What is life insurance and how does it work? (2022)
Life insurance comes in two main types: term life insurance and permanent life insurance. The one you choose will mainly depend on your needs and your budget. If you want coverage that lasts your lifetime, choose a permanent policy. If you need an economical option, consider a term policy.
Term life insurance
Term life insurance provides coverage for a certain period of time, known as a term. This policy only pays if the covered person dies during the term. Therefore, term life insurance tends to be more affordable than permanent life insurance, with a fixed rate that lasts for the duration.
As the initial term draws to a close, you may have three options for continued coverage:
- Let the policy expire and replace it with a new policy
- Renew the policy for another year at an adjusted rate
- Convert your term life insurance into whole life insurance
All term life insurance policies are not renewable or convertible. Some policies include a decreasing term, which means coverage decreases over time. Although the duration of most policies is a predetermined number of years, such as 20 or 30 years, there are some exceptions. Below are some examples.
Group life insurance
The free life insurance you receive through your employer is a type of group life insurance. Group life insurance may also be provided by your church or another organization to which you belong. Although the employer or organization is the policyholder, the people covered choose their own beneficiaries. Coverage is usually guaranteed but only lasts as long as you belong to the group.
Complementary life insurance
Supplemental life insurance is often offered as a complement to group life insurance. Supplemental cover is generally cheaper and easier to obtain than other types of insurance, but, as the name suggests, it is intended to supplement rather than replace an individual policy. Most supplementary life insurance policies expire at the same time as the associated group life insurance. This means that you will likely lose this coverage if you quit or lose your job, stop paying premiums, or sever ties with the group policyholder.
Mortgage life insurance
Mortgage life insurance covers the full or partial balance of a mortgage if the borrower dies before paying it off. This type of policy lasts until the mortgage has been paid in full. Although it is designed to protect the borrower’s family from the burden of mortgage payments, the beneficiary is actually the mortgage lender. Mortgage life insurance does not require a medical exam.
Credit life insurance
Like mortgage life insurance, credit life insurance covers a specific debt and lasts until the debt has been paid. As a general rule, the premiums for this insurance are included in the repayments of the loan. The payment goes to the lender rather than the survivors to pay off the remaining balance. Because credit life insurance is so targeted, it’s easier to qualify for than other options.
Permanent life insurance
As long as the insured pays the premiums, permanent life insurance never expires. Because it covers the life of the insured, it costs more than a term life insurance policy. These policies generally have a cash value that increases over time.
Learn more about the different types of permanent life insurance below.
Whole life insurance
Whole life insurance is what most people think of when considering permanent life insurance. It pays regardless of when the insured dies and has a cash value that increases over time, similar to a savings account.
As long as the insured is still alive, he can draw on the cash value of the policy. However, a cash value withdrawal works like a loan and must be repaid with interest. If the policyholder dies before repaying the loan, the insurer will deduct the remaining principal and interest from the death benefit before paying the beneficiaries.
Universal life insurance
Universal life insurance, also called adjustable life insurance, can differ from whole life insurance in three ways:
- Flexible premiums: The policyholder may be able to adjust their premiums and death benefit as needed, within certain limits.
- No package: The interest rate can go up and down depending on market conditions, although the policy guarantees a minimum rate.
- Decreasing premiums: The cash value can become high enough to cover the policy premiums, leaving the policyholder with zero out-of-pocket.
The terms of universal life insurance policies vary. Before buying a universal policy, make sure you understand exactly what it does and does not cover and how the costs and benefits may change over time.
Variable life insurance
Like other types of permanent life insurance, variable life insurance has both a death benefit and a cash value. The main difference is the ability of the policyholder to invest the cash value of the policy. Depending on the performance of this investment, the cash value may increase or decrease over time. Throughout all of this, the policyholder must maintain a cash value high enough to cover the policy costs. Otherwise, the policy will lapse.
If the investments perform poorly, the policyholder may have to pay higher premiums to make up the difference and avoid a policy lapse. On the other hand, the income from a high yield investment could cover some or all of the premium costs. Another advantage is that, unlike most policies, the cash value of a variable policy can be added to the death benefit.
Final expense life insurance
Final expense life insurance, also known as funeral or burial insurance, is intended to cover bills that will be billed to the policyholder’s family or estate. Examples include medical and funeral expenses as well as any unpaid debts, such as a mortgage or credit card balance. Since the death benefit is usually between $5,000 and $25,000, this coverage may be less expensive and easier to obtain than other permanent life insurance policies.
Survivor life insurance
A survivor life insurance policy covers two people, usually two spouses. As a joint policy, it does not pay until both people covered are dead. This type of font can cost less than two separate fonts. It’s a particularly attractive option if one party has health issues that make an individual policy unaffordable. However, it is less common than other types of permanent life insurance.