What Is Life Insurance and How Does It Work?

Nicolas Cesare
A family with a good life insurance policy
Reading Time: 6 minutes

Insurance is something that we all hope we’ll never have to use, but the right insurance policy at the right time can save you and your family from financial disaster. Perhaps no form of insurance can have a greater impact under tragic circumstances than life insurance, which can help your surviving dependents or household maintain financial stability in the wake of your death. Life insurance can help your loved ones cover funeral costs, living expenses, and even mortgage payments following your death, but life insurance policies can still be a confusing labyrinth those on the market. Find out more about whether you should get a life insurance policy and, if so, what kind of life insurance is best.

What Is Term Life Insurance?

Term life insurance (also called pure life insurance) will provide a payout (called a death benefit) in the event of your death, but only as long as you pass away within a specified time period (aka the “term” in “term life insurance”). Usually these policies come in 10, 20, or 30 year terms.

Term life insurance is usually one of the cheaper forms of life insurance because of the limited coverage, but cheap doesn’t necessarily mean bad. Term life insurance can be very useful if your death would be especially disastrous during a certain period of time. For example, you may want to provide for your children after your death, but the need to provide for them will lessen as they grow up and start careers of their own. Term life insurance could cover the period before they turn 18, or 21, or some other benchmark you decide on.

It’s tempting to worry that term life insurance is useless if you purchase a policy, but continue living after it has expired. After all, you will have made all of those life insurance payments without ever having received a dime in benefits. However, it is at times like these that we should remember that insurance protects against risk, and not against certainty. Even if you or your loved ones never receive a payout from a term life insurance policy, you can still look back on that decision as a good one.

What Is Whole Life Insurance?

Whole life insurance (also called permanent life insurance) will provide a death benefit following your death at any time. Essentially, you can think of whole life insurance as being term life insurance, but with an unlimited term. Whole life insurance is ideal for those who want to be able to provide for dependents and loved ones at any time following their death. This can be beneficial for households with a single breadwinner where, if that breadwinner were to pass away without life insurance coverage, the family would be left with no income to make mortgage payments, cover living expenses, or manage funeral costs. Thanks to the unlimited term of application, whole life insurance usually costs more than your average term life insurance policy.

How Does Life Insurance Work?

When you agree to a life insurance policy of any kind, you will be expected to pay a fixed premium, or a monthly payment that goes into the insurance company’s pool of cash. You, along with many others, pay into this pool and, in the event that one of these policyholders dies, the insurance company will use some of the money in that pool to pay a fixed death benefit. Death benefits are usually paid out to a specific beneficiary, who is named at the time when the policy was negotiated. Be aware that changing beneficiaries later on in the policy can often turn into a sticky legal situation, so it’s important to consider your choice of beneficiary carefully. Pick someone who you have confidence in to carry out the necessary duties with the death benefit.

How Term Life Insurance Works

Term life insurance works in a similar way: policyholders pay premiums and, in the event of their death during the covered term, the insurance company will pay a death benefit to a named beneficiary.

Term life insurance premiums tend to be smaller because of the limited term during which an insurance company is obligated to pay a death benefit. The existence of this limited term also means that term life insurance is best for those with dependents who will eventually achieve financial independence, such as parents.

Cash Value Life Insurance

Cash value life insurance is a variation on whole life insurance because it has an unlimited term of coverage. Like a regular whole life insurance policy, cash value life insurance requires a fixed premium from policyholders. However, a portion of this premium will go into a separate cash value account, from which policyholders may withdraw money during their lives. Upon the policyholder’s death, any money left in this cash value account becomes the property of the insurance company and helps them to offset their loss from having paid death benefits.

Depending on your policy, withdrawals from a cash value account will probably follow certain terms. Some insurers place limits on the amount that can be withdrawn from a cash value account during a year, while others allow unlimited withdrawals. A cash value account can also be used to back loans to the policyholder. However, if there are outstanding loans at the time of the policyholder’s death, the value of those loans and accumulated interest will be subtracted from the value of the death benefit.

How Much Life Insurance Do I Need?

As with any insurance policy, the big question surrounding life insurance is: do you need it and, if so, how much life insurance do you need? The answer depends on a variety of factors:

  • Your risk of death. Healthy and young individuals are not quite as likely to end up making use of a death benefit. Life insurance is most useful for family members of an elderly or otherwise less healthy policyholder.
  • Age and number of dependants. The nature of life insurance means that a policyholder will never directly benefit from their death benefit. If you’re considering life insurance, you need to think about how many dependants you have and for how much longer they’re likely to depend on you for financial support.
    Non-insurance savings. Life insurance isn’t the only way that you can support dependants after your death. Savings accounts can be inherited by your loved ones as spelled out in your will.

Do You Really Need Life Insurance?

If you are young and you don’t have any dependants, a life insurance policy would be virtually useless to you. Life insurance becomes gradually more useful as you grow older take on dependents, but it’s impossible to pin down an exact age and level of need where you should absolutely buy a life insurance policy. If you’re trying to figure out whether or not you need life insurance, ask yourself: are my financial dependants going to be okay upon my death?

If they won’t be okay in the short term (for example, because of their ages), then you may benefit from a term life insurance policy. No matter what, be sure to compare the cost and benefits of life insurance against other means of providing for your dependants, such as a savings account. An end of life checklist can help you secure the future of your dependants.

Finally, some employers offer life insurance plans at a discounted rate. Be sure to ask your employer about such offers before leaping into a life insurance policy or saving account for your dependants. The discount may change up your calculations.

Use the DIME Formula

In order to calculate your level of need for life insurance in terms of hard numbers, you can use the DIME (Debts, Income, Mortgage, Education) formula. These are the four things that dependants are most likely to need help with following a policyholder’s death:

  • Debt: Do you have any outstanding debts? If you do, your loved ones may be held responsible for them after your death. The amount that you negotiate for death benefits should cover these debts.
  • Income: Are you an important breadwinner for your family? If so, your death benefits should be able to act as a substitute for your income, at least until your dependants can stand up on their own feet.
  • Mortgage: Your family has just lost you, don’t let them lose their house as well. Make sure that death benefits can cover mortgage payments.
  • Education: A college education can be essential for your children to establish an income of their own. If you don’t already have a college savings plan, then your life insurance payout can help cover the cost of a college education.

Add these four amounts together and then subtract any other funds that would help your dependents following your death (e.g. saving accounts, college fund, death benefits from your employer, etc.). The amount that you end up with is the amount of coverage you should plan on getting from your life insurance policy.

Life insurance policies come in several varieties. When considering what kind of life insurance is right for you (or whether you need life insurance at all) consider your own health and expected lifespan, the needs of your dependants, and what other means you have of providing for them after your death.

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