There’s a lot of misconceptions about life insurance out there: what it is, how it works, and who needs it. While buying life insurance can give you peace of mind that other types of insurance can’t, it’s not for everyone.
We’ll break down everything you need to know about life insurance, including:
- What Life Insurance Is—and What It Isn’t
- How Life Insurance Works
- When to Consider Life Insurance
- Types of Life Insurance
- How Much Life Insurance Do You Need?
- How to Buy Life Insurance
- What to Do When Updating Your Life Insurance Policy
What Life Insurance Is—and What It Isn’t
Before we dive into specifics like how to buy life insurance, let’s define what life insurance is and dispel some of the myths surrounding it.
What is Life Insurance?
The purpose of life insurance is to protect those who are financially dependent on you after you die. Unlike most other types of insurance that you'll buy, buying life insurance doesn't benefit you. Rather, it benefits those you leave behind when you pass away.
I know—talking about death and unexpected, catastrophic events is not most people’s cup of tea. But that’s what insurance is about: being covered when uninvited chaos ensues. Life insurance can help your loved ones cover costs that they might otherwise have trouble making without you. Expenses like lost income, mortgage payments, and debt payments can be paid with life insurance.
Life Insurance: Betting on Your Life to Manage Risk
Like all types of insurance, life insurance is a bet. Your monthly payments to the life insurance company, known as “premiums,” are essentially wagers. As strange as it sounds, when you buy life insurance, you’re betting against the insurance company that you’ll die. The insurance company is taking the opposing bet that you’ll stay alive.
If you die when you’re covered by life insurance, the life insurance company loses the bet and has to pay up. The money goes to your chosen beneficiaries, which should cover some of the income you would have made if you had stayed alive. Each month you stay alive, the life insurance company is winning the bet and collects your premium. But let’s face it, you’re winning too since you’re still alive.
What Life Insurance Is Not
There are two things that are often misconstrued regarding life insurance: how it relates to health insurance, and whether or not it’s an investment tool.
Life Insurance vs. Health Insurance
Some people confuse life insurance with health insurance or think that the two are somehow related. To be clear: life insurance and health insurance are two very different things.
Life insurance is betting on your life, and health insurance is betting on your health. When you die, and the insurance company loses the bet on life insurance, it pays your dependents. When you fall ill, and the insurance company loses the bet on health insurance, it pays you to help cover your medical care.
Is Life Insurance an Investment?
Life insurance is primarily a risk management tool, not an investment. While there are types of life insurance that do have an investment feature, these life insurance policies are best for very few people.
The advantages? Life insurance policies with investment features offer tax benefits and grow (albeit slowly) over time.
The disadvantages? They’re much more expensive than life insurance policies without the investment feature. Plus, they aren’t the best returns you could be getting for your money.
If you’re looking to invest, there are more effective ways to build wealth. You’re better off making sure you have a solid six months of emergency savings, max out your retirement savings, and pay off debts first. If you have all those covered, there’s a ton of investment options out there to explore that range from mutual funds to health savings accounts. Only commit to life insurance with an investment feature if you’ve determined it’s a good fit for your financial goals compared to other alternatives.
How Life Insurance Works
To understand how life insurance works, we’ll look at the terminology, the players involved, and the typical life insurance process.
Life Insurance Terms
With life insurance comes life insurance jargon. To understand how life insurance works, it’s helpful to make sure you have some basic terms down.
- Life insurance policy: the contract that lays out the terms of your wager with the life insurance company. Different policies have different rules. More affordable policies will have lower payouts after death.
- Premiums: the monthly payment you make to the life insurance company. When you pay your monthly premium, you’re placing your monthly wager that you’ll die, protecting your dependents in the case of unexpected death.
- Claims/death benefit: the payout after death as detailed in the life insurance policy.
Life Insurance Players
There are four players when it comes to life insurance:
- The Insured: the person whose life is being bet on. When the insured passes away, the life insurance policy ceases, and the claim is paid out.
- The Insurer: the insurance company, or whoever is betting that the insured stays alive. The insurer is responsible for paying out the death benefit.
- The Owner: the person betting that the insured will die, betting against the insurer. The owner is responsible for paying monthly premiums to the insurer.
- The Beneficiary: the person (or people) who get the death benefit from the insurance company after the insured passes away.
Life Insurance Explained
When you buy life insurance, you’re agreeing to terms set in your life insurance policy with the insurer, your chosen life insurance company. If you take out a life insurance policy on yourself, you are both the insured as well as the owner. The life insurance policy details the monthly premiums you make in exchange for the promise of death benefit to your chosen beneficiaries upon your death.
Paying Life Insurance Premiums
Contrary to popular belief, life insurance isn’t necessarily expensive. We’ll dive deeper into types of life insurance later, but it’s good to know that “term life insurance” can be surprisingly affordable. For instance, a 35-year-old nonsmoker on a term life insurance policy with no bells and whistles can pay less than $40 per month for 20 years with a death benefit of $500,000.
What Affects the Cost of Life Insurance?
The riskier you seem to the insurer, the higher your monthly premiums will be for the same payout. Your age, sex, health, family’s medical history, job mortality rate, and even your hobbies can all affect how expensive life insurance is.
For example, if you’re a 65-year-old skydiving male with health problems and you smoke, you’ll be paying a hefty premium. On the flipside, life insurance for young adults in good health is the most affordable since it’s the least risky for the insurance company. As far as sex goes, life insurance is generally more expensive for men in their 20s and for men over 50 than it is for women of the same ages. You can expect smoking to double your premium and health problems to triple it.
Will My Life Insurance Premiums Increase with Age?
If you take out a life insurance policy in your 20s, it will cost you less than if you took it out in your 30s. That’s because every year you’re older, the life insurance company sees it as you inching closer to death, making you riskier to insure.
No matter what age you took out your life insurance policy, the monthly premium you pay will stay the same over the term of the policy. Rather than raising your premiums each year, insurance companies take the average of all your payments over the term of the policy and make that your monthly payment.
This means that when your life insurance policy expires and you want to get a new policy, you can expect the monthly amount you are expected to pay to go up significantly for the same death benefit.
For instance, you might have been paying $40 per month for a 20-year life insurance policy in your 30s and 40s. That $40 premium was the average amount calculated across the risk you pose from age 30 to 50. If that policy expired at age 50 and you were considering taking out another 20-year life insurance policy with the same payout, your new premium could jump from $40 to $85 per month. Your new premium would be the average amount calculated across the risk you pose from age 50 to 70. Since you’re riskier to insure when you’re 50-70 than when you were 30-50, your monthly premium will be higher.
In other words, there is not an advantage to getting a life insurance policy at a younger age. Even though your payments are the same across time during a given policy, don’t think you’ve “locked in” a lower payment at a younger age. Your payment is your average risk throughout the term of the policy.
Life Insurance Payouts
If you have a life insurance policy for yourself and you die, your beneficiaries must file a death claim and send a certified copy of your death certificate to the insurance company. Most states give the insurer 30 days to look over the claim.
Once it’s been determined that the beneficiaries should get the death benefit, the insurance company makes the payout to the beneficiaries within one to two months. Getting the death benefit in one lump sum used to be the only option for life insurance payouts. Today, beneficiaries of a life insurance policy can receive the payout over time for a steady stream of income.
The payout timeline through installments is usually between 5 and 40 years and is pre-determined as part of the policy. If the payout is made in one lump sum, that money can be invested for the beneficiaries to live off of the interest for a steady income stream as well.
Possible Payout Delays
While life insurance is meant to be there when your loved ones need it the most, there are some circumstances which could cause payout delays.
For instance, many insurance companies have a two-year contestability clause to prevent fraud. A two-year contestability clause allows them to investigate the death of the insured if they died within two years of taking out the life insurance policy. If an investigation is opened, it could take up to a year before the death benefit makes it to the beneficiaries.
Another factor that could cause delay the payout is if the death certificate lists homicide as the reason the insured died. In this case, the insurance company will talk to the detective of the homicide case to make sure the beneficiary isn't a murder suspect. If the beneficiary assisted in the death of the insured, this violates the policy and is known as life insurance fraud.
Thankfully, life insurance fraud is much more difficult to commit today than it was in past decades. A particularly infamous case of attempted life insurance fraud was Michael Malloy, a homeless former firefighter who survived numerous murder attempts on his life in the 1930s. When ingesting antifreeze, turpentine, rat poison, and carpet tacks didn’t result in his death, the attempted fraudsters tried to freeze him to death and hit him with a car, which also didn’t work. While they did eventually succeed in killing Malloy, the fraudsters were found out and were either executed or sent to prison.
Accelerated Death Benefits
With modern life insurance policies come modern options, such as pre-death benefits, known as accelerated death benefits. If you have a life insurance policy with accelerated death benefits, that means you can take money out of your life insurance policy if you get terminally, chronically, or critically ill. However, you’d only get cash advances from the face value of the policy rather than the death benefit amount.
When to Consider Life Insurance
Life insurance for young adults can make as much sense as life insurance for middle-aged adults. What really matters when it comes to whether or not you should take out a life insurance policy is your would-be beneficiaries. If you have someone that relies on you financially that would be in a bind when your death came, you should consider life insurance.
While children, spouses, and partners come to mind as common financial dependents, there are other relationships to consider as well. For instance, if you have a business partner or even your parents.
Types of Life Insurance
When you're buying life insurance, there are two main types to consider: permanent life insurance and term life insurance.
Permanent Life Insurance
Permanent life insurance can be five to twenty times more expensive than term life insurance. It provides lifetime coverage and includes an investment element called the policy’s cash value. You don’t have to pay taxes on the cash value, which grows slowly over time. But, the cash value goes entirely to the insurance company at the time of the insured’s death if left untouched.
Permanent life insurance is not for most people. It’s usually part of estate planning to help preserve wealth transferred to beneficiaries.
Cash Value Options
If you don't want your cash value to go to the insurance company upon your death, you'll need to do something with it. There are a few things you can do with the cash value.
- Increase the Death Benefit: You can tell your insurance company that you’d like to increase the death benefit on your policy in exchange for the cash value. Ideally, you’d get the entire cash value transferred to the death benefit.
- Put Towards Retirement: There are a few ways to use the cash value from life insurance policies as an asset in your retirement plan. You’ll want the cash value to grow at least 10 to 15 years before tapping into your cash value for retirement savings.
- Take Out a Loan: You can borrow against the cash value, which means you’d be taking out a loan. Borrowing against the cash value will reduce the payout your beneficiaries will receive though if you don’t pay back what you borrowed, plus interest.
- Partial Withdrawals: Another similar option is to make partial withdrawals, which also would have to be repaid to maintain the death benefit amount.
- Cash Out: You can surrender your life insurance policy and cash out, taking all of the cash from the cash value. You'd be canceling your life insurance policy and may have to pay a fee to do this if you're on the younger side.
- Pay Premiums: If you’re keeping your permanent life insurance, you can use the cash value to pay your premiums later in life.
Whole Life Insurance
Whole life insurance is the most well-known and simplest type of permanent life insurance, but there are others like universal and variable life insurance too.
Whole life insurance is pretty straightforward. Your premiums stay the same, and the death benefit and cash value growth rate are guaranteed. Like other types of permanent life insurance, whole life insurance is significantly more expensive than term life insurance because it lasts a lifetime and includes the cash value component.
While whole life insurance policies invest in low-yield savings for the cash value—things like bonds and CDs—other types of permanent life insurance invest elsewhere. For instance, variable life insurance have investment options like mutual funds.
Term Life Insurance
Term life insurance is much more affordable and common than permanent life insurance. If you die within the term of the policy, your beneficiaries can collect your death benefit. Term policies are usually 10, 20, or 30 years, and the premium and death benefit remain the same for the life of the policy.
If you’re looking for affordable coverage for dependents over a certain time period, term life insurance is a good bet.
How Much Life Insurance Do You Need?
When choosing a life insurance policy, you need to determine the length of the policy you want as well as the death benefit amount.
Life Insurance Policy Length
Coverage length is up to you and your circumstances. But, if you have long-term dependents, life insurance is best up until retirement. Since life insurance is basically a safety net for lost income, it makes sense to get life insurance for as long as you’re working.
If there are people that are financially dependent on you temporarily, you can get a life insurance policy that covers just that time period. For instance, you can get term life insurance to cover your kids until they’re on their own.
Life Insurance Payout Amount
Common life insurance death benefit amounts are $250,000, $500,000, and $1,000,000. While the payout amount is up to you, it's a common rule of thumb to try to replace 75% of the insured's income. When calculating the ideal death benefit, make sure you take into account whether the payments would be in installments or one lump sum. If a lump sum death benefit is conservatively invested, your beneficiaries could live off of the interest indefinitely.
An easy way to calculate the ideal death benefit is to multiply the insured’s income by 15. For instance, if you were making $100,000, then $1,500,000 would be the ideal death benefit. If that $1,500,000 was invested earning 5% annually, that would leave your beneficiaries $75,000 each year, which is 75% of your income.
How to Buy Life Insurance
If your employer doesn’t offer life insurance, you can buy life insurance on your own. You may want to buy life insurance independently anyway since it’s likely your employer life insurance policy would end once you left the company.
Once you’ve calculated how much you can afford in premiums, your preferred death benefit amount, and the term length, you’re ready to shop around for the best deal. Research online or find an online broker to get quotes. Once you’ve done some initial research, you’ll want to talk to an insurance agent about the specifics of the policies to make sure you understand the differences. You may be able to bundle your life insurance with other insurance policies you already have (think: auto, homeowner) to save even more.
What to Do When Updating Your Life Insurance Policy
There may come a time when you want to update a life insurance policy. If you have a term life insurance policy and would like to upgrade, some policies allow you to convert your term policy into permanent life insurance within a certain timeframe. If you can't convert your life insurance policy, make sure you get a new policy in place before canceling the old one. Not only will you cover any gaps, but there's a chance that you may not qualify for a new policy.
If you want to cancel your term life insurance policy, you can simply stop paying your premiums. Cancelling permanent life insurance is a bit trickier. Because of the cash value component, you should crunch the numbers and take a look at the tax implications before cashing in a permanent life insurance policy. To aid your analysis, ask your life insurance agent for an “in-force illustration” and a “cost basis report.”