An introduction to life insurance

Many of you have asked for life insurance information, so Ray from Financial Highway offered to provide this guest post on the subject. This is new info for me, too.

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.

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Nicki at Domestic Cents
Nicki at Domestic Cents
11 years ago

Thanks so much for this post. I was more on the confused side of things as far as life insurance goes. This was a big help.

frugalscholar
frugalscholar
11 years ago

I’ve noticed that some of the guest posts have been written by “professionals,” that is, people who make their living by selling these products. That is, sales people who make commissions. Perhaps these posts should be balanced with posts by non-professionals? Just a thought.

I don’t know about this one in particular, but others have been written by financial planners etc. It would be helpful to warn people of the kinds of commissions attached to various products.

John
John
11 years ago

Great post, I have actually just begun to think about getting life insurance with my second child on the way. I hate to think of the financial burden my family will face if something ever happens to me. Good timing.

Amy Williams
Amy Williams
11 years ago

I have a ‘friend’ (actually, acquaintance who’s a rather obnoxious insurance salesman) who tries to push whole life insurance on anyone and everyone because of its “cash value” that can be withdrawn at any time.

I’m 31. I’ve had a whole life policy since birth that has a pretty decent cash value built up. Are there any disadvantages to withdrawing it?

Kevin
Kevin
11 years ago

Sorry JD, but I was disappointed by this article. It really felt like an infomercial. It failed to address the single most important question of all: “How do I know if I need life insurance?” Instead, it just said “Life insurance is great,” which is what I’d expect to hear from an insurance salesman. I think a paragraph discussing how to determine how much life insurance you need (or if you even need it at all) was sorely needed in this post. Incidentally, if you’re single and have don’t have any dependents or co-signers on any of your debts, you… Read more »

Kyle
Kyle
11 years ago

In general, I think its best to keep to the simplest (TERM) life insurance and forget about the other types. With the more complicated life insurance products you are mixing insurance with investments and its easy to get confused about what kind of a deal you’re actually getting. By keeping your insurance and investments separate its easier to compare apples to apples.

BloggingBanks
BloggingBanks
11 years ago

That was an interesting post Ray. I didn’t know about insurance, but now I have a stronger foundatin on the subject.

Keep upi the good work!

Blogging Banks

Tim
Tim
11 years ago

If you have not maxed out your 401k, IRA, and Roths and want to invest money, max them out before investing in cash value life insurance. Don’t buy the salesman’s pitch that you get great returns and flexibility as you can get those with your IRAs and Roths as well. Review the fees in the different types of insurance categories. Also, if your looking for the worst performing mutual funds you will probably find some of them in the life insurance products. This is because the insurance company has “captive” money. You can’t remove it without penalty so they can… Read more »

getagrip
getagrip
11 years ago

While this is a decent article, it leaves out much of the decision processing that goes on in chosing life insurance. How much should you get? What type is best now? Do you really want to make your death the lottery win for your family? etc. Also, most insurance agents will tend to push the Whole or Universal life policies because the commisions are substantially higher, but if your goal is protection of your family during your prime earning years, you get much more bang for the buck with a term policy. For example, a $500K policy for a non-smoking,… Read more »

Tonya Askins
Tonya Askins
7 years ago
Reply to  getagrip

This helped me make my decision because with the term policy. I/My family would have spend $24,000 with 0% return. If I spend $24K on something, I’d like to have something to show for it.

Ray
Ray
11 years ago

@ Amy If you have had the policy for 31 years that is great! Right now the premiums are probably lower than a term for you. So defiantly keep the policy, unless you really need the Cash value leave it in the policy it can be a great additional retirement income.

@ Kevin: JD and I wanted to go over the basics of insurance first, there is a follow up post that address questions re life insurance and how much you’d need.

@ Kyle 100% agreed!

Ray
Ray
11 years ago

p.s. I am not sure how some get the idea that I am an insurance salesperson, I WAS one but currently NOT involved in direct insurance sales to clients. 😉

Kelly
Kelly
11 years ago

This is a great starting point to understand the basics of insurance, but I would love to see an article on how to figure out IF you need life insurance, and how to come up with a $ amount to be insured for.

I also want to personally say that we used Accuquote for obtaining my husband’s insurance, and we were very happy with the process and the price! (I’m in no way affiliated with them BTW!)

RAJEEV KUMAR SINGH
RAJEEV KUMAR SINGH
11 years ago

Interesting and very informative post.. Gives clear idea on the various types of insurance.. I have myself worked for insurance companies and out of my own experience I can tell you that other than Term Insurance, all other insurance schemes are a big scam. They just dont get you enough in return. Term insurance ic a pure insurance and is a must for every individual. So my advice would be “Buy Term and Invest The Rest” as Dave Ramsay would agree.

Brad Harbach
Brad Harbach
11 years ago

Good post. I think it is important to point out that Life Insurance is NOT for everyone. I blogged about this back in January.

http://www.twentysomethingsense.com/2009/01/do-you-have-any-dependents.html

Buying Life Insurnace when you have no dependents – someone who relies on you for support or aid – is like buying a lottery ticket that only pays out if you die.

Beth
Beth
11 years ago

I found this post to be helpful because I’m not familiar with the insurance terms I’ve been reading in the financial blogs (Not sure if insurance is sold differently where I am though).

I too would like to know if I’ve got enough. I’ve got a policy through work that pays a year of my salary, but any financial calculator I’ve tried says that’s not enough. I’m single, no kids and only one debt (which is insured itself), but I’ve been thinking of getting life insurance while I’m still reasonably young and healthy.

Helen
Helen
11 years ago

Most every reputable financial advice source I’ve read says “Stay away from whole/variable and stick with term!” Big emphasis on this. What I’ve heard over and over is that life insurance should NOT be used as an investment. Ideally it’s income replacement protection, just in case, same as disability insurance (which everyone should also have). Also, a timely topic would be how to evaluate the health of an insurance company. We’re looking at unstable period in general, and there have been warnings about quite a few major companies in the news recently. How does one make sense out of various… Read more »

Atticus
Atticus
11 years ago

I’m going to echo concerns of earlier posters. I really hope you’ll weigh in with a more substantive post about the pros and cons of the various types of life insurance. Most people who know about the issue consider whole life insurance a complete scam. Period. By giving it equal billing with term life insurance, you’re implying that it’s a similarly worthwhile option. It’s not all that different from discussing types of investments, and listing “Ponzi scheme” alongside stocks, bonds, and mutual funds. No offense intended–I’m not saying you mean to promote bad investment options. I’m just saying that this… Read more »

Ray
Ray
11 years ago

@ Beth I am not a big fan of employer sponsored policies, if you really NEED life insurance always get an individual policy. If you are single and no obligations than you do not have much of an insurance need. there’ll be a second post with tips on how to get the right insurance policy. @ Helen, I know many people are worried about their policies BUT all policies are backed by state guranty association in the US so if your company goes down you will still get the bailout. I am usually against switching companies unless you have a… Read more »

Michael @ The Life Insurance Insider
Michael @ The Life Insurance Insider
11 years ago

Get off of Ray’s back. He delivered what the title described. Introduction to Life Insurance. Your description of term insurance is a little off. The “term” in term life insurance refers to the length of time that coverage lasts. In most term products the term usually lasts until the insured reaches ages 70-100 years old. If you look on most policies it will say something like “Term to age 80”. This means that you have guaranteed coverage until that age. The period of 5, 10, 20, etc years you describe above is the level premium period. During this time the… Read more »

Brett
Brett
11 years ago

J.D. Another good article topic would be on disability insurance. From what I’ve seen, however, disability can be more difficult to get than life insurance. Furthermore disability insurance is probably *more* important than life insurance (from my understanding) since it is more expensive to be disabled.

Paularado
Paularado
11 years ago

You can now purchase term life insurance where you get the entire premium back at the end. I think that this type should have been addressed. It is called Return of Premium (ROP). This type of insurance is sort of crossing the line of investment with term because the monthly premiums are more. Kiplinger’s did an analysis of it and determined that you would be better off investing your extra premium yourself at the end. http://www.kiplinger.com/magazine/archives/2006/03/insurance.html My husband and I determined that we needed enough insurance to pay off the house and have 1-2 years of salary. We got a… Read more »

Ray
Ray
11 years ago

@ Micheal ahah thanks for the back up. I am a little confused about the two different terms you talking about. Unless US has some different policies usually all premiums with term is level till RENEWAL, yes ones you renew your premium increases.

@ Brett agreed. Disability is important but VERY complex policy. Chances of disability before 65 is much higher than chances of death

Tim
Tim
11 years ago

Wasn’t gonna comment until I saw an ad right under the article for…. insurance for your children. What’s the author’s view on that? I’ve always been skeptical from a financial perspective — and always a bit turned off on the often-emotional sales of insuring your children’s lives, even if it’s in a whole-life ‘investing in their future’ wrapper.

J.D.
J.D.
11 years ago

Good morning, everyone. For the first time in a week, I’m available to participate in the comments. I appreciate the concerns from those who think this post is “sales-y”, but it didn’t strike me that way. Still, I know almost nothing about this subject, which is the main reason this post had a long, tortured path before publication. We worked on it a lot behind the scenes in order to get it right. It still might not be perfect, but I think it does answer the basics. As Ray mentioned, he has submitted a second post (which may go up… Read more »

Colin
Colin
11 years ago

Also, a bit disappointed to see that no one touched on the estate planning aspects of life insurance. Since the estate tax is quite high and life insurance payouts are not considered taxable income, the benefit of having life insurance to cover your estate value, can in many ways save you from losing 35-45% of your estate to the Federal Gov’t!

Crystal Groves
Crystal Groves
11 years ago

I’ve been trying to find life insurance for my father for months now with no luck because he has Type II diabetes. If you have any suggestions for insurance for diabetics, let me know.

Aman@BullsBattleBears
11 years ago

This is something that I needed to read! I have been considering getting life insurance (even tho I”m still under 30) but did not know the types. This really was a good introduction. Thanks.

Richard
Richard
11 years ago

A few things that were left out of the post. A) Term can go to age 100 with some policies level up to 35 years. B) Whole Life insurance builds up cash value to EQUAL the face amount at around age 95 or 100. (Funding OWN policy with OWN money) C) Universal, Variable, and Variable Universal (at least from the ones I have seen) have a date on the first page stating when the policy will lapse IF you pay all your premiums on time as expected. Usually, it is around age 65 – 70. It lapse’s because it was… Read more »

Omer
Omer
11 years ago

I have both a term and whole life policy. I figure in 20 years once the term runs out I should be okay without it. However it’s nice to know that I will have the Whole Life policy forever (in my low 30’s now). I was taking a look at my investments in the beginning of the year, and the only thing that did not lose money was my Whole Life “investment”, it actually gained because of Dividends. So ultimately the way I see it is get Term as a necessity, Whole life as a luxury/hedge investment. Thoughts?

Sharon
Sharon
11 years ago

I don’t have Life Insurance. I am 53, children all grown, live alone, house paid for, with no debt. I plan on pre-paying my funeral.
I hope it’s not a mistake but I don’t see the need for me to have life insurance. I would appreciate any thoughts, if you think that I’m making the wrong choice.

AXE
AXE
11 years ago

I do employee benefits consulting work and I’m a licensed insurance agent although I do not actively sell insurance. I’ll throw in my $.02. Need: Even if you are single and relatively young you may want to take advantage of a small cheap term policy to help pay off your funeral expenses and the costs of liquidating your stuff. Life insurance will pay a benefit faster than some of your funds may become available at the time of your death. Your loved ones will have to float the costs. Small and cheap should work. For everyone else I will echo… Read more »

The Beagle
The Beagle
11 years ago

Although I agree with posters that stated that young people without dependents do not need life insurance, there is a risk factor involved in holding off on a policy. A few years ago I thought $100K on top of one year’s salary was plenty (I was living in a rental apartment with a girlfriend). Then I was diagnosed with cancer. Although I recovered (after lengthy chemo), it means I am now blacklisted and, with a mortgage, spouse and child, I am still limited to that same amount I signed up for as a carefree 20something. After 2 1/2 years of… Read more »

Richard
Richard
11 years ago

@omar the reason the policy grew was because it is not an investment. It’s closer to a savings account earning between 1 and 4%. It wasn’t a dividend. A dividend in life insurance is a return on intentioanlly over paid premium. Does that spound fair to you? @axe I advise against ad&d policies. Only about 2 to 5% of claims pay out because death was not caused by an accident. In otherwords, if in a car wreck, you better die at the scene BEFORE the ambulence gets there, otherwise you died due to complications and NOT the accident. A fine… Read more »

Richard
Richard
11 years ago

@the beagle
Wait a few more years. After 5 years of being clean, companies will start looking at you. Once that 5 year mark hits, try adding every 6 months until you get the extra coverage. Miracles will happen if you work for AND expect them.

AXE
AXE
11 years ago

@ Beagle Thats a good point. It really depends on you personal situation and related risk tolerance. The odds are still very small that a person will contract cancer while relatively young however each person’s needs are different. Keep in mind too that the cost of Life insurance in the group market has been fairly level. In reality it should be going down as people live longer and efficencies in administration and underwriting increase. A young person stands to get a better deal on a term policy in a few years vs. in today’s market although that value will be… Read more »

JC
JC
11 years ago

I’ve done my research when I bought my term life policy recently. I think anything other than term is a waste as you’ll be paying the agent a nice bonus. I’m 31 but have four kids, and my wife currently stays home so insurance is a must. I settled on a 1mill 10yr policy at $390 a year (I got lower premiums by taking health/blood tests). By purchasing the insurance through my home/auto provider, I saved on those policies as well. Colin pointed out a big point, as life insurance payouts are not considered taxable income; your beneficiary will receive… Read more »

Aaron
Aaron
11 years ago

There is a lot of talk and focus on the different types of life insurance there are and which type is best for an individual. In general (not just here), this is an over-emphasis that leads to more confusion than it is worth. Some agents I know even use the vast number of types (not all are listed here) and technical details to confuse and steer clients towards the agent’s favorite choice. Folks should focus on their needs and the purpose behind the insurance first. Once they define that, then go shopping. This will eliminate a lot of confusion because… Read more »

ABCs of Investing
ABCs of Investing
11 years ago

Along with some of the other commenters, I demand to know why this post, along with the vast majority of other posts on this blog (including the ones I’ve written) don’t cater to my exact life scenario, knowledge base and intelligence? 🙂 Seriously – good post Ray – looking forward to the part II. I have term insurance only. From what I understand – all other types of insurance have high fees. I’m kind of a “keep things separate” kind of guy – I want my insurance products to be insurance-only and I want my investment products to be investment-only.… Read more »

Lesley
Lesley
11 years ago

@Beagle I had something similar happen, EXCEPT I’d just gotten the insurance less than a year previous. We’d had one kid and I’d just gotten pregnant with the second, so we realized we really needed to get some life insurance. We insured ourselves appropriately, and one week after the birth of my second child I almost died of a pulmonary embolism, a blood clot in my lung (a rare complication of pregnancy). Although no underlying clotting disorders were found, I still have 20x the risk of having a second embolism, and I might not survive it if it happens again.… Read more »

Heather
Heather
11 years ago

I can’t read through every comment, but regarding the tax side of life insurance: I deal with estates and inheritance tax and I’ve often seen where a person will die with no beneficiary listed on their policy, or the beneficiary on their policy has died and the default is the estate. When this happens, the proceeds are taxable on the fiduciary return, as well as Indiana Inheritance tax returns.

A note of advice: Keep beneficiaries current and list more than just a primary beneficiary. List a second…a third…even a fourth.

Jeff
Jeff
11 years ago

The issue I have come across many times discussing life insurance with friends is that we tend to look at a life insurance payout like a lottery win for our family after we are gone.

The part that is more difficult to understand is how the insurance company is making a profit from my premiums while still paying a large sum when I die.

Ray
Ray
11 years ago

Tones of good comments and some questions I think some of it was answered I’ll try to get to a few of them. @ Richard those are great points, but again JD and I wanted to keep it very basic and just an introduction to the topic. There will be a second post with tips. @ Beagle sorry to hear your situation, there are too many in your situation that is why I think insurance planning is so important. Depending on the type of cancer and your health status you can still qualify for insurance. I suggest you find a… Read more »

lisa
lisa
11 years ago

Good basic info. I carried term life while I was young and raising my family. That expired and now I have only a small whole life policy that I pay into until I am 65. At that point I can just let it sit, borrow against it, or cash it out. I was maxed out on 401K’s and IRA’s so this seemed like a no brainer to me. But as a rule, term is your best bet if you want lots of coverage while raising your family.

Chett
Chett
11 years ago

I am taking Estate Planning for my CFP this semester and this is what I’ve learned about life insurance. It depends. That’s it. It depends on your individual circumstances. It is reckless to agree that the best way to deal with life insurance is to buy term and invest the difference. While I do agree that for a large portion of the population that is 40 or younger, term is a more cost effective measure, it is not the only solution. For example, if you own a small business that has generated a fairly large estate for your family and… Read more »

DebtGoal
DebtGoal
11 years ago

While life insurance might have its merits, it is not something that a family revolving non-mortgage debt from month to month should invest in. Setting financial priorities is key.

Richard
Richard
11 years ago

@Lisa You will still be paying for that policy till you cancel it or you die. Instead of coming out of your pocket, they take it out of the cash value. After all, the purpose of the cash value in a whole life policy is to reduce what the insurance company has to pay. At age 100, your CV = Face amount. @DebtGoal If a family has revolving debt they have a need for life insurance. Upon death, the debts get paid out of the estate or by whom ever is a joint on the accounts. Most families, although the… Read more »

Kevin
Kevin
11 years ago

@Chett (#44): You make some good points, but I wanted to provide a counterpoint. Someone who buys a term policy at age 40 could very well need life insurance. However, as they grow older and the premiums increase, they should have less and less need for life insurance. They should have accumulated assets on their own that would enable their surviving spouse to carry on without them. That’s one thing that’s always bothered me about the life insurance industry. If you watch a little daytime TV, you’ll eventually see commercials featuring an elderly couple discussing life insurance, and how they… Read more »

Chett
Chett
11 years ago

I don’t want to get in an argument over details that are beyond basic life insurance. I just wanted to make a point that the advice to “buy term and invest the difference” does not apply to all. The argument could take a lot of different directions and in the end a person should contact professionals to see what is best for *them* I don’t work in the industry, I don’t sell anything. I just think readers here should not take a few comments from a blog and make a decision that could cost their family money, without talking to… Read more »

Richard
Richard
11 years ago

@Chett you are right. It doesn’t apply to all. Sometimes it is just invest, others it is just buy term.

You don’t work in the industry yet you are working towards (or keeping) your CFP? Hmm. That’s odd because a CFP does work in the financial services industry and is a salesman like any other agent in the industry.

Ray
Ray
11 years ago

@ Richard CFP is not necessarily involved in the sales of products

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