What Is Life Insurance?
Understanding how life insurance works and how to shop for a policy can help you find the best coverage to meet your family’s needs. Life insurance is a contract between an insurance company and a policy owner in which the insurer guarantees to pay a sum of money to one or more named beneficiaries when the insured person dies in exchange for premiums the policyholder pays during their lifetime. The best life insurance companies have good financial strength, a low number of customer complaints, high customer satisfaction, several policy types available, optional riders, and easy application processes.
KEY TAKEAWAYS
- Life insurance is a legally binding contract that promises a death benefit to the policy owner when the insured person dies.
- The policyholder must pay a single premium upfront or pay regular premiums over time for the life insurance policy to remain in force,.
- When the insured person 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 person dies, stops paying premiums, or surrenders the policy.
- A life insurance policy is only as good as the financial strength of the life insurance company that issues it.
Types of Life Insurance
Many different types of life insurance are available to meet all sorts of needs and preferences. Depending on the short- or long-term needs of the person to be insured (or their family members), the choice of whether to select temporary or permanent life insurance a major consideration.
Term life insurance
Term life insurance is designed to last a certain number of years, then end. 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.1
- Decreasing term life insurance is renewable term life insurance with coverage that decreases over the life of the policy at a predetermined rate.
- Convertible term life insurance allows policyholders to convert a term policy to permanent insurance.
- Renewable term life insurance provides a quote for the year the policy is purchased. Premiums increase annually and are usually the least expensive term insurance in the beginning.
Many term life insurance policies allow you to renew the contract on an annual basis once the term is up. However, since the renewal premiums are based on your current age, the cost can rise steeply each year. A better solution for permanent coverage is to convert your term life insurance policy into a permanent policy. This is not an option on all term life policies, so look for a convertible term policy if this is important to you.
Permanent Life Insurance
Permanent life insurance is more expensive than term, but it stays in force for the insured’s entire life unless the policyholder stops paying the premiums or surrenders the policy. Some policies allow for automatic premium loans when a premium payment is overdue.2
- Whole life insurance is a type of permanent life insurance, which means it lasts your entire lifespan. It includes a cash value component, which is similar to a savings account. Cash-value life insurance allows the policyholder to use the cash value for many purposes, such as to take out loans or to pay policy premiums.
- Universal life (UL) insurance is another type of permanent life insurance with a cash value component that earns interest. Universal life features flexible premiums. Unlike term and whole life, the premiums can be adjusted over time. It also provides options for a level death benefit or an increasing death benefit.
- Indexed universal life (IUL) 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.
- Variable universal life (VUL) insurance allows the policyholder to invest the policy’s cash value in an available separate account. It also has flexible premiums and can be designed with a level or increasing death benefit.
Term vs. Permanent Life Insurance
Term life insurance differs from permanent life insurance in several ways but tends to best meet the needs of most people looking for affordable life insurance coverage. Term life insurance only lasts for a set period of time and pays a death benefit should the policyholder die before the term has expired. That’s in contrast to permanent life insurance, which stays in effect as long as the policyholder pays the premium. Another critical difference involves premiums—term life is generally much less expensive than permanent life because it does not accumulate cash value.
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. Also, consider how long you’ll need coverage for.
For example, if you are the primary caretaker and have children 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 of hiring a nanny and a housekeeper or using commercial child care and cleaning services, then perhaps add money for education. Include any outstanding mortgage and retirement needs for your spouse in your life insurance calculation—especially if the spouse earns significantly less or is a stay-at-home parent. Add up what these costs would be over the next 16 or so years, add a little more for inflation, and that’s the death benefit you might want to buy—if you can afford it.