Comprehensive guide to life insurance basics: Understanding Coverage, how it works. (2024)

Life insurance is a financial tool that can safeguard your partner, children, and loved ones in the result of a loss: namely, your death.

“In practicality, life insurance is much more than a contract. It’s a risk planning tool that can provide income replacement upon the death of a breadwinner, protect families from financial hardship, pay for funeral expenses, cover future expenses for a special needs child, help surviving family pay off debts and other liabilities so that these do not become a financial burden, protect businesses from financial hardship, and more,” says Celeste Moya, senior vice president of Lion Street in Dallas.

Put another way, a life insurance policy can give your survivors financial peace of mind if you’re no longer here to support them.

“If you are planning to start a family, purchase a home, or simply need to cover your final expense costs, you are among the perfect candidates for life insurance,” says Christopher Steven, licensed insurance producer with Ethos Life in San Francisco.

What is life insurance?

Life insurance is a legally binding contract between you and an insurance provider. A life insurance policy guarantees that the insurer will pay a death benefit to your named beneficiaries if you pass away, so long as you pay premiums for the policy while you’re alive and the policy is still active.

There are two main life insurance policies; term life and permanent life insurance. Under these two policies exist various kinds of insurance, such as whole life, universal life, and variable life insurance. Each type has its features and benefits depending on the individual’s needs and financial goals.

What does life insurance cover?

A life insurance policy covers different causes of death insured by your policy and the expenses the death benefit can help pay.

Causes of death covered by life insurance

Life insurance generally covers most causes of death with a few exclusions. If your life insurance policy is active when you die, the life insurer will pay out if the death is caused by:

• Natural causes: Such as illness, disease, or old age.

• Accidental death: Includes deaths caused by accidents and injuries.

• Suicide: If it happens after the policy’s two-year suicide clause period ends.

• Homicide: As long as there is no evidence of the insured’s involvement.

• Exclusions: Life insurance covers most causes of death, but certain exclusions may apply. These exclusions vary between insurance companies and policies but commonly include deaths resulting from war, terrorism, participation in hazardous activities (e.g., extreme sports), or illegal activities.

Expenses covered by life insurance

A life insurance payout can ensure that your beneficiaries have the financial means to pay the bills and achieve personal goals. Beneficiaries can use the death benefit for:

• Funeral expenses: Death benefit can be used to pay for the funeral or burial after the policyholder’s death.

• Debt repayment: Life insurance can be used to pay off outstanding debts, such as mortgages, personal loans, credit card debt, or other financial obligations.

• Education expenses: Life insurance can fund education costs for children or dependents.

• Childcare: Taking over the responsibilities that a spouse previously handled.

• Everyday expenses: Death benefit may help pay monthly bills and buy groceries and essential household supplies.

How does life insurance work?

Life insurance provides financial protection for your loved ones in the event of your death. To get a quote, you will need to decide the policy’s term length, the payout amount you want your beneficiary to receive, and who will receive the payout.

The carrier will also ask for personal information, including your health status and pre-existing medical conditions. If you have regularly paid your premiums, the insurance company will pay a death benefit to your designated beneficiaries if you die while the policy is in force.

When you pass away, your designated beneficiaries must file a claim with the insurance company and provide proof of your death. The insurer will then investigate the claim and, if deemed valid, will pay the death benefit to your beneficiaries. The death benefit is typically paid out tax-free to your beneficiaries and can be used for any purpose they choose.

How to get life insurance?

Buying a life insurance policy requires a few simple steps:

• Determine your needs.
• Decide on coverage length and amount.
• Identify reputable insurance companies that offer life insurance policies.

Depending on where you live, you have three potential options to purchase a life insurance plan.

• Independent local insurance agent represents multiple insurance companies and works directly with clients in person or through local offices to provide insurance policies and personalized advice.

• Independent online broker offers insurance policies from multiple insurance companies online, allowing customers to compare options and purchase coverage conveniently online.

• Life insurance companies provide insurance policies to individuals or businesses. Depending on the carrier, you can buy life insurance quotes online, by phone or through the company agent.

The way you choose depends on your personal preferences and convenience.

Types of life insurance policy

There are two primary types of life insurance:

• Term life
• Permanent life

Term life is typically the more affordable life insurance option, representing the simplest form of life insurance.

“Term life pays out only if death occurs during the term of the policy, which is usually between one and 30 years,” explains Mark Friedlander, director of corporate communications for the Insurance Information Institute in St. Johns, Florida. “Most term policies offer no other benefits than payout upon death.”

There are two basic types of term life insurance policies

• Level term
• Decreasing term

“Level term means the death benefit stays the same throughout the duration of the life insurance policy. Decreasing term means that the death benefit drops, usually in one-year increments, over the policy’s term,” Friedlander says.

Permanent life insurance, which includes whole life insurance, also pays a death benefit when the policyholder dies. But it doesn’t have to have a predetermined duration; instead, it’s intended to remain in place throughout the policyholder’s lifetime.

“Additionally, many permanent life insurance policies have an equity-like component called cash value. Policies that accumulate cash value have a specified interest rate credited each year, which compounds over time, building a cash reserve that can be accessed for various purposes,” says Celeste Moya, senior vice president of Lion Street in Dallas.

There are several subtypes of permanent insurance, including:

• Whole life
• Universal life
• Variable life

What is term life insurance?

Term life insurance is a policy that protects you over a limited amount of time or “term” — such as 10, 15, 20, or 30 years.

“Term life insurance is like renting an insurance policy. When you pay for it, you have it. But when you stop paying for it, you no longer have the coverage,” says Christan Hisco*ck, co-founder/CEO of Kardia Financial Group in Cowichan Valley, British Columbia, Canada.

Advantages of term life insurance

• A lower cost (especially when you’re younger) than whole-life policies.
• The ability to obtain a policy more quickly than a whole life policy.
• Possibly a larger death payout to beneficiaries than other types of life insurance.

Term policies can also often be converted to whole life insurance later.

Disadvantages of term life insurance

• It’s only temporary coverage.
• It may be challenging to qualify for a policy if you have serious health issues.
• You have to re-qualify after each term.
• Premiums can rise each time you take out a new term on the policy.
• The policy itself has no cash value.

“Unless it offers a return of premium feature, which can be costly, at the end of your term, you will have paid premiums into something that does not offer any kind of return or benefit. At that time, your premiums will likely increase substantially as well,” cautions Moya.

What is traditional whole life insurance?

Whole life insurance is a permanent life insurance offering protection with guaranteed premiums, cash values, and death benefits.

The base policy death benefit is guaranteed if you pass away, so long as your premium is paid as initially agreed upon. With traditional whole-life insurance, both the premium and the death benefit are designed to remain the same throughout the life of your policy.

“The insurer keeps the premium level by charging a premium that, in the early years, is higher than what is needed to pay claims; they invest that money and then use it to supplement the level premium, which helps pay the cost of life insurance for older people,” Friedlander says.

Moya explains that whole-life policies classified as “participating” offer the possibility of receiving policy dividends, which represent a portion of the life insurance company’s profits that are paid to policyholders.

“These dividends are generally not guaranteed and are paid at the company’s discretion. A dividend may be taken as cash or a policy may offer several other ways the dividend might be used, such as to reduce current premium payments,” she says.

Other pros besides a guaranteed premium, death benefit, and cash value include:

• The ability for the death benefit to increase over time when your “paid-up additions” option is selected for the dividends or when your cash value exceeds the death benefit.
• Coverage remains in place over your lifetime, unlike term life insurance.

“However, whole life insurance will be more costly upfront because it is a permanent policy,” says Hisco*ck.

It’s also not very flexible or easily adjustable, Hisco*ck adds.

What is universal life insurance?

Universal life is a type of permanent life insurance policy that provides more flexibility than traditional whole-life policies. That’s because a savings account is involved — called a cash value account — that commonly earns a money market interest rate.

“After money has accumulated in this account, you will also have the option of altering your premium payments — provided there is enough money in the account to cover the costs,” says Friedlander.

Universal life, also known as adjustable life, provides level or flexible premiums and death benefits with the potential for cash value accumulation. The cash value may rise based on the performance of assets within your account and per the declared crediting rate, which the insurer can increase or decrease at its discretion.

Universal life provides the added flexibility to modify the policy face amount or premium in response to changing needs and circ*mstances, according to Moya. She adds that there are several different types of universal life, including current assumption universal life, no-lapse guarantee universal life, universal index life, and variable universal life.

“People like universal life because of its flexible funding options and flexible death benefit that can be decreased, if necessary, to reduce coverage or lower premiums. But unless the death benefit is guaranteed and the premiums have been paid as originally agreed, the policy could lapse early, and/or additional premiums may be required to keep the policy in force if it does not perform as originally projected,” Moya says.

What is variable life insurance?

Variable life insurance is a policy combining death protection with a savings account that can be invested in money market mutual funds, stocks, and/or bonds.

“This type of policy permits you to allocate a portion of each premium to one or more investment options through separate accounts. As with universal life, the death benefit and premium structure may be modified to meet changing needs,” notes Moya.

One advantage of variable life insurance is that the value of your policy may grow more quickly, as there is uncapped growth potential for cash accumulation. However, it can take on more risk, too.

“If investments do not perform well, your cash value and death benefit may decrease,” says Friedlander. “Some policies, however, guarantee that the death benefit will not fall below a minimum level.”

Unless your death benefit is guaranteed and your premiums have been paid as initially agreed, your policy could lapse early, and/or extra premiums may be required to keep your policy intact if it does not perform as expected initially.

If you’re more risk-averse, variable universal life policies offer a moreconservative fixed account as an investment option with a declared crediting rate, which is not guaranteed and can be decreased at the insurer’s discretion to a contractually guaranteed minimum.

Which is better: term or whole life insurance

The answer to what’s the best life insurance will depend on several factors and your personal needs and circ*mstances.

“You should consider term life insurance if you need life insurance for a specific period. For example, if you have young children and want to make sure there will be funds to pay for their college education, you might purchase 20-year term life insurance. Or, if you want insurance to repay a debt that will be paid off over a specified time, buy a term life policy for that,” suggests Friedlander.

On the other hand, if you desire life insurance for as long as you live, the permanent/whole policy will pay a death benefit whether you die tomorrow or live to be over 100.

“If you want to accumulate a savings element that will grow on a tax-deferred basis and could be a source of funds you can borrow from for a variety of purposes, a whole life policy is worth exploring,” adds Friedlander.

“The savings you earn can be used to pay your premiums or for any other purpose. You can borrow from these funds even if your credit is shaky as well. The death benefit is collateral for your loan and if you die before it’s repaid, the insurance company collects what is due before determining what goes to your beneficiary,” Friedlander says.

The major caveat is that premiums for whole-life policies are usually higher than for term-life policies. The good news is that whole-life premiums remain the same, while term insurance premiums can increase significantly each time you renew the policy.

Types of life insurance riders

Life insurance riders are additional benefits that can be added to a basic life insurance policy, usually for a price. These are often available on permanent life insurance policies. Adding one or more riders enables you to customize your policy to your needs.

This allows you and your beneficiaries to have extra financial protection if particular circ*mstances arise covered by the rider.

Popular life insurance riders include:

• Waiver of premium disability rider – This rider allows you to stop paying your premium if you become permanently disabled or lose income due to an illness.

• Daily living rider — This rider accelerates a portion of your life insurance policy’s death benefit in the event you’ve been chronically ill for a minimum of 90 days and remain ill for an additional 90 days or beyond. This rider may provide a daily allowance to cover your long-term care needs, such as assisted living or nursing home care.

• Long-term care rider — This rider helps pay for in-home care, medical equipment, and other healthcare costs associated with aging.

• Cost-of-living rider — This rider enables you to automatically increase life insurance coverage benefits to your existing policy based on the Consumer Price Index, which counters the effect of rising inflation over your policy’s lifespan.

• Chronic illness rider — This rider provides a way to take out money from your life insurance policy if you’re diagnosed with a qualifying chronic illness.

Life insurance terminology

It’s wise to become familiar with commonly used words and phrases related to life insurance. You’ll notice these terms mentioned in your policy, and your insurance agent may use them during your conversations.

Here are several of the most important terms to understand:

• Accelerated death benefit — This life insurance policy option allows the insured to receive a portion of the policy’s death benefit while they’re still living. These funds can typically be accessed if you have a terminal illness and a life expectancy of 12 months or fewer.

• Accidental death and dismemberment — A policy that only pays out a benefit when your death is caused by an accident or when there is a loss or loss of use of a body part. An AD&D policy can be a standalone or added as a rider to a life insurance policy.

• Beneficiary — The person(s) or entity(ies) you name and a life insurance policy who will receive the death benefit payout when you pass away.

• Cash surrender value — The amount before adjustments for factors like policy loans that the owner of a permanent/whole life insurance policy is entitled to receive if the policy doesn’t remain in force until the insured’s death.

• Coverage period — The time during which a life insurance policy remains in force.

• Death benefit — The policy proceeds paid out to the designated beneficiary(ies) upon the insured’s death.

• Group life insurance— A single policy covering a group of individuals, often employees or members of the same organization, and their dependents. An employer owns most group policies and covers their employees.

• Insured — The person whose life is covered by the life insurance policy and whose death triggers the payout of the policy’s death benefit.

• Living benefits — Benefits that pay out when the insured is still alive, such as in the event of a critical illness or disease for which the policy may pay out a percentage of the benefits.

• Living will — A legal document that allows the insured to outline his or her wishes for end-of-life medical care, including procedures or medications desired, in the event they become unable to communicate their decisions.

• Mortgage life insurance — A form of decreasing term insurance that covers the life of a person taking out a mortgage loan. Death benefits provide payment of the outstanding balance of the loan. Coverage is in the form of decreasing term insurance, which means the amount of coverage decreases as the debt decreases.

• Premium — The payment required to keep a life insurance policy in force.

• Rider — An attachment or add-on to a life insurance policy that alters the policy’s terms or coverage.

• Underwriting — The process of examining, accepting, or rejecting insurance risks and classifying the ones accepted so that an appropriate premium level can be charged. The underwriting process involves a team of experts who determine whether the applicant is qualified for the insurance policy.

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