Life insurance provides financial security for people, such as family, loved ones, and business associates, who would be financially distressed if you were to pass away.
Whether you make $20,000 a year or $2 million, your income matters to several people. This is true even if you’re single with no children.
So what would happen to these individuals or organizations if you passed away suddenly due to an accident or unexpected illness?
This question can be easily answered with life insurance — the focus of this in-depth article, which covers:
- The definition of life insurance
- How life insurance works
- The cost of life insurance
- Different types of life insurance
- Who needs life insurance
Let's get started.
Life insurance definition
Life insurance is a type of coverage that pays out a lump sum benefit in the event you die. It provides financial security for people, such as family, loved ones, and business associates, who would be financially distressed if you were no longer alive to work and provide income. It is also useful to cover funeral, estate settlement, and debt repayment costs that arise when a person dies.
How does life insurance work?
People who buy life insurance generally do so to replace the income that would be lost due to unexpected death. It helps the survivors pay bills, cover debts, and pay for funeral expenses.
A life insurance policy is a contract with an insurance company. The policy’s owner pays the company a regular payment, called the premium. In exchange, the company will provide a payment if the insured individual dies while the policy is still active.
The payment goes to the person, people, or organization named as the recipient(s) in the contract. This payment, called a death benefit, is generally tax-free to the recipients, known as beneficiaries.
There are a few ways to obtain life insurance. One way is to join a company or organization that provides no-cost or reduced group life insurance as a benefit of being employed or an organization member.
You can also buy your own individual life insurance policy. This may require a lengthy application and underwriting process with a lot of decisions for you to make. Therefore, it helps to enlist an independent licensed insurance professional to help you select the right policy for your individual needs.
If you’re approved by the insurance company and are issued a policy, then you are covered. Depending on the type of policy you have, you may be covered for as long as you pay the required premium or up to a certain time period.
If you die while still covered by your life insurance policy and in a manner that is acceptable under the terms of the contract (e.g. you aren’t killed while committing a crime), your beneficiaries are entitled to the policy’s contractual death benefit.
To file a claim for benefits, the most important information your beneficiary will need is a death certificate. This official document ensures that policies are being claimed legitimately and helps prevent fraud.
The insurance company will also require the completion of a claims form. The form will request information about the policyholder, including the cause of death. The form will also require beneficiary information, such as his or her relationship with the deceased.
Once the insurance company has the necessary documents, they will process the claim. They will check to ensure the policy is still in force. They will also ensure the beneficiary claiming the death benefit is the person assigned in the policy. The claims process may take as long as 30 to 60 days.
How much does life insurance cost?
The amount you pay for life insurance will depend on a number of factors.
One of the most important factors is the amount of life insurance coverage you elect. The larger your death benefit and the longer the period of time you want coverage, the more you will pay in premium.
Premiums also vary based on the insurance company you select. Insurers charge different premium rates based on their operating expenses, their interest earnings, and other factors.
For most types of life insurance, how much risk you pose will also influence how much your life insurance costs.
If you pose a higher than normal risk of dying at an earlier age, the insurance company will charge more in premium. If you pose no such risks, your premium payments will be lower.
Some of your individual traits that influence how much life insurance costs for you include:
- Overall health
- Family history
- Whether or not you smoke
- How much alcohol you consume
- Your driving record
- Lifestyle traits such as hobbies and foreign travel
If all the above traits work in your favor and pose little risk to an insurance company, then it’s definitely possible to find life insurance coverage for as little as $20 to $30 a month. There are a number of ways to reduce the cost of life insurance so that it fits into your budget.
[ Related read: How Much Does Life Insurance Cost in 2021? ]
What are the different types of life insurance?
Life insurance comes in many forms. Here are a few distinctions between the many types of life insurance.
Group vs. individual
You can buy life insurance as part of a group plan and/or you can purchase your own individual policy.
Group life insurance covers the lives of several individuals, usually based on employment with the same employer or on membership with the same organization. With an individual policy, the insured’s life is the only one covered by the policy.
Group life insurance is typically cheaper because the life insurance company is collecting premiums and spreading its risk among multiple people. Also, group policies are sometimes provided at no cost to the insureds by the plan sponsor, be it an employer or association.
However, group life insurance plans also limit the amount of coverage you can apply for. Employers, for example, often limit your coverage to an amount based on your salary.
Guaranteed issue vs. underwritten
A life insurance policy may be guaranteed issue or you may have to submit to an underwriting process.
With a guaranteed issue policy, you automatically qualify for life insurance coverage once you submit an application. There is nothing about your age, health, or other factors that disqualify you from coverage. Most group life insurance policies are guaranteed issue.
Most individual policies, on the other hand, are underwritten. This means you must qualify for coverage by going through the insurance company’s underwriting process. Underwriting is how an insurance company assesses the risk that you could die during a certain time period. The underwriting process also dictates how much you will pay in premium for your policy.
Depending on the policy you’re applying for, underwriting may sometimes involve just a short questionnaire. In other cases, you may need to answer more detailed questions, submit to a medical exam, and have the insurer assess your finances.
Term vs permanent
Another important distinction between different types of life insurance is whether a policy is permanent or covers a person for a set period of time.
Term life insurance is the most common form of life insurance. It is designed to cover you for a set period. If you die within that period, the policy will pay the death benefit.
If the term expires before your death, your coverage will terminate. You will have to decide whether to renew your life insurance. Doing so means going through underwriting. It also means paying a higher premium. That’s because you’ll be older and may have health conditions that present more risk to the insurance company.
Term life insurance typically comes in terms of 10 years, 20 years, or 30 years. The shorter the term, the less you will pay in premium. Your premium amount will be the same for the entire term.
There are also several types of permanent life insurance. These are policies that, once you buy them, do not expire as long as you pay the required premium. Because of this, permanent life insurance is much more expensive than term life insurance.
Permanent life insurance has a cash value component, which term life insurance does not. This means that when you pay your premium, any amount not needed to cover the cost of your insurance coverage goes into a cash-value account that collects interest. You can access the value of this account through withdrawals or loans. However, doing so may lower your death benefit. Also, if you withdraw or borrow too much, you could lose your life insurance coverage altogether.
The two main types of permanent life insurance are whole life and universal life.
- A whole life policy’s premium and death benefit typically remain the same for the life of the insurance contract. When you buy whole life, the insurer establishes a premium amount for the life of the policy. The amount is designed so that you pay more of the cost of insurance upfront. This enables the company to recoup as much of its expenses before you pass away or surrender the policy.
- In a universal life policy, your premium payments support the amount of coverage you elect to own, also known as the face amount. Each premium payment is placed in the policy’s account value. From that account, the insurance company deducts fees and charges for providing the insurance. Whatever is left over is considered the policy’s cash value, which earns interest.
The amount of premium you pay and the death benefit you receive can vary from month to month and year to year. This is largely dictated by how much interest is credited to the policy.
[ Related read: What Are the Different Types of Life Insurance? ]
Do I need life insurance?
Once you are in the workforce and living on your own, chances are you could use life insurance.
Even if you are single, your unexpected passing will result in funeral costs, estate settlement expenses, and repayment of certain debts. It will be easier on your surviving family members if you have a life insurance death benefit to cover these costs.
If you are married, have a domestic partner that you share expenses with, have children, and/or own a business, you definitely need life insurance.
Anybody who depends on you and your income for their needs would be adversely affected if you die and can no longer provide that income.
According to LIMRA, a life insurance trade organization, 35 percent of households would feel adverse financial impact within one month if a primary wage earner died.
As beneficiaries of your life insurance policy, your family members can pay bills and cover debts and your business partners can keep things operating in your absence.
[ Related read: How Much Disability Insurance Do I Need? ]
Jack Wolstenholm is the head of content at Breeze.
The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.