What Is Life Insurance, and How Does It Work?

Life insurance is a contract through which a policyholder pays an insurer in exchange for a payout when the insured dies. Most adults have heard of life insurance, and many have been told that they should have it. However, conversations around life insurance often leave people wondering what types of life insurance are available, what the various industry terms mean and whether such policies are worthwhile. Here’s what you need to know about the types of life insurance and how it works.

A financial advisor can help you assess your life insurance needs and how a policy could fit into your broader financial plan. Connect with an advisor today.

What Is Life Insurance?

Life insurance is an agreement between an individual and an insurance provider designed to offer financial support to chosen beneficiaries after the policyholder’s death. By paying regular premiums, the policyholder ensures their loved ones will receive a payout, known as a death benefit, which can be used for expenses like mortgage payments, daily living costs, or future planning.

Life insurance policies generally fall into two categories: term and permanent. Term life insurance provides coverage for a set number of years – commonly 10, 20, or 30 – and is typically less expensive because it focuses solely on the death benefit. In contrast, permanent life insurance, such as whole life or universal life, remains active for the policyholder’s lifetime and often includes a cash value feature that grows over time and can be accessed while the policyholder is alive.

Premiums are influenced by a variety of factors, including age, health, and lifestyle habits. For instance, younger and healthier individuals often qualify for lower rates, while factors like smoking or certain medical conditions may increase costs. Life insurance offers a customizable way to provide financial stability for dependents, making it a practical solution for individuals looking to safeguard their family’s financial future.

Who Needs Life Insurance?

If you have people depending on you financially, you should have some form of life insurance. While most people know they should protect their spouse or children financially, such protection is also needed when there are people, such as dependent parents, who would have to bear your debts after you die.

Life insurance helps protect your beneficiaries in the case of your death. Therefore, if someone in your life might be responsible for your funeral costs, debt payments or would be financially crippled due to their reliance on your income, you may want to buy a life insurance policy to cover these costs.

For example, many people choose to get their first life insurance policy when they get married. This helps protect a spouse who depends on your income. If a married couple has children, they may want to provide for the child’s living expenses with a life insurance policy.

Life insurance gets more expensive as you get older, so purchasing early can help you protect yourself in the future. Additionally, it can cover any funeral or other costs in the event of your untimely death. Business owners and investors may also want to purchase term life insurance to protect their business or personal debts. Life insurance may be included in a trust to protect both the policyholder and the beneficiaries from taxation.

Types of Life Insurance

Before purchasing life insurance, it’s important to understand what your options are so that you can choose the most appropriate type of life insurance for you. The most popular types of life insurance in the United States are term life insurance and whole life insurance, which is one of several types of permanent life insurance. Here are a few of the key features and differences between various types of policies:

Term Life Insurance

Term life insurance covers the policyholder for a specific period. Typically, term life insurance policies are issued for terms of five to 30 years, with the most common policy length being 10 years. During the coverage period, the policyholder pays a fixed annual premium and if they die during their coverage period, a death benefit is paid to the policyholder’s beneficiaries.

If the policyholder reaches the end of the term, then no death benefit is paid and he or should would not receive any premiums in return. Term life insurance premiums typically cost a fraction of what whole life insurance policies cost but do not have a cash value and expire after a set number of years.

Permanent Life Insurance

There are a few types of permanent life insurance, but most policies have some similarities. One of these similarities is that they have a cash value. The cash value increases over time as a policyholder makes regular premium payments, and the policyholder can borrow against their policy’s cash value on a tax-deferred basis. Here are a few types of permanent life insurance:

Whole Life Insurance

Whole life insurance, as the name suggests, lasts a policyholder’s whole life. Instead of only making premium payments for a set number of years, policyholders make payments throughout their lives. Many policies include a dividend option in addition to the cash value of a policy. Additionally, whole life insurance offers consistent premiums and fixed death benefits.

Universal Life insurance

Universal life insurance, also known as adjustable life insurance, allows policyholders to reduce or increase their death benefits and pay premiums more flexibly. Some policies also allow people to increase the face value of their insurance. This means that the payments on a policy can change, as can the death benefit.

Other Types of Permanent Life Insurance

Depending on your health, budget and goals, other types of permanent life insurance may be best for you. For example, variable life insurance combines death protection with a savings account that policyholders can invest. Variable universal life policies carry the same risks and rewards of variable life insurance, but with the adjustability that universal life insurance offers. Before choosing a policy, be sure to speak with a financial professional to evaluate which option is best for you.

How to Apply for Life Insurance

The first step to applying for life insurance is to decide how much coverage you will need. You can do this by evaluating how much you want your beneficiaries to have to cover their living expenses, funeral costs and any debt payments. You should also consider how long you want to be covered.

Next, you’ll want to search for companies which you might want to purchase life insurance from. There are plenty of companies out there, so only consider working with companies with an A+ or A++ rating by A.M. Best. This will ensure that you are only working with the most financially sound companies.

Finally, you’ll be able to get quotes from these companies and decide which company you’d like to apply for life insurance with. Your approval might be contingent on your ability to pass a physical that includes blood testing.

How Much Is Life Insurance?

Insurance company underwriters play a significant role in setting the price of life insurance policies. They determine if a policy would be profitable for the insurer. They consider if an applicant meets certain criteria to qualify for an insurance policy. From there, they establish the type of policy for which an applicant is eligible. Finally, they provide an outline of what the policy covers for the applicant’s unique circumstances. The upshot of an underwriter’s work influences the premiums to be charged.

Premiums are also affected by several other factors, such as:

Term: Term life insurance comes in short- and long-term policies. Longer-term policies tend to cost more, while permanent policies typically cost more than term life insurance policies.
Health: People in good health are likely to get the best rates. People who smoke have some of the worst health insurance rates due to the risk of cancer and heart disease.
Age: Because older individuals are closer to death, it costs more to insure their lives. Life insurance costs less for someone in their 20s than it does for someone in their 40s, and so on.
Company: The most reputable insurance providers are in a position to charge higher premiums than their financially weaker rivals. Thus, if you choose to work with a highly reputable company, it will likely cost you.

For example, the average cost of a $250,000 term life insurance policy for healthy 35-year-old men and women is $40 and $37.50 per month, respectively, according to Aflac.

Of course, the older the policyholder, the more costly the policy. For instance, the average cost of a $250,000 term life insurance policy for a 55-year-old man is nearly $232.50 per month and $175 per month for a woman of the same age, according to Aflac. This is for a basic term policy, which typically offers lower premiums compared to permanent policies like whole life or universal life insurance.

Bottom Line

Every person has unique needs that will determine the type, term and amount of life insurance he or she need. It is important to do your research before purchasing life insurance, and it is wise to discuss your options with a financial advisor. This will help you choose the best product that fits within your budget, and a financial advisor can help you decide how much of your budget should be allocated to life insurance and other financial engines.

Tips for Buying Life Insurance

Consider talking to a financial advisor about life insurance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Alternatives to the above-mentioned types of life insurance are less well-known but are sometimes worth examining. They include return-of-premium, endowment and no-exam policies, any one of which may be suitable for you.