Photo: KnowInsiders
Photo: KnowInsiders

Life insurance can be an important part of your financial strategy. That's because a life insurance policy can help you ensure that your loved ones have a secure financial future after you pass away.

Not only can life insurance help cover your final expenses — it can also provide your family with a financial safety net by helping to replace your income or serving as an inheritance for a loved one. Read on to learn about some of the ways life insurance benefits may be used:

What is Life Insurance?

Life insurance is a contract between you and an insurance company. Essentially, in exchange for your premium payments, the insurance company will pay a lump sum known as a death benefit to your beneficiaries after your death.

Your beneficiaries can use the money for whatever purpose they choose. Often this includes paying everyday bills, paying a mortgage or putting a child through college. Having the safety net of life insurance can ensure that your family can stay in their home and pay for the things that you planned for.

There are two primary types of life insurance: term and permanent life. The permanent life insurance such as whole life insurance or universal life insurance can provide lifetime coverage, while term life insurance provides protection for a certain period.

What are the Main Purposes of Life Insurance?

Protection and savings?

The major purpose of life insurance is protection — the instant estate to meet survivor needs. Some policies include a savings feature, but there are many other ways to save money and make investments. When buying life insurance, your primary concern should be providing adequate protection; the possible savings feature is a secondary consideration.

Even when protection needs have been met, it is a good practice to consider other forms of saving and investment plans for a family. Whether to save or invest through life insurance or other saving or investment media is a family choice, based on needs, preferences, and ability to manage finances. It is a saving/investment decision, not an insurance decision.

You may get a better return on your money through other savings or investment vehicles. In addition, a variety of saving and investment opportunities are available that do not require paying any commission or require a commission that is lower than that for saving through life insurance.

Earnings on the saving or investment element of life insurance are tax-deferred, but there is a variety of other saving/investment media that also provide deferral of taxes on earnings. However, earnings in a life insurance policy that are part of the proceeds paid to a beneficiary after the death of the insured are not subject to income tax at all.

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How Life Insurance Works

Photo: Smart Business Daily
Photo: Smart Business Daily

A life insurance policy has two main components—a death benefit and a premium. Term life insurance has these two components, but permanent or whole life insurance policies also have a cash value component.

1. Death Benefit—the death benefit or face value is the amount of money the insurance company guarantees to the beneficiaries identified in the policy when the insured dies. The insured might be a parent, and the beneficiaries might be their children, for example. The insured will choose the desired death benefit amount based on the beneficiaries’ estimated future needs. The insurance company will determine whether there is an insurable interest and if the proposed insured qualifies for the coverage based on the company’s underwriting requirements related to age, health, and any hazardous activities in which the proposed insured participates4.

2. Premium—premiums are the money the policyholder pays for insurance. The insurer must pay the death benefit when the insured dies if the policyholder pays the premiums as required, and premiums are determined in part by how likely it is that the insurer will have to pay the policy’s death benefit based on the insured’s life expectancy. Factors that influence life expectancy include the insured’s age, gender, medical history, occupational hazards, and high-risk hobbies.4 Part of the premium also goes toward the insurance company’s operating expenses. Premiums are higher on policies with larger death benefits, individuals who are at higher risk, and permanent policies that accumulate cash value.

3. Cash Value—the cash value of permanent life insurance serves two purposes. It is a savings account that the policyholder can use during the life of the insured; the cash accumulates on a tax-deferred basis. Some policies may have restrictions on withdrawals depending on how the money is to be used. For example, the policyholder might take out a loan against the policy’s cash value and have to pay interest on the loan principal. The policyholder can also use the cash value to pay premiums or purchase additional insurance. The cash value is a living benefit that remains with the insurance company when the insured dies. Any outstanding loans against the cash value will reduce the policy’s death benefit.

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, the major choice of whether to select temporary or permanent life insurance is important to consider.

Term life insurance

Term life insurance lasts a certain number of years, then ends. 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.

• Decreasing Term Life Insurance—the decreasing term is renewable term life insurance with coverage decreasing over the life of the policy at a predetermined rate.

Convertible Term Life Insurance—convertible term life insurance allows policyholders to convert a term policy to permanent insurance.

Renewable Term Life Insurance—is a yearly renewable term life policy that provides a quote for the year the policy is purchased. Premiums increase annually and is usually the least expensive term insurance in the beginning.

Benefits of term life insurance

There are several types of life insurance, but the most popular type that makes sense for most people is term life insurance. Term life insurance is meant to last until your debts are paid off (generally a 20- to 30-year period while people depend on you most). The benefits of a term life plan include:

Term life insurance is the cheapest life insurance you can buy.

If you buy term life insurance when you’re young, you can lock in low rates.

Term life insurance is purely an insurance product and doesn’t have a savings or investment component. This is a good thing — you can increase your returns by investing and saving on your own.

If you have a term life policy and can no longer afford it, you won’t lose anything more than the premiums you’ve paid if you decide to abandon the policy.

Permanent life insurance

Permanent life insurance stays in force for the insured’s entire life unless the policyholder stops paying the premiums or surrenders the policy. It’s typically more expensive than term.

• Whole Life—whole life insurance is a type of permanent life insurance that accumulates cash value. Cash-value life insurance allows the policyholder to use the cash value for many purposes, such as a source of loans or cash or to pay policy premiums.

• Universal Life—a 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 and can be designed with a level death benefit or an increasing death benefit.

• Indexed Universal—this 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—with variable universal life insurance, the policyholder is allowed to invest the policy’s cash value in an available separate account. It also has flexible premiums and can be designed with a level death benefit or an increasing death benefit.

Benefits of whole life insurance

Photo: JC Bass Insurance
Photo: JC Bass Insurance

Alternatively, whole life insurance is a permanent insurance product that combines investing and life insurance. Once you buy a policy, as long as you continue to pay premiums (or build up enough cash value to cover the premiums), you are covered until you die. According to Policygenius quotes from 2021, whole life insurance is much more expensive than a term – sometimes as much as 5 to 15 times the cost – but it also has its own benefits:

Combines life insurance with an investment component.

The cash value component can be used as part of a complex estate planning strategy.

Works as a forced savings vehicle.

You can often take out loans against the cash value portion, although this could decrease your death benefit.

Financial Benefits of having Life Insurance

The more insurance you have, the more beneficial it can be. When you buy a life insurance policy, make sure you have enough to cover the basics (like funeral expenses and end-of-life medical care), but also try to secure coverage for the future too. "We typically recommend people aim for 10 to 15 times their income in life insurance," says Nicholas Mancuso, senior operations manager of Policygenius' advanced planning team.

Your beneficiaries can use the life insurance to pay for any expenses, including:

Housing costs, including paying off a mortgage or paying rent

Other debts, like student loans, credit cards or car payments

Existing or future college education costs for your children

Childcare

Income replacement; this can be especially helpful if your loved ones require time off from work to grieve or if you are the breadwinner

Everyday costs – including food, transportation and healthcare

Because a life insurance benefit is a tax-free lump sum of money, your family can use the cash however they wish.

Considerations when buying

The financial needs of surviving family members may include:

Expenses in connection with the death (funeral expenses, final medical expenses not covered by health insurance, expenses for estate settlement, and possibly readjustment expenses such as relocation of the family, etc.)

Day-to-day living expenses of surviving dependents (food, clothing, etc.).

Payments on debts (a mortgaged home or farm debt, car loan, etc.).

Special needs (securing a loan, assuring children's educational expenses, gifts to family, friends or organizations).

Retirement income for the surviving spouse, and perhaps for other dependents.

Principles for buying

When buying life insurance, a family should develop a plan and select policies that fit their particular financial needs. They should use life insurance to provide for financial needs that are not met in other ways.

This plan should fit the family's ability to pay for the insurance because premiums must be paid to keep the insurance in force.

A family should select the premium period that provides the most economical rate (usually annually). This takes planning and must be included as an item in the monthly budget.

Families should read each policy carefully. Policy owners should assure themselves they are making the best use of their insurance dollars for the financial security of survivors of the insured person.

The family insurance program should be reviewed periodically and revised to meet changing needs.

How Much Does Life Insurance Cost?

The cost of life insurance varies significantly depending on several different factors. One of the biggest cost factors will be the type of life insurance you buy. For example, a term life insurance policy is significantly less expensive than a whole life insurance policy for the same amount of coverage.

Here are some of the most common factors affecting life insurance rates:

• Age. The younger you are when you buy a policy the less you’ll pay. That’s because your chance of death is smaller.

• Sex. Females have a life expectancy that is nearly five years longer than males, according to the National Center for Health Statistics. This means that men generally pay more for life insurance than women (except in Montana where insurers must provide gender-neutral life insurance rates).

• Health. Your health has a major impact on your life insurance rates. The insurer will evaluate your past and current medical conditions in order to calculate your life expectancy.

• Lifestyle. Your driving history (such as a DUI conviction), criminal record, and dangerous occupations and hobbies (such as scuba diving) can all result in higher life insurance rates.

Who needs life insurance?

Life insurance is most useful for people who need to provide security for a spouse, children, or other family members in the event of their death. Life insurance death benefits, depending on the policy amount, can help beneficiaries pay off a mortgage, cover college tuition, or help fund retirement. Permanent life insurance also features a cash value component that builds over time.

How do you qualify for life insurance?

Life insurance is available to anyone, but the cost or premium level can vary greatly based on the risk level an individual presents based on factors like age, health, and lifestyle. Life insurance applications generally require the customer to provide medical records and medical history and submit to a medical exam. Some types of life insurance such as guaranteed approval life don't require medical exams but generally have much higher premiums and involve an initial waiting period before taking effect and offering a death benefit.

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