What Is Life Insurance?
Life insurance is a type of financial product that is sold by insurance companies. When a covered individual dies, designated beneficiaries receive a death benefit in exchange for paying regular premiums.
While many financial professionals agree that life insurance is an important part of financial planning, the average person may not understand how it can benefit them or whether they even need it. Let's look at what you need to know about life insurance and how it can fit into your financial plans.
What Is Life Insurance?
Life insurance is essentially a contract between an insurance company and a policyholder. The contract states that the policyholder will pay fixed premiums to the insurer for a set period of time, and the insurer will pay a death benefit if the covered individual dies while the policy is in effect.
The insurer cannot change or cancel the life insurance policy if the covered individual's health changes, implying that life insurance provides a financial guarantee. However, insurance companies may refuse to insure certain people due to health issues, substance abuse, or other factors. Because the likelihood of death increases with age, age is frequently the most important factor influencing health insurance availability and cost.
Term and whole (or permanent) life insurance are the two most common types of life insurance. Term life insurance will only pay out if the insured person dies during the coverage term. There is no death benefit if the covered individual outlives the policy. Whole life insurance is typically more expensive than term life insurance, but the insurer will pay a death benefit if the policyholder dies.
How Does Life Insurance Work?
Begin by determining your needs before purchasing a life insurance policy. Many people buy life insurance as a form of income protection, ensuring that their family can maintain their standard of living even after the policyholder dies. Other financial considerations include paying for a funeral and burial, leaving an inheritance to heirs, or leaving a charitable legacy. Knowing how you want your beneficiaries to use the proceeds of your life insurance policy can help you determine how much coverage you need.
You can then compare the prices of various insurers' policies. While you can shop around to get a general idea of how much a policy with your desired death benefit will cost, you will almost certainly need to go through underwriting with an insurer to find out exactly how much your premiums will cost. Underwriting is the process by which an insurance company determines whether or not to insure you. Underwriting for life insurance can include anything from health questions to medical tests or exams.
You will pay the premiums in accordance with your insurance contract. When you die, your beneficiaries will receive the death benefit specified in your contract as long as you have coverage.
Types of Life Insurance
There are two basic types of life insurance: term and whole life insurance, but the whole life insurance umbrella includes some additional options:
- Traditional whole life insurance: Because this type of coverage provides a death benefit regardless of how long the policyholder lives, whole life insurance premiums are typically higher than term life insurance premiums. If you live long enough, your premiums will "overpay" for the death benefit, and the excess will be made available to the policyholder as a cash value in lieu of the death benefit.
- Universal whole life insurance: Also known as an adjustable life insurance policy, includes an interest-bearing savings vehicle (the cash value account). After a certain amount of money has accumulated in your cash value account, you may be able to change your premium payments. Loans from the cash value account are also permitted, and the death benefit remains in effect as long as there is enough money in the cash value account to cover the cost of the insurance.
- Variable life insurance: This type of whole life insurance policy combines a death benefit with a cash value account that can be invested. Policyholders have the option of investing in stocks, bonds, or money market mutual funds. This means that policyholders accept both the additional potential reward if the investments perform well and the potential risk if the investments do not perform well. The cash value and death benefit of a variable life insurance policy may decline depending on the performance of the underlying investments.
Do I Need Life Insurance?
To determine whether you require life insurance, ask yourself the following questions:
- Would my family be unable to cover my final expenses if I died unexpectedly?
- Is anyone dependent on my income to survive?
- Do I have a mortgage?
- Do I carry any other debt?
- Do I have a child who has not yet attended college?
- Am I the owner of a business?
- Is there anything I'd like to leave as a charitable gift or an inheritance for my family?
If you answered "yes" to any of these questions, you should think about purchasing life insurance. Although not everyone requires the financial protection provided by life insurance, those in any of the situations listed above are good candidates. If this describes you, you can use a life insurance policy to ensure that your death does not leave a financial burden behind.