefits.
Cash value: If you have permanent life insurance (but not term insurance), part of your premium goes toward the cash value component. You can use the cash value to make partial withdrawals, take a policy loan, pay your premiums or withdraw it all and surrender the policy.
Regardless of what type of policy you have, the death benefit is generally income tax-free for your beneficiaries. If you have permanent life insurance, your cash value grows on a tax-deferred basis as long as the policy is in force. You can take tax-free loans or withdrawals against the policy if the amount you take out isn’t more than your cost basis, i.e., what you paid in premiums.
Purpose and benefits of life insurance
The most important reason you’d want to buy life insurance is to avoid putting a financial burden on your loved ones when you die. Beyond that peace of mind, some specific reasons for buying life insurance include:
Paying for final expenses. The median cost of a funeral with a viewing and burial was $7,848 in 2021, according to the National Funeral Directors Association. Life insurance — and specifically burial insurance — can help your loved ones pay for these costs and other final expenses.
Income replacement. Buying life insurance can help replace your income if you die, allowing those who financially depend on you to maintain their standard of living. Some people also opt for a death benefit that would cover the cost of their children’s education and/or college tuition.
Paying off a mortgage or other debt. Obtaining a policy with a large enough benefit to pay off your mortgage and any other debt provides financial protection for your partner or spouse. If you have debt that someone else cosigned for, you might consider buying life insurance for at least that amount so they won’t be stuck paying it off if you die.
Providing a tax-advantaged supplement to retirement savings. Buying cash value life insurance can provide a tax-deferred way to save for retirement, particularly if you’re already maxing out tax-deferred accounts, like a 401(k) and individual retirement account (IRA).
Leave a legacy. Choosing permanent life insurance can allow you to leave a guaranteed inheritance to your loved ones or make a substantial gift to charity.
Pay for estate taxes. With the federal estate tax exemption at $12.92 million in 2023, most people don’t need to worry about estate taxes. But some high-net-worth people use life insurance as an estate-planning tool to cover the tax bill.
Determining your coverage amount
There’s no one-size-fits all method to determine how much life insurance coverage is sufficient, but there are a few common formulas that can help you gauge your needs. Keep in mind that these are rough estimates. Consider working with a financial professional to determine the amount of life insurance coverage and the best life insurance policy type for your unique situation.
Multiple of income
Determine how many years you’d want to replace your income for, then multiply your salary by that number. If you earn $50,000 a year and want to replace your income for 20 years, you need a $1 million death benefit.
Younger people will usually want to choose a higher multiple than older individuals because they have more potential future earnings. Someone who’s 35 may want to replace 30 years of income, while replacing 10 years of income may suffice for a 60-year-old.
10 times your income plus college costs
In this formula, you multiply your income by 10, then add in the costs of higher education for your children. Many experts recommend estimating college costs at $100,000 to $150,000 per child.
With the DIME formula, you add up the following amounts to estimate how much life insurance you need:
Debt: Your total non-mortgage debt
Income: The amount of income you want to replace
Mortgage: The amount you need to pay off your mortgage in full
Education: The expected costs of your children’s education
Essentially, you’d use the multiple of income formula, then add in your total debt (including your mortgage payoff amount) and education costs to arrive at a benefit amount.
Pro tip: Even if no one relies on your income, you might still need life insurance. For example, stay-at-home parents of young children should consider buying a policy.
Life insurance process
The first step in the life insurance process is to decide what type of insurance you want, along with how much coverage you’re seeking. Then, you can obtain a quote online or through a life insurance agent. To get an accurate life insurance quote, you’ll usually need to provide some basic information like your date of birth, gender, height and weight, tobacco usage, and whether you take blood pressure or cholesterol medication.
Once you’ve chosen the policy you want, you’ll need to complete the application. The typical underwriting process involves a detailed health questionnaire and a medical exam. The insurer may also ask you to get what’s called an attending physician statement from your doctor if they need more context about any health issues.
After your application is approved, you’ll need to review the policy documents and sign the contract. Coverage will begin shortly after you make your first premium. To avoid a lapse in coverage, you’ll need to continue paying the premiums.
Pro tip: Some policies, known as guaranteed issue policies, approve nearly all applicants without requiring health information. But these policies have low death benefits, often $25,000 or less.
Conclusion: Do you need life insurance?
Not everyone needs life insurance. If you don’t have dependents and you have enough savings to pay for final expenses, you may not need coverage. However, if you hope to have a family someday, buying coverage while you’re young can help you lock in an affordable insurance rate.
To determine whether you need life insurance, consider whether anyone would be financially burdened if you die. If the answer is yes, life insurance is probably well worth the cost.
No one likes to think about dying. But it’s essential to take time to prepare for the worst to protect your loved ones’ well-being.