What Is Life Insurance?
Life insurance is a contract between an insurer and a policyholder in which the insurer guarantees payment of a death benefit to named beneficiaries when the insured dies. The insurance company promises a death benefit in exchange for premiums paid by the policyholder.
- Life insurance is a legally binding contract.
- For the contract to be enforceable, the life insurance application must accurately disclose the insured’s past and current health conditions and high-risk activities.
- For a life insurance policy to remain in force, the policyholder must pay a single premium up front or pay regular premiums over time.
- When the insured dies, the policy’s named beneficiaries will receive the policy’s face value, or death benefit.
- Term life insurance policies expire after a certain number of years. Permanent life insurance policies remain active until the insured dies, stops paying premiums, or surrenders the policy.
- A life insurance policy is only as good as the financial strength of the company that issues it. State guaranty funds may pay claims if the issuer can’t.
Who Should Buy Life Insurance?
Life insurance provides financial support to surviving dependents or other beneficiaries after the death of an insured. Here are some examples of people who may need life insurance:
- Parents with minor children – If a parent dies, the loss of their income or caregiving skills could create a financial hardship. Life insurance can make sure the kids will have the financial resources they need until they can support themselves.
- Parents with special-needs adult children – For children who require lifelong care and will never be self-sufficient, life insurance can make sure their needs will be met after their parents pass away. The death benefit can be used to fund a special needs trust that a fiduciary will manage for the adult child’s benefit.
- Adults who own property together – Married or not, if the death of one adult would mean that the other could no longer afford loan payments, upkeep, and taxes on the property, life insurance may be a good idea. An example would be an engaged couple who took out a joint mortgage to buy their first house.
- Elderly parents who want to leave money to adult children who provide their care – Many adult children sacrifice by taking time off work to care for an elderly parent who needs help. This help may also include direct financial support. Life insurance can help reimburse the adult child’s costs when the parent passes away.
- Young adults whose parents incurred private student loan debt or cosigned a loan for them – Young adults without dependents rarely need life insurance, but if a parent will be on the hook for a child’s debt after their death, the child may want to carry enough life insurance to pay off that debt.
- Young adults who want to lock in low rates – The younger and healthier you are, the lower your insurance premiums. A 20-something adult might buy a policy even without having dependents if there is an expectation to have them in the future.
- Wealthy families who expect to owe estate taxes – Life insurance can provide funds to cover the taxes and keep the full value of the estate intact.
- Families who can’t afford afford burial and funeral expenses – A small life insurance policy can provide funds to honor a loved one’s passing.
- Businesses with key employees – If the death of a key employee, such as a CEO, would create a severe financial hardship for a firm, that firm may have an insurable interest that will allow it to purchase a life insurance policy on that employee.
- Married pensioners – Instead of choosing between a pension payout that offers a spousal benefit and one that doesn’t, pensioners can choose to accept their full pension and use some of the money to buy life insurance to benefit their spouse. This strategy is called pension maximization.
How Life Insurance Works
A life insurance policy can has two main components - a death benefit and a premium. Term life insurance has these two components, but permanent or whole life insurance policies also have a cash value component.
- Death Benefit – The death benefit or face value is the amount of money the insurance company guarantees to the beneficiaries identified in the policy when the insured dies. The insured might be a parent, and the beneficiaries might be their children, for example. The insured will choose the desired death benefit amount based on the beneficiaries’ estimated future needs. The insurance company will determine whether there is an insurable interest and if the proposed insured qualifies for the coverage based on the company’s underwriting requirements related to age, health, and any hazardous activities in which the proposed insured participates.
- Premium – Premiums are the money the policyholder pays for insurance. The insurer must pay the death benefit when the insured dies if the policyholder pays the premiums as required, and premiums are determined in part by how likely it is that the insurer will have to pay the policy’s death benefit based on the insured’s life expectancy. Factors that influence life expectancy include the insured’s age, gender, medical history, occupational hazards, and high-risk hobbies. Part of the premium also goes toward the insurance company’s operating expenses. Premiums are higher on policies with larger death benefits, individuals who are higher risk, and permanent policies that accumulate cash value.
- Cash Value – The cash value of permanent life insurance serves two purposes. It is a savings account that the policyholder can use during the life of the insured; the cash accumulates on a tax-deferred basis. Some policies may have restrictions on withdrawals depending on how the money is to be used. For example, the policyholder might take out a loan against the policy’s cash value and have to pay interest on the loan principal. The policyholder can also use the cash value to pay premiums or purchase additional insurance. The cash value is a living benefit that remains with the insurance company when the insured dies. Any outstanding loans against the cash value will reduce the policy’s death benefit.
Types of Life Insurance
Many different types of life insurance are available to meet all sorts of needs and preferences.
- Term Life – Term life insurance lasts a certain number of years, then ends. You choose the term when you take out the policy. Common terms are 10, 20, or 30 years. The best term life insurance policies balance affordability with long-term financial strength.
- Level Term – The premiums are the same every year.
- Increasing Term – The premiums are lower when you're younger and increase as you get older. This is also called “yearly renewable term.”
- Permanent – This stays in force for the insured’s entire life unless the policyholder stops paying the premiums or surrenders the policy. It’s typically more expensive than term.
- Single Premium – In this case the policyholder pays the entire premium up front instead of making monthly, quarterly, or annual payments.
- Whole Life – Whole life insurance is a type of permanent life insurance that accumulates cash value.
- Universal Life – A type of permanent life insurance with a cash value component that earns interest, universal life insurance has premiums that are comparable to term life insurance. Unlike term and whole life, the premiums and death benefit can be adjusted over time.
- Guaranteed Universal – This is a type of universal life insurance that does not build cash value and typically has lower premiums than whole life.
- Variable Universal – With variable universal life insurance, the policyholder is allowed to invest the policy’s cash value.
- Indexed Universal – This is a type of universal life insurance that lets the policyholder earn a fixed or equity-indexed rate of return on the cash value component.
- Burial or Final Expense – This is a type of permanent life insurance that has a small death benefit. Despite the names, beneficiaries can use the death benefit as they wish.
- Guaranteed Issue – A type of permanent life insurance available to people with medical issues that would otherwise make them uninsurable, guaranteed issue life insurance will not pay a death benefit during the first two years the policy is in force (unless the death is accidental) due to the high risk of insuring the person. However, the insurer will return the policy premiums plus interest to the beneficiaries if the insured dies during that period.
Life Insurance Riders
Many insurance companies offer policyholders the option to customize their policies to accommodate their needs. Riders are the most common way policyholders may modify their plan. There are many riders, but availability depends on the provider. The policyholder will typically pay an additional premium for each rider or a fee to exercise the rider, though some policies include certain riders in their base premium.
- The accidental death benefit rider provides additional life insurance coverage in the event the insured’s death is accidental.
- The waiver of premium rider relieves the policyholder of making premium payments if the insured becomes disabled and unable to work.
- The disability income rider pays a monthly income in the event the policyholder becomes unable to work for several months or longer due to a serious illness or injury.
- Upon diagnosis of terminal illness, the accelerated death benefit rider allows the insured to collect a portion or all of the death benefit.
- The long-term care rider is a type of accelerated death benefit that can be used to pay for nursing home, assisted living, or in-home care when the insured requires help with activities of daily living, such as bathing, eating, and using the toilet.
- A guaranteed insurability rider lets the policyholder buy additional insurance at a later date without a medical review.
Each policy is unique to the insured and insurer. It’s important to review your policy document to understand what risks your policy covers, how much it will pay your beneficiaries, and under what circumstances.
How Much Life Insurance to Buy
Before you apply for life insurance, you should analyze your financial situation and determine how much money would be required to maintain your beneficiaries’ standard of living or meet the need for which you’re purchasing a policy.
For example, if you are the primary caretaker and have children who are two and four years old, you would want enough insurance to cover your custodial responsibilities until your children are grown up and able to support themselves. You might research the cost to hire a nanny and a housekeeper, or to use commercial childcare and a cleaning service, then perhaps add some money for education. Add up what these costs would be over the next 16 or so years, add more for inflation, and that’s the death benefit you might want to buy—if you can afford it.
It’s prudent to reevaluate your life insurance needs annually or after significant life events, such as divorce, marriage, the birth or adoption of a child, or major purchases, such as a house. You may need to update the policy’s beneficiaries, increase your coverage, or even reduce your coverage.
Qualifying for Life Insurance
Insurers evaluate each life insurance applicant on a case-by-case basis, and with hundreds of insurers to choose from, almost anyone can find an affordable policy that at least partially meets their needs. In 2018 there were 841 life insurance and annuity companies in the United States, according to the Insurance Information Institute.
On top of that, many life insurance companies sell multiple types and sizes of policies, and some specialize in meeting specific needs, such as policies for people with chronic health conditions. There are also brokers who specialize in life insurance and know what different companies offer. Applicants can work with a broker free of charge to find the insurance they need. This means that almost anyone can get some type of life insurance policy if they look hard enough and are willing to pay a high enough price or accept a perhaps less-than-ideal death benefit.
Insurance is not just for the healthy and wealthy, and because the insurance industry is much broader than many consumers realize, getting life insurance may be possible and affordable even if previous applications have been denied or quotes have been unaffordable.
In general, the younger and healthier you are, the easier it will be to qualify for life insurance, and the older and less healthy you are, the harder it will be. Certain lifestyle choices, such as using tobacco or engaging in risky hobbies such as skydiving, also make it harder to qualify or lead to higher rates.
Additional Uses for Life Insurance
Most people use life insurance to provide money to beneficiaries who would suffer a financial hardship upon the insured’s death. However, for wealthy individuals, the tax advantages of life insurance, including tax-deferred growth of cash value, tax-free dividends, and tax-free death benefits, can provide additional strategic opportunities.
Funding Retirement – Policies with a cash value or investment component can provide a source of retirement income. This opportunity can come with high fees and a lower death benefit, so it may only be a good option for individuals who have maxed out other tax-advantaged savings and investment accounts. The pension maximization strategy described earlier is another way life insurance can be used to fund retirement.
Avoiding Taxes – The death benefit of a life insurance policy is usually tax free. Wealthy individuals sometimes buy permanent life insurance within a trust to help pay the estate taxes that will be due upon their death. This strategy helps to preserve the value of the estate for their heirs. Tax avoidance is a law-abiding strategy for minimizing one’s tax liability and should not be confused with tax evasion, which is illegal.
Borrowing Money – Most permanent life insurance accumulates cash value that the policyholder can borrow against. Technically, you are borrowing money from the insurance company and using your cash value as collateral. Unlike with other types of loans, the policyholder’s credit score is not a factor. Repayment terms can be flexible, and the loan interest goes back into the policyholder’s cash value account. Policy loans can reduce the policy’s death benefit, however.