Life insurance 101: basics
Life insurance is a contract between an insured person (the policyholder) and a life insurance carrier. The policyholder pays the insurance carrier regular premium payments, and in return, the carrier promises a lump-sum payment, known as the death benefit, to the policyholder’s beneficiaries upon his or her death.
Why do people get life insurance?
Life insurance provides financial protection and security to the policyholder’s loved ones/beneficiaries, particularly in the form of income replacement and funding of expenses. If the insured policyholder was the main breadwinner and income earner for the family, the death benefit from life insurance can help ensure that his or her family will be able to continue paying day-to-day expenses to maintain a certain lifestyle as well as paying for other debts and expenses that may arise. Such various expenses include funeral costs, outstanding debts, mortgage payments, daily living expenses, college tuition and schooling, and other long-term financial needs. Read more about the 12x income rule of thumb in Do you have enough life insurance?
Types of life insurance
Two primary types of life insurance are:
- Term Plan Life Insurance
Offers coverage to a policyholder for a specific term. In the unfortunate event of the policyholder's death during this term, his or her beneficiaries get paid a death benefit lump sum. This term can often be 10, 20, or 30 years. If the term expires, the policy is no longer in force and the policyholder no longer gets coverage from this term life policy; if the term expires without the policyholder dying, then there is no payout.
- Permanent (Whole) Life Insurance
Provides coverage to a policyholder for his or her entire life, as long as they continue to pay the necessary premiums. Whole life insurance also includes a savings or investment component, allowing the policy to build cash value over time. Because there is cash value affiliated, policyholders may be able to borrow against the policy.
Components of life insurance
- Premiums: Regular, periodic payments paid by the policyholder to the life insurance carrier to ensure the life insurance policy remains in force.
- Death benefit: Payout or lump sum paid to insured’s beneficiaries upon the insured’s death.
- Policyholder/insured: The individual whose life is insured by the life insurance policy; oftentimes this covered individual is also the payer of premiums.
- Beneficiaries: The person(s) or entities designated by the insured to receive the death benefit upon the insured’s death.
Factors affecting life insurance premium amounts
- Age: The younger you are, you typically pay lower premiums.
- Coverage amount: Higher coverage (death benefit) results in higher premiums.
- Health: A healthier individual pays lower premiums.
- Lifestyle: Riskier habits and behavior such as smoking lead to higher premiums.
Benefits of life insurance
- Financial security: Provides income or money replacement that acts as a safety net for an insured’s loved ones and beneficiaries during tough times, such as the passing of the insured, particularly if he or she is the primary breadwinner in the family and/or if there are expenses and debts needing to be paid.
- Estate planning: Can be used by the insured as an essential part of estate planning to transfer the wealth of the estate to beneficiaries upon the insured’s death.
- Tax benefits: Death benefits are often tax-free for beneficiaries, and some life insurance policies offer tax-deferred growth on cash value. Note, term life does not have cash value, while permanent (whole) life does.
- Business continuity: Life insurance can help businesses mitigate key person risks by providing funding that can help the business continue operations in case the key person passes away.
- Choosing the right life insurance: Key factors include the insured’s needs and financial goals. Other factors needing to be evaluated include coverage amount, policy duration or term length, affordability of premium payment options, and any additional features or policy riders offered by the life insurance company.
- Working with a life insurance agent: Life insurance can be straightforward or complex, and if it’s the latter, it may be useful to consult with a financial advisor or insurance agent, who can help you assess your needs, explain different options, and help you make an educated decision.
Read more about the 12x income rule of thumb in Do you have enough life insurance?
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Note: This summary is a generalization. Updated as of July 30, 2023.