What
Is Life Insurance?
Life insurance is a contract between a life insurance
company and a policy owner. A life insurance policy guarantees the insurer pays
a sum of money to one or more named beneficiaries when the insured person dies
in exchange for premiums paid by the policyholder during their lifetime.
KEY
TAKEAWAYS
- Life insurance is a legally binding contract that
pays a death benefit to the policy owner when the insured person dies.
- For a life insurance policy to remain in force, the
policyholder must pay a single premium upfront or pay regular premiums
over time.
- When the insured person dies, the policy’s named
beneficiaries will receive the policy’s face value, or death benefit.
- Term life insurance policies expire after a certain
number of years. Permanent life insurance policies remain active until the
insured dies, stops paying premiums, or surrenders the policy.
- A life insurance policy is only as
good as the financial strength of the company that issues it. State
guaranty funds may pay claims if the issuer can’t.
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
is designed to last a certain number of years, then end. 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 is renewable
term life insurance with coverage decreasing over the life of the policy
at a predetermined rate.
- Convertible term life insurance allows
policyholders to convert a term policy to permanent insurance.
- Renewable term life insurance provides a
quote for the year the policy is purchased. Premiums increase annually and
are usually the least expensive term insurance in the beginning.
Many term life insurance policies allow you to renew the
contract on an annual basis once the term is up. This is one way to extend your
life insurance coverage but since the renewal rate is based on your current
age, premiums can rise precipitously each year. A better solution for permanent
coverage is to convert your term life insurance policy into a permanent policy.
This is not an option on all term life policies; look for a convertible term
policy if this is important to you.
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 more expensive than term.
- Whole life insurance is a type of permanent life
insurance. It accumulates a cash value in order to last the lifetime of
the insured person. Cash-value life insurance also 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 (UL) insurance is 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
designed with a level death benefit or an increasing death benefit.
- Indexed universal life (IUL) 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 life
(VUL) insurance
allows the policyholder 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.
Top-Rated
Companies to Compare
|
Company |
AM
Best Rating |
Coverage
Capacity |
Maximum
Issue Age |
Policies
Offered |
|
< Nationwide Best Overall Compare
Quotes on BestMoney |
A+ |
Over
$5 million |
85 |
Term,
whole, UL, IUL, VUL, final expense |
|
Protective Best for Term Compare
Quotes on BestMoney |
A+ |
Over
$5 million |
85 |
Term,
whole, UL, IUL, VUL |
|
MassMutual Best for
Financial Stability Compare Quotes on BestMoney |
A++ |
Over
$5 million |
90 |
Term,
whole, UL, VUL |
|
Mutual
of Omaha Best
for Living Benefits Compare Quotes on BestMoney |
A+ |
Over
$5 million |
85 |
Term,
UL, IUL, final expense |
|
Guardian Fewest
Complaints Compare Quotes on BestMoney |
A++ |
Over
$5 million |
90 |
Term,
whole, UL, VUL |
|
USAA Best for
Military Compare Quotes on BestMoney |
A++ |
Over
$5 million |
85 |
Term,
whole, UL |
|
New
York Life Best
for Seniors Compare Quotes on BestMoney |
A++ |
Over
$5 million |
90 |
Term,
whole, UL, VUL |
Term
vs. Permanent Life Insurance
Term life insurance
differs from permanent life insurance in several ways but
tends to best meet the needs of most people looking for affordable life
insurance coverage. Term life insurance only lasts for a set period of time and
pays a death benefit should the policyholder die before the term has expired.
Permanent life insurance stays in effect as long as the policyholder pays the
premium. Another critical difference involves premiums—term life is
generally much less
expensive than permanent life because it does not involve building a cash
value.
Before you apply for life insurance, you should analyze
your financial situation and determine
how much money would be required to maintain your
beneficiaries’ standard of living or meet the need for which you’re purchasing
a policy. Also, consider how long you'll need coverage for.
For example, if you are the primary caretaker and have
children 2 and 4 years old, you would want enough insurance to cover your
custodial responsibilities until your children are grown up and able to support
themselves.
You might research the cost of hiring a nanny and a
housekeeper or using commercial child care and cleaning services, then perhaps
add money for education. Include any outstanding mortgage and retirement needs
for your spouse in your life insurance calculation. Especially if the spouse
earns significantly less or is a stay-at-home parent. Add up what these costs
would be over the next 16 or so years, add more for inflation, and that’s the
death benefit you might want to buy—if you can afford it.
Burial or final expense insurance is a
type of permanent life insurance that has a small death benefit. Despite the
names, beneficiaries can use the death benefit as they wish.
What
Affects Your Life Insurance Premiums and Costs?
Many factors can affect the cost of life insurance premiums.
Certain things may be beyond your control, but other criteria can be managed to
potentially bring down the cost before (and even after) applying. Your health
and age are the most important factors that determine cost, so buying life
insurance as soon as you need it is often the best course of action.
After being approved for an insurance policy, if your
health has improved and you’ve made positive lifestyle changes, you can request
to be considered for a change in risk class. Even if it is found that you’re in
poorer health than at the initial underwriting, your
premiums will not go up. If you’re found to be in better health, then you your
premiums may decrease. You may also be able to buy additional coverage at a
lower rate than you initially did.
Life
Insurance Buying Guide
Step
1: Determine How Much You Need
Think about what expenses would need to be covered in the
event of your death. Things like mortgage, college tuition, and other debts,
not to mention funeral expenses. Plus, income replacement is a major factor if
your spouse or loved ones need cash flow and are not able to provide it on
their own.
There are helpful tools online to calculate the lump sum
that can satisfy any potential expenses that would need to be covered.
Step
2: Prepare Your Application
Life insurance applications generally require personal
and family medical history and beneficiary information. You may need to take a
medical exam and will need to disclose any preexisting medical conditions,
history of moving violations, DUIs, and any dangerous hobbies, such as auto
racing or skydiving. The following are crucial elements of most life insurance
applications:
- Age: This is the most important
factor because life expectancy is the biggest determinant of risk for the
insurance company.
- Gender: Because women statistically
live longer, they generally pay lower rates than males of the same age.
- Smoking: A person who smokes is at
risk for many health issues that could shorten life and increase
risk-based premiums.
- Health: Medical exams for most
policies include screening for health conditions like heart disease,
diabetes, and cancer and related medical metrics that can indicate risk.
- Lifestyle: Dangerous lifestyles can make
premiums much more expensive.
- Family medical history: If you have evidence of
major disease in your immediate family, your risk of developing certain
conditions is much higher.
- Driving record: A history of moving
violations or drunk driving can dramatically increase the cost of
insurance premiums.
Standard forms of identification will also be needed
before a policy can be written, such as your Social Security card, driver's
license, or U.S. passport.
Step
3: Compare Policy Quotes
When you've assembled all of your necessary information,
you can gather multiple life insurance quotes
from different providers based on your research. Prices can differ markedly
from company to company, so it's important to take the effort to find the best
combination of policy, company rating, and premium cost. Because life insurance
is something you will likely pay monthly for decades, it can save an enormous
amount of money to find the best policy to fit your needs.
Benefits
of Life Insurance
There are many benefits
to having life insurance. Below are some of the most important features and
protections offered by life insurance policies.
Most people use life insurance to provide money to
beneficiaries who would suffer a financial hardship upon the insured’s death.
However, for wealthy individuals, the tax advantages of life insurance,
including the tax-deferred growth of cash value, tax-free dividends, and
tax-free death benefits, can provide additional strategic opportunities.
Avoiding
Taxes
The death benefit of a life insurance policy is usually
tax-free.1 Wealthy
individuals sometimes buy permanent life insurance within a trust to pay estate taxes. This strategy helps to
preserve the value of the estate for their heirs.
Tax avoidance is
a law-abiding strategy for minimizing one’s tax liability and should not be
confused with tax evasion,
which is illegal.
Who
Needs Life Insurance?
Life insurance provides financial support to surviving
dependents or other beneficiaries after the death of an insured policyholder.
Here are some examples of people who may need life insurance:
- Parents with minor children. If a
parent dies, the loss
of their income or caregiving skills could create a financial hardship.
Life insurance can make sure the kids will have the financial resources
they need until they can support themselves.
- Parents with special-needs adult
children. For
children who require lifelong care and will never be self-sufficient, life
insurance can make sure their needs will be met after their parents pass
away. The death benefit can be used to fund a special
needs trust that
a fiduciary will manage for the adult child’s benefit.2
- Adults who own property
together. Married or
not, if the death of one adult would mean that the other could no longer
afford loan payments, upkeep, and taxes on the property, life insurance
may be a good idea. One example would be an engaged couple who take out a
joint mortgage to buy their first house.
- Seniors who want to leave
money to adult children who provide their care. Many adult children sacrifice time
at work to care for an elderly parent who needs help. This help may also
include direct financial support. Life insurance can help reimburse the
adult child’s costs when the parent passes away.
- Young adults whose parents
incurred private student loan debt or cosigned a loan for them. Young adults without dependents
rarely need life insurance, but if a parent will be on the hook for a
child’s debt after their death, the child may want to carry enough life
insurance to pay off that debt.
- Children or young adults who
want to lock in low rates. The younger and healthier you are, the lower your
insurance premiums. A 20-something adult might buy a
policy even
without having dependents if there is an expectation to have them in the
future.
- Stay-at-home spouses. Stay-at-home spouses should have
life insurance as they have significant economic value based on the work
they do in the home. According to Salary.com, the economic value of a
stay-at-home parent would have been equivalent to an annual salary of
$162,581 in 2018.
- Wealthy families who expect to owe
estate taxes. Life insurance can provide funds to cover the taxes and keep the
full value of the estate intact.
- Families who can’t afford
burial and funeral expenses. A small life insurance policy can provide funds to
honor a loved one’s passing.
- Businesses with key employees. If the death of a key employee,
such as a CEO, would create a severe financial hardship for a firm, that
firm may have an insurable interest that will allow it to purchase a life
insurance policy on that employee.
- Married pensioners. Instead of choosing between a
pension payout that offers a spousal benefit and one that doesn’t,
pensioners can choose to accept their full pension and use some of the
money to buy life insurance to benefit their spouse. This strategy is
called pension maximization.
- Those with preexisting
conditions. Such as cancer, diabetes, or smoking. Note, however, that some
insurers may deny coverage for such individuals, or else charge very high
rates.
Each policy is unique to
the insured and insurer. It’s important to review your policy document to
understand what risks your policy covers, how much it will pay your
beneficiaries, and under what circumstances.
Considerations
Before Buying Life Insurance
Research
Policy Options and Company Reviews
Because life insurance policies are a major expense and
commitment, it's critical to do proper due diligence to make sure the company
you choose has a solid track record and financial strength, given that your
heirs may not receive any death benefit for many decades into the future.
Investopedia has evaluated scores of companies that offer all different types
of insurance and rated the best in numerous categories.
Consider
How Much Death Benefit You Need
Life insurance can be a prudent financial tool to hedge
your bets and provide protection for your loved ones in case of death should
you die while the policy is in force. However, there are situations in which
it makes less sense—such
as buying too much or insuring those whose income doesn't need to be replaced.
So it's important to consider the following.
What expenses couldn't be met if you died? If your spouse
has a high income and you don't have any children, maybe it's not warranted. It
is still essential to consider the impact of your potential death on a spouse
and consider how much financial support they would need to grieve without
worrying about returning to work before they’re ready. However, if both
spouses' income is necessary to maintain a desired lifestyle or meet financial
commitments, then both spouses may need separate life insurance coverage.
Know
Why You're Buying Life Insurance
If you're buying a policy on another family member's
life, it's important to ask—what are you trying to insure? Children and seniors
really don't have any meaningful income to replace, but burial expenses may
need to be covered in the event of their death. Beyond burial expenses, a
parent may also want to protect their child’s future insurability by purchasing
a moderate-sized policy when they are young. Doing so allows that parent to
ensure that their child can financially protect their future family. Parents
are only allowed to purchase life insurance for their children up to 25% of the
in-force policy on their own lives.
Could investing the money that would be paid in premiums
for permanent insurance throughout a policy earn a better return over time? As
a hedge against uncertainty, consistent saving and investing—for example,
self-insuring—might make more sense in some cases if a significant income
doesn't need to be replaced or if policy investment returns on cash value are
overly conservative.
How
Life Insurance Works
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 participates.3
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.3 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.
The policy owner and the
insured are usually the same person, but sometimes they may be different. For
example, a business might buy key
person insurance on a crucial employee such as a CEO, or an insured
might sell their own policy to a third
party for cash in a life
settlement.
Life
Insurance Riders and Policy Changes
Many insurance companies offer policyholders the option
to customize their policies to accommodate their needs. Riders are the most common way
policyholders may modify or change their plans. There are many riders, but
availability depends on the provider. The policyholder will typically pay an
additional premium for each rider or a fee to exercise the rider, though some
policies include certain riders in their base premium.
- The accidental death benefit rider provides additional life
insurance coverage in the event the insured’s death is accidental.
- The waiver of premium rider relieves the policyholder of
making premium payments if the insured becomes disabled and unable to work.
- The disability income rider pays a monthly income in
the event the policyholder becomes unable to work for several months or
longer due to a serious illness or injury.
- Upon diagnosis of terminal illness, the accelerated
death benefit rider allows
the insured to collect a portion or all of the death benefit.
- The long-term care rider is a type of accelerated
death benefit that can be used to pay for nursing-home, assisted-living,
or in-home care when the insured requires help with activities of daily
living, such as bathing, eating, and using the toilet.
- A guaranteed insurability rider lets the policyholder buy
additional insurance at a later date without a medical review.
Borrowing Money. Most
permanent life insurance accumulates cash value that the policyholder can
borrow against. Technically, you are borrowing money from the insurance company
and using your cash value as collateral. Unlike with other types of loans, the
policyholder’s credit score is not a factor. Repayment terms can be flexible,
and the loan interest goes back into the policyholder’s cash value account.
Policy loans can reduce the policy’s death benefit, however.
Funding
Retirement. Policies with a cash value or investment component can
provide a source of retirement income. This opportunity can come with high fees
and a lower death benefit, so it may only be a good option for individuals who
have maxed out other tax-advantaged savings and investment accounts. The
pension maximization strategy described earlier is another way life insurance
can fund retirement.
It’s prudent to
reevaluate your life insurance needs annually or after significant life events, such as divorce,
marriage, the birth or adoption of a child, or major purchases, such as a
house. You may need to update the policy’s beneficiaries, increase your
coverage, or even reduce your coverage.
Qualifying
for Life Insurance
Insurers evaluate each life insurance applicant on a
case-by-case basis, and with hundreds of insurers to choose from, almost anyone
can find an affordable policy that
at least partially meets their needs. In 2018 there were 841 life insurance and
annuity companies in the United States, according to the Insurance Information
Institute.4
On top of that, many life insurance companies sell
multiple types and sizes of policies, and some specialize in meeting specific
needs, such as policies for people with chronic health conditions. There are
also brokers who specialize in life insurance and know what different companies
offer. Applicants can work with a broker free of charge to find the insurance
they need. This means that almost anyone can get some type of life insurance
policy if they look hard enough and are willing to pay a high enough price or
accept a perhaps less-than-ideal death benefit.
Insurance is not just for the healthy and wealthy, and
because the insurance industry is much broader than many consumers realize,
getting life insurance may be possible and affordable even if previous
applications have been denied or quotes have been unaffordable.
In general, the younger and healthier you are, the easier
it will be to qualify for life insurance, and the older and less healthy you
are, the harder it will be. Certain lifestyle choices, such as using tobacco or
engaging in risky hobbies such as skydiving, also make it harder to qualify or
lead to higher rates.
Who
Needs Life Insurance?
You need life
insurance if you need to provide security for a spouse,
children, or other family members in the event of your 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.
What
Affects Your Life Insurance Premiums?
- Age (life insurance is less expensive)
- Gender (female tends to be less expensive)
- Smoking (smoking increases premiums)
- Health (poor health can raise premiums)
- Lifestyle (risky activities can increase premiums)
- Family medical history (chronic illness in relatives
can raise premiums)
- Driving record (good drivers save on premiums)
What
Are the Benefits of Life Insurance?
- Payouts are tax-free. Life
insurance death
benefits are paid as a lump sum and are not subject to federal income tax
because they are not considered income for beneficiaries.
- Dependents don't have to worry about living
expenses. Most policy calculators recommend a multiple of your gross
income equal to seven to 10 years that can cover major expenses like
mortgages and college tuition without the surviving spouse or children
having to take out loans.
- Final expenses can be covered. Funeral expenses can
be significant and can be avoided with a burial policy or with standard
term or permanent life policies.
- Policies can supplement retirement savings.
Permanent life policies such as whole, universal, and variable life
insurance can offer cash value in addition to death benefits, which can
augment other savings in retirement.
How Do
You Qualify for Life Insurance?
To qualify for life
insurance, you need to submit an application. But life insurance
is available to almost anyone. However, the cost or premium level can vary
greatly based on your age, health, and lifestyle. Some types of life insurance
don't require medical information but generally have much higher premiums and
involve an initial waiting period before the death benefit is available.
How
Does Life Insurance Work?
Life insurance works by providing a death benefit in
exchange for paying premiums. One popular type of life insurance—term life insurance—only lasts for a set
amount of time, such as 10 or 20 years. Permanent
life insurance also features a death benefit but lasts for the
life of the policyholder as long as premiums are paid.
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