Protecting your family from financial disasters is one of the fundamental components of financial planning. Life insurance should be a core part of that planning process. This article is a basic primer on life insurance, which should introduce you to the concept and give you an idea of how life insurance works.
What is life insurance?
Most people have a basic understanding of insurance. You receive financial compensation when an insured event occurs. Consider auto insurance, for example. If your car is in an accident or stolen, your insurance company provides compensation according to the terms outlined in your insurance policy.
On the surface, life insurance is pretty straightforward. When the insured person dies, the policy pays a prearranged amount to the designated beneficiary. The following parties are generally involved in a life insurance policy:
- The Insured: The person on whose life the policy is based.
- The Beneficiary: The person who receives the payment.
- The Owner: The person responsible for payment of premiums. It is typically the insured, but it could be the beneficiary.
- The Insurer: The insurance company that issues the policy promising payment.
Traditionally, both spouses have life insurance policies in order to protect their family in case one of them dies.
Why purchase life insurance?
The main purpose of any life insurance policy is to protect your family and loved ones against the risk of financial uncertainty. Life insurance can provide for the welfare of your family in face of your death. If you have a spouse, three kids, a mortgage, car payments, and credit card bills, what would happen to them if you were suddenly to die? Would your family have enough money to keep the house, car, pay off credit card debt, and send your children to college?
Life insurance can guard your family and loved ones from potential financial disaster.
Types of life insurance
While the idea of life insurance may be pretty basic, there are some complexities to consider. The most important point to remember is that there are several different types of life insurance products, which can make it difficult to select the right one for your family and your financial needs.
There are two basic forms of life insurance — term life and permanent life, the latter of which comes in several flavors. Here's a quick breakdown of the basic policy types:
Term life is the simplest and (typically) cheapest form of life insurance. Term life is designed to provide coverage for a fixed period of time, such as 5, 10, or 20 years. The premium for the term policy is guaranteed for the duration of the term; if it is a renewable policy, the premium will increase with each renewal. The premiums for renewals are generally guaranteed when the original policy is issued. Because term life policy is for a specific period of time and the payout does not increase, the overall cost of term life insurance is usually very low.
The other three common types of life insurance are permanent policies &mash; they last for the entire life of the insured, not just for a fixed period of time.
Whole life policies, for example, are designed to provide you and your loved one with coverage until your death. Unlike term life, there are no fixed periods for whole life coverage. Whole life is sometimes referred to as “cash value” insurance because it builds cash value over your lifetime. Whole life coverage contains both investment and insurance components. The investment portion invests your premiums, earns interest, and accumulates a cash value. On the other hand, the policy also has a stated insurance coverage amount that is paid upon the death of the insured.
One of the most popular forms of permanent life insurance is variable life. Variable life policies allow you to invest your premiums in the stock market. While a variable policy may offer more significant returns, it's also at the mercy of stock market performance. In a poor performing market, the overall death benefit/cash value of the policy may decline — but never below a defined level. As a result, the policy may be more expensive because you may have to pay more to keep the policy active because less money is available to cover the policy's premiums.
Universal life is a popular option that acts like whole life. It is a renewable policy — the investment component, premiums, and death benefits can be renewed and changed based upon the policy owner's needs. The policy owner has flexibility over the policy — money can be moved between the insurance and investment components of the policy. The premiums, unlike whole life policies, can be paid out of interest from the accumulated savings.
Life insurance: A great tool
Because of its many options and overall flexibility, life insurance can be a powerful tool in your financial planning arsenal. Consider that life insurance can be used to pay for funeral costs, college tuition, mortgage payments, debts, and more. It can also serve as income replacement — providing your spouse and family with a greater sense of financial certainty. Make sure you compare multiple quotes from different providers to make sure you're getting a good rate, but also be careful to make sure you're being priced for the same level of coverage (here's a table where you can compare different life insurance companies).
Remember, like all insurance policies, your coverage can lapse if you do not make timely payments. If you need help to cope with the complexities of life insurance, contact an insurance professional. You should also read the fine print closely (possibly with the help of your insurance professional) to understand if there are any limitations on the policy and what it covers.
Note: Ray has submitted a follow-up article that builds on this info to offer tips for purchasing life insurance. I'll post that soon. Also, here's a guest article on disability insurance that I hosted last year.