Life insurance mitigates financial risks when the insured person dies. It’s actually a very straightforward concept.
The life insurance policy (contract) is simply a promise to pay in exchange for a premium. What makes life insurance confusing to most people is the number of promises that can be a part of the contract.
These are known by insurance nerds as “terms and conditions.” At the risk of turning what should be a simple article into a reference book, we intend to keep this simple and explain the who, what, when, where, and why, to respond to “how does life insurance work.”
In This Article:
- Why Purchase Life Insurance?
- Who Should Buy Life Insurance?
- What Are The Types of Life Insurance?
- How Much Life Insurance Do I Need?
Why Purchase Life Insurance?
The purpose of life insurance depends on the needs (the risks) of the individual, family, or business considering it. As we mentioned earlier, life insurance mitigates financial risk by transferring the risk from the policyholder to the insurance company.
In most cases, the word “risk” is plural because rarely will someone purchase life insurance to mitigate only one risk. There are usually multiple risks involved, even if the insurance shopper doesn’t know it.
For example, when a working head-of-household decides that life insurance is the best method to replace a family’s primary source of income if he or she dies, the financial risks that are considered are relatively common for most families:
- Monthly living expenses for a certain number of years
- Paying off the mortgage on the family home
- Paying off debt like credit cards or vehicle loans
- Paying for college tuition
- Investing in a retirement plan for the surviving spouse or partner
- Paying final expenses like funeral expenses and unpaid medical expenses.
Unless you have a boatload of cash that your survivors will be able to access immediately after your death, a life insurance policy can mitigate each one of the above-mentioned risks with one affordable insurance contract with an insurance company you select.
Certainly, life insurance can mitigate a single risk like paying off a mortgage in the event of death, and many companies market life insurance in that fashion. But in most cases, a life insurance policy will do so much more for the policyholder.
Who Should Purchase Life Insurance?
Now that we know why someone would purchase life insurance, let’s discuss who should purchase it. The answer is easy; every adult should purchase life insurance. It’s plain and simple.
Even if you are single and have no dependents when you die, someone is going to have to pay for disposing of your remains, whether by burial or cremation. The average cost of a no-frills funeral is at least seven or eight thousand dollars, and cremation is about half of that amount.
But when you have people (loved ones) that will be affected financially upon your death, the best method to provide the funds they’ll need is to purchase life insurance that will pay an immediate death benefit (unless death is in the first two years and not accidental).
And, let’s not forget about the financial benefits of permanent life insurance like whole life or universal life insurance. With these policies, there are living benefits like interest on your cash value account and the accelerated death benefit provision that provides money to the insured in the event of a chronic, critical, or terminal illness.
If structured and funded properly, certain kinds of policies can be used for retirement planning (commonly referred to as a LIRP) and deliver a tax-free income stream for retirement.
The bottom line here is that even if you have put cash aside for final expenses or other financial needs for surviving loved ones, the money you’ve set aside will likely not be available ten days following your death when your loved ones will need it the most. With a life insurance policy in place, the death benefit is typically paid within a week (and funeral directors know this).
What Are The Different Types of Life Insurance?
Here’s where most people get hung-up, and quite frankly, there’s no reason for it. There are two primary kinds of life insurance:
- Term Life Insurance: which is considered temporary
- Permanent Life Insurance: which lasts a lifetime
All of the different types of life insurance that are being marketed today are based on these two primary kinds of life insurance.
Term life insurance is considered “temporary” because the policy is purchased with a pre-determined expiration date like 10, 15, 20, 25, or 30-years. But in reality, most of these policies can be renewed at the end of the term on an annual basis until age 90.
If you happen to die within this time period (and most people do), did the term policy last for a lifetime? Yes, it did.
So the difference in term insurance and permanent life insurance is not really that one (term) is temporary and the other (whole life or universal life) is permanent. The difference is that whole life, or universal life, builds cash value and term doesn’t.
Not to get too far into the weeds, there are different types of term insurance policies that are used for various reasons, but in most cases, the differences are based on the length of “guaranteed” coverage and any riders added to the policy.
Actually, we could make the same argument about whole life and universal life insurance because there are different kinds of these policies as well. But in every case, the difference is based on how the cash value is treated and the ancillary benefits (riders) that are attached to the policy.
How Much Life Insurance Do I Need?
Can you imagine paying a premium every month on a life insurance policy only to discover 10 or 20 years later that the amount you purchased (or was “sold” to you) really wasn’t enough?
Having too much life insurance is typically never an issue, but not having enough is.
Determine Your Risk You Want Life Insurance To Mitigate
To determine how much life insurance you need, you must first determine what risk(s) that you want your policy to mitigate and then quantify the risk(s).
An easy example would be purchasing mortgage protection life insurance (not a type of insurance but a purpose for life insurance). You simply determine the current payoff for your mortgage (because you could die tomorrow) and how many years you have left on it and then buy a policy sufficient to meet those needs.
Example of Purchasing Mortgage Protection Insurance:
Tom wants to make certain that his wife and kids can live in a paid-for home in the event he dies with an outstanding mortgage:
- Number of years left on the mortgage = 20
- The current balance on the mortgage = $341,000
Tom purchases a 20-year $350,000 term insurance policy so his family can pay off the outstanding mortgage balance if he dies within the next 20 years.
If, for example, you want to cover multiple risks like what is done with income replacement coverage, then the easiest way to determine how much life insurance you need is by using an insurance calculator that will calculate your “needs analysis.”
In most cases, your insurance professional will perform your needs analysis by conducting an interview with you or sending you a questionnaire that, when completed properly, your total insurance needs will be calculated.
If, however, you’d like to know before you begin shopping for life insurance what your appropriate death benefit will look like, you can use a free online life insurance calculator that works similar to an agent interview. You can simply respond to each question in the calculator, and then your total life insurance needs are revealed.
In a lot of cases, life insurance shoppers find that the size of the policy is typically more than they assumed it would be. This realization means that had you not properly diagnosed your actual insurance needs, your family would have been negatively impacted by a less than sufficient death benefit.
Purchasing a life insurance policy to cover a funeral is one thing, but planning to mitigate your surviving loved ones’ financial risks when you’re no longer in the picture is much more important. Do your homework or speak with an experienced and reputable agent so you’ll get it right the first time.
Summing Up How Life Insurance Works
“How does life insurance work” is certainly a very popular question and hopefully we’ve illustrated here that how it works is probably less important than:
- why should you buy life insurance
- who should buy life insurance
- what are the different kinds of life insurance
- how much life insurance do I need
There is always more to say when discussing life insurance, and hopefully, this article motivates you to find out which type to buy and the amount to purchase.