What Is Life Insurance?

Definition & Examples of Life Insurance

A little girl adds ingredients to a bowl while two women smile at her as they bake together
•••

MoMo Productions/Getty Images

Life insurance is a financial product sold through insurance companies. In exchange for paying regular premiums, you’ll receive a death benefit upon the death of the covered individual.

While many financial professionals agree that life insurance is an integral part of financial planning, the average person might not be clear on how life insurance can benefit them or whether they even need it. Let’s take a closer look at what you need to know about life insurance and how it might fit into your financial plans.

What Is Life Insurance?

At its core, life insurance is a contract drawn up between an insurance company and a policyholder. The contract stipulates that the policyholder will pay set premiums to the insurer for a certain period of time, and the insurer will pay a death benefit upon the passing of the covered individual—if the death occurs while the policy is in place.

The insurer cannot change or cancel the life insurance policy if the health of the covered individual changes, which means that life insurance provides a kind of financial guarantee. However, insurance companies may refuse to insure some people because of their health issues, substance use, or other reasons. Age is often the biggest factor that affects health insurance availability and cost, since the likelihood of death rises with age.

The two basic types of life insurance are term and whole (or permanent) life insurance. Term life insurance will only pay out if the covered individual passes away during the coverage term. If the covered individual outlives the policy, there is no death benefit. Whole life insurance tends to be more expensive than term, but the insurer will pay a death benefit whenever the policyholder dies.

How Does Life Insurance Work?

To purchase a life insurance policy, you will need to start by determining your needs. Many people purchase life insurance as a sort of income protection—a way to ensure that their family will be able to maintain their standard of living even after the death of the policyholder. Other financial considerations include covering the cost of a funeral and burial, or creating an inheritance for your heirs or a charitable legacy. Knowing how you intend for your beneficiaries to use the life insurance proceeds can help you decide how much coverage you need.

From there, you can research the cost of a policy with various insurers. While you can shop around to get a basic idea of how much a policy with your preferred death benefit will cost, it’s likely that you will need to go through underwriting with an insurer to find out exactly how much your premiums will cost. Underwriting is the process by which an insurance company gauges the risk of insuring you. Life insurance underwriting may include everything from health questions to medical tests or exams. 

You will pay the premiums according to your contract with the insurer. When you die, as long as you still have coverage, your beneficiaries will receive the death benefit outlined in your contract.

Types of Life Insurance

Life insurance may come in two basic types, term and whole, but the whole life insurance umbrella includes some additional options:

  • Traditional whole life insurance: This kind of coverage provides a death benefit no matter how long the policyholder lives, so premiums for whole life insurance are usually higher than those for term life insurance. However, if you live long enough that your premiums have “overpaid” for the death benefit, the excess in premiums will be made available to the policyholder as a cash value in lieu of the death benefit. 
  • Universal whole life insurance: Also known as an adjustable life insurance policy, this kind of whole life comes with a savings vehicle (the cash value account) that earns interest. Once your cash value account has accumulated a certain amount of money, you may have the option to change your premium payments. Loans may also be taken from the cash value account, and the death benefit remains in place as long as there is enough money in the cash value account to cover the cost of the insurance. 
  • Variable life insurance: This kind of whole life insurance policy combines a death benefit with an investable cash value account. Policyholders can choose to invest in things like stocks, bonds, or money market mutual funds. This means policyholders take on both the additional potential reward, if the investments do well, and the potential risk if the investments don’t have a good return. It is possible that the cash value and death benefit of a variable life insurance policy can decrease based on the performance of the underlying investments.

Do I Need Life Insurance?

To decide if you need life insurance, ask yourself the following questions:

  1. Would my family struggle to pay for my final expenses if I were to die unexpectedly?
  2. Does anyone rely on my income to live?
  3. Do I have a mortgage?
  4. Do I carry any other debt?
  5. Do I have a child who has yet to go to college?
  6. Am I the owner of a business?
  7. Is there any kind of legacy I’d like to leave, as either a gift to charity or an inheritance for my family?

If you answer yes to any of these questions, you may want to consider buying life insurance. Though not everyone needs the financial coverage life insurance provides, people in any of the above circumstances are good candidates for it. If that’s you, you can use a life insurance policy to ensure that your death won’t leave behind a financial burden.

Key Takeaways

  • Life insurance pays a death benefit in exchange for regular premium payments.
  • Term life insurance provides a death benefit only for a defined term, while whole life insurance pays out no matter when the policyholder dies.
  • The cost of life insurance may go up with age and if you have any health conditions, and some people may not be eligible to purchase life insurance if they cannot pass the medical exam or underwriting process.
  • Whole life insurance may come with a cash value account.
  • If you have family members or others who depend on your income and ability to pay off debts, you may be a good candidate for life insurance.