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By Gabriel Rodriguez and Chris Huntley
Updated: May 4, 2021 5:01 PM ET | Originally published: April 20, 2021
Person looking at a life vest, an umbrella and a life saver. A metaphor for deciding which type of life insurance you should pick
Rangely García / Money

Life insurance can serve many purposes, from replacing your family income and covering outstanding debt or expenses such as funeral and burial costs, to funding a quality education for your kids. Life insurance is a must for anyone who wants to leave an inheritance for surviving loved ones and ensure their financial security – check out our top picks for best life insurance. Read our guide to understand what is life insurance and how it works.

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What Is Life Insurance?

Life insurance is a way to protect the financial future of your family and/or business (and your own peace of mind). Like other insurance, it’s a contract between you (the policyholder) and an insurance company. There are different types of life insurance policies but they all have one thing in common: they’re designed to pay money, usually as a lump sum, to your “named beneficiaries” in the event of your passing.

How does life insurance work?

In exchange for a premium, life insurance companies will grant a payment known as a death benefit to beneficiaries once the policyholder has passed away. A beneficiary can be one or more individuals, a trust, an estate, or even an organization.

In severe cases, such as being diagnosed with a terminal illness, you may access a portion of your life insurance funds before you die with a policy add-on known as an accelerated death benefit. You’ll need to have evidence of a qualifying condition or situation according to your life insurance contract.

Payout options

  • Lump Sum Payout: A lump sum payout allows the beneficiary to receive the entire death benefit at once. This is the most common form of disbursement for life insurance products. It allows greater flexibility and is not taxable with respect to income tax. If the payout is too large, you may have to spread it across multiple checking and/or savings accounts, since the FDIC only covers $250,000 per depositor.
  • Installments or Annuities: With this option, the beneficiary regularly receives proceeds and accumulated interest over a period of time. Because interest income is subject to taxation, you might be better off getting a lump sum of money rather than being paid in installments, depending on how large the policy’s death benefit is.
  • Retained Asset Account: If a policy is large enough, your insurance company may allow you to write checks against the balance of the account. The account would pay interest to the beneficiary, although it wouldn’t allow deposits.

Choosing Beneficiaries

When taking out a life insurance policy, policyholders will be asked to name one or more beneficiaries. A beneficiary can be a spouse, parent, sibling, children, trust, estate, business partner, or charity organization.

So long as you can prove that they will struggle financially due to your death, you can name anyone or anything as your beneficiary. This is known as insurable interest, which is decided by the life insurance company based on the insured’s relationship to the policyholder and beneficiary.

In addition to naming multiple beneficiaries, policyholders can also name secondary beneficiaries. The policy’s death benefit will be passed on to them if your primary beneficiary cannot accept it. Make sure to update your beneficiaries as you undergo major life events to ensure that the payout doesn’t go to your estate or to the wrong person.

Be aware that should you name your estate (or a similar entity) as your beneficiary, this will then subject policy to the probate process, since you’ve taken away the contractual advantage of naming a real person. While it increases the estate’s value, it could mean very high estate taxes for your heirs.

What does life insurance cover?

Once disbursed, beneficiaries can use the money from the life insurance policy for whatever they want. Examples include covering everyday bills, paying off a mortgage, covering funeral costs, and putting someone through college.

  • Everyday expenses: monthly bills, groceries, other household essentials
  • Continuing education: tuition for your children, continuing education for your spouse
  • Outstanding debts: a mortgage, credit card debt, auto loans, private student loans
  • End-of-life expenses: end-of-life medical care, the cost of burial and funeral expenses
  • Child or dependent care: daycare programs, replacing care provided by a spouse

The payment from a life insurance policy may also function as a safety net by ensuring that a family can stay in their home and pay for the things that were planned before the policyholder’s passing.

Life insurance companies must be contacted following the death of the insured individual to begin the claims and payout process. So long as your policy is still active at the time of your death, your provider is obligated to pay out — with a few notable exceptions. Providers will pay out death claims due to:

  • Natural causes, such as a heart attack, old age, or illnesses like cancer
  • Accidental death, including accidental drug overdose
  • Suicide, after the policy’s suicide clause period ends
  • Homicide, unless the beneficiary played a role in the murder

Specific exclusions are often written into life insurance contracts as a way of limiting the insurer’s liability. In cases of an expired policy, fraud, criminal activity, or certain other exclusions, your beneficiaries may not receive your policy’s death benefit. Claims related to suicide, fraud, war, riot, and civil commotion may also result in failure to receive the policy’s funds.

Additional difficulties may arise where an event is not clearly defined, for example, when the insured knowingly consents to use medication or to participate in an experimental medical procedure that results in their injury or death.

  • Expired policies: Policies only stay active if you pay your premiums and for the length of the policy’s term. If your policy expires or lapses, your beneficiaries lose out on the death benefit.
  • Fraud: Your provider can cancel your policy while you’re alive or deny or reduce the death claim after you pass away if they found out you lied on your application.
  • Criminal activity: If you die while committing a crime (or your beneficiary committed a crime to access your insurance money), your provider won’t pay out.
  • Other exclusions: If you have a hazardous hobby, like skydiving, your provider may exclude it from your coverage, meaning the policy would not pay out if your death was skydiving-related.
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Who needs life insurance?

The quickest way to answer whether or not life insurance is a worthwhile investment is by asking yourself: Would your death financially impact the people in your life? If the answer is yes, then you should consider taking out a policy and determining how much life insurance you need. Here are a few examples of the kind of people who would benefit from having life insurance:

  • Parents with young children or special needs dependents – Life insurance can provide young children who lose one or both of their parents with the financial resources they need, (and help with childcare expenses for the surviving partner). Life insurance can make sure that children who require lifelong care will have their needs met even after their parents pass away. The policy’s death benefit can also be used to fund a special needs trust managed by a fiduciary for the adult child’s benefit.
  • Older adults without savings – Older adults who want to provide financial coverage for their families or caretakers but lack substantial savings can leave them a death benefit. This financial support can be helpful if they’ve taken time off work. Additionally, a life insurance policy can provide funds to cover funeral expenses.
  • Young adults who want to lock in low rates – Because age factors into life insurance premiums, younger adults are offered much more favorable rates. Younger people also tend to be healthier, which further reduces premiums.
  • Adults with private student loans – Unlike debt from federal student loans, private student loan debt is transferred to cosigners if the borrower dies. Having life insurance ensures that your loved ones are not stuck paying off the rest of your debt.
  • Business owners – Firms, companies, and organizations can purchase a life insurance policy on employees whose passing would create severe financial hardship for the company.

When is the best time to start thinking about life insurance?

The best time to start is now. Regardless of age, it’s really never too early to start thinking about your life insurance needs, and long-term care insurance. In fact, you’re much better off purchasing as early as you can when it comes to certain types of policy, such as universal or whole life policies. This isn’t to say getting life insurance as a senior is impossible, but it will be more difficult.

You should consider buying life insurance when:

  • You prefer to pay lower premiums
  • You’re young and healthy
  • You reach certain life milestones, such as starting a family, planning your retirement, and buying a home or car (or otherwise accumulating debt)

Life insurance for income replacement

Income replacement is one of the main reasons to get life insurance. Life insurance provides your loved ones with an additional source of income if you are no longer around to provide for them.

This is very important for people whose families depend on their income as part of their budget. Having life insurance means that you can make sure they have the financial support they need to maintain the lifestyle they’re used to, even after you pass away.

Life insurance for final expenses

Older adults without any dependents don’t need traditional life insurance coverage. However, they still have to plan for their funeral, which can cost anywhere from $8,000-$10,000. This does not include the other end-of-life expenses such as medical bills. By taking out final expense (or burial) insurance, the cost of your death and funeral arrangements may be covered entirely.

Life insurance for covering debt

Individuals who are worried about passing on debt to their loved ones should consider credit life insurance. Unlike traditional life insurance, this type of insurance is uniquely designed to pay off a borrower’s debts after their death.

You may receive an offer to take out a credit life policy after a major purchase, such as a home or expensive vehicle. The amount of money, or value, of the policy will correspond to the value of the loan it’s intended to pay off. Credit life insurance is easier to qualify for than traditional life insurance but has limited use and loses value if the death benefit is larger than your outstanding debt.

Types of Life Insurance

There are two main types of life insurance: term and permanent. A term life insurance policy provides financial protection for a specific amount of time. Permanent life insurance, such as whole or universal life, can provide coverage for a lifetime.

Go for it: Skip it:
If you just need to replace your income or cover debts for a specific period, such as the duration of your mortgage If you have a child or relative who will depend on you for the long term

The most affordable type of life insurance policy is term life insurance, and it is widely available and easy to understand. This type of policy is best for people with temporary financial obligations who want coverage for a specified period or “term.” Once the life of the policy reaches its term, it expires unless it features the option to convert into a permanent policy.

Term life premiums can be as little as $35 a month. Coverage amounts can go up into the millions, and term lengths vary but can span anywhere from a one-year term (annually renewable policies) to 30 years.

Go for it: Skip it:
If you have a lot of disposable income and have exhausted other investment options If your financial situation is likely to change in the future

A whole life insurance policy is the most expensive type, as it covers you for your entire life. It features fixed premiums and introduces guaranteed cash value accumulation on top of its death benefit. Some companies pay out dividends on whole life policies, which can be used to cover premium payments or purchase additional coverage.

To determine how much the policy will yield in the future, insurers calculate its expected yearly growth, or internal rate of return.

Universal life insurance

Universal life insurance is the most flexible permanent life insurance option. Policyholders can pay premiums at any time and reduce or increase their death benefit. In turn, this lowers or increases their premiums.

Universal life policies are subject to market fluctuations because the cash value component of universal life policies is invested in stocks or bonds. In low-interest-rate environments, the cash value account won’t grow as intended and you may not be able to cover future premiums with those funds.

Universal life insurance exists in several forms. These include:

Go for it: Skip it:
If you want a fixed death benefit and premiums If you care about cash value accumulation

Guaranteed universal life policies have little to no cash value accumulation. However, their premiums are fixed and the death benefit is guaranteed.

Go for it: Skip it:
If you have a moderate risk tolerance and want higher gains from your cash value but with caps on gains and losses If you have a low risk tolerance

With this type of universal life insurance policy, the cash value is invested in market indexes such as Nasdaq, S&P 500, and Dow Jones. They have high policy fees and there is a cap on gains and losses.

Go for it: Skip it:
If you want to invest your cash value component in high-risk, high-gain investment vehicles like bonds, stocks, and mutual funds If you have a moderate or low-risk tolerance or don’t want to actively manage your account

A variable universal life insurance policy’s cash value is invested in sub-accounts that hold bonds or stocks. This entails more risk and requires hands-on account management. The fees can be higher than for other universal life policies.

Go for it: Skip it:
If you are willing to pay higher premiums to avoid a medical exam and are not eligible for a traditional life insurance policy. If you have no objection to taking a medical exam, want more affordable rates, and would like greater coverage.

Most life insurance companies require that applicants take a medical exam to assess the risk of insuring you and set a suitable premium. No-exam life insurance allows applicants to bypass this step, making the process more convenient at the cost of higher premiums.

Policies of this type include accelerated underwriting, simplified issue, and guaranteed. The first two require that applicants answer a series of questions about their health, family medical history, financial situation, and lifestyle.

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How to Get Life Insurance

Life insurance policies are purchased by the person whose life is meant to be insured. However, spouses, family, or anyone else who can prove that they have an insurable interest in the person can also take out a policy for them.

To be able to purchase life insurance, consumers will need to complete an application and phone interview. They must also present several documents and, unless they opt for a no-exam life insurance policy, get a medical examination. As with every financial decision, we recommend getting multiple life insurance quotes.

Eligibility Requirements

The eligibility criteria required to buy life insurance vary from company to company. However, there are two main requirements that nearly every company will ask for when you apply.

Medical checkup

Unless you are applying for a no-exam life insurance policy, it’s compulsory to undergo a medical test before taking out a life insurance policy. This test will help the insurance company to remain informed about any medical contingencies and risk factors. The medical checkup decides the premium sum the person taking the policy will be asked to pay.

Documents

For completion of the application of term insurance policy, The policyholder must present all the needed documents. The documents which are usually required by life insurance companies are the following:

 

Proof of identity, citizenship, and age – driver’s license, birth certificate, or valid passport; noncitizen residents may use their green card

 

 

Proof of residency – for renters, signed lease or a rent receipt; for homeowners, mortgage bill or a property tax statement; a utility bill or a postmarked envelope also acceptable

 

 

Proof of income – pay stubs, a letter of employment, a tax return, or an earnings statement from your bank; if unemployed, an unemployment letter or monthly statement

 

 

Social Security Number – for preliminary background checks

How much does life insurance cost

The cost of life insurance varies widely depending on a number of factors. According to Business Insider, in 2021 the average monthly cost of life insurance is $53 for term life, $52 for whole life, and $55 for regular universal life.

What affects life insurance premiums?

Many factors affect the cost of life insurance premiums. It mostly comes down to the following factors:

  • Age: Older policyholders are seen as higher risk. The older you are when you buy a life insurance policy, the more expensive it’ll be.
  • Gender: Men and women tend to pay different rates for all types of insurance. Men can expect to pay more for life insurance due to a shorter life expectancy.
  • Cigarette use: Because smokers are more likely to develop significant health issues, they require more coverage and will always pay a higher rate than non-smokers.
  • Weight: Life insurance companies may charge more from individuals with a higher BMI.
  • Health: Health concerns or a history thereof directly correlate to higher life insurance premiums. Pre-existing conditions, such as cancer, diabetes, or heart disease, might make it more difficult for you to get life insurance at an affordable rate — or at all.
  • Lifestyle: Frequently engaging in hazardous activities, such as skydiving or rock climbing, may increase the cost of your premiums.
  • Policy type: Longer-lasting policies tend to have higher premiums, as the risk of death is greater.
  • Amount of coverage: The more coverage you get, the higher your premiums will be.

Things to keep in mind when buying life insurance

  • Understand what factors affect your premiums – Seven key factors that will affect your life insurance premiums are age, gender, cigarette use, health, lifestyle, family medical history, and driving record. While some of these are out of your control, others are things that can be “improved on” in order to receive a lower quote when purchasing life insurance.
  • Know the difference between term life insurance and whole life insurance – Remember: term life insurance is more affordable and easier to understand, but has an expiration date.
  • Determine whether you can get a no-exam policy – In order to qualify for a no-exam policy, it’s generally required that applicants be in sufficiently good health. Evaluate whether or not it’s feasible to apply for this type of policy and if you should even get this type of policy in the first place.
  • Assess your current financial situation – There’s no point in investing in life insurance if your financial situation is already difficult. Carefully assess how much you can pay in monthly premiums before taking out a policy.
  • Know how much coverage you need – Depending on what you expect your death benefit to be used for, you’ll need more or less coverage. For example, a life insurance policy meant to replace your income should probably be larger than one meant for final expenses.
  • Shop around – Do not simply jump at the first sight of a good deal on life insurance. Make sure you’re comparing at least three or more different providers when purchasing life insurance to get the best deal possible.
  • Don’t just focus on premiums – Premiums are important, but try to avoid tunnel vision. It’s better to opt for a more expensive policy if it’s from an established company with a history of meeting its financial obligations.
  • Have your answers at the ready – Be prepared to be asked questions about anything related to your health and lifestyle habits. Go into your phone call with the company representative with all your documents at hand.
  • Don’t lie in your application – It goes without saying that under no circumstances should you lie in your life insurance application. Doing so could result in a lower payout amount or your policy being voided altogether.

Life Insurance Key Takeaways

  • Many adults, young and older, can benefit from life insurance in one way or another.
  • Start the process by evaluating your finances, then determining how much coverage and the type of policy you should get.
  • Where term life insurance expires after a predetermined number of years, permanent life insurance policies remain active until the policyholder dies, stops paying premiums, or surrenders the policy.
  • Health concerns won’t necessarily prevent you from taking out a policy, but will increase your premiums.
  • Choosing your named beneficiaries carefully is paramount to ensure that the right people are eligible to receive the proceeds from your policy.