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What Is Life Insurance and What Does It Cover?

What would your loved ones do if you died tomorrow? They’d grieve. They’d cry. They’d reminisce about your time together. 

But when the shock wore off, how would they pick up the pieces? Would they have the means to continue living as before, or would they need to make drastic changes to their lives?

They’d probably need to make some changes unless you left them with financial protection to replace the debts you left behind and the income you’ll never earn. That’s where life insurance comes in. 

What Is Life Insurance?

Life insurance can provide your loved ones with financial protection after you die. 

A life insurance policy is a binding contract between you and an insurance company. The contract requires the life insurance company to pay a lump-sum amount to your beneficiary if you die while the policy remains in effect. 

This payout is the policy’s death benefit. It’s generally tax-free, meaning the beneficiary doesn’t have to pay income tax or estate tax on it.

How Life Insurance Works

At its core, life insurance is straightforward. 

You — the policyholder — pay an agreed-upon monthly or annual premium. In exchange, your insurer promises to pay an agreed-upon death benefit to your named beneficiaries. You can name multiple beneficiaries and customize each person’s portion of the death benefit.

To keep the contract in force, the policyholder must make on-time premium payments. If the policyholder lapses on these payments and doesn’t make up the shortfall in time, the insurance company can cancel the contract with no further obligation.

How the Death Benefit Works

To receive the death benefit, the policy’s beneficiaries must file a death claim with the insurance company. They must provide an official death certificate and fill out an application. Depending on the circumstances of your death, the life insurance company might investigate before paying out, but the vast majority of death claims draw quick payouts.

Applying for Life Insurance

You can’t just buy life insurance on a whim. You need to apply for it first. Before approving and issuing your policy, the insurance company reviews your application and sends it through underwriting. The underwriters calculate your risk of dying while the policy remains in effect and determine your policy premium. 

The application process involves an initial questionnaire that asks about your age, occupation, medical history, family health history, tobacco use, and lifestyle. It may also require a medical exam to assess your current health status, though many insurers offer life insurance policies without a medical exam.

In either case, the insurer pulls your medical records and prior life insurance application records. It may also review your criminal history and driving record. Based on all this information, the insurer approves or denies your application, calculates your life expectancy, and sets a premium. 

Policy Riders

Most life insurance policies have complimentary riders, or modifications that give the policyholder and their beneficiaries additional benefits. You may also have the option to add additional riders if you’re willing to pay a higher premium.

Common life insurance riders include:

  • Accidental death benefit rider, which increases the death benefit if you die in a covered accident
  • Waiver of premium rider, which allows you to stop paying premiums if you become unable to work due to disability
  • Long-term care rider, which helps cover the cost of assisted living
  • Return of premium rider, which returns premiums paid into a term life policy if you outlive the term

Types of Life Insurance

There are two primary categories of life insurance: term life insurance and permanent life insurance.

Term life is usually best for most people, but a whole life policy or other permanent policy could make sense in certain situations. 

Term Life Insurance

Every term life insurance policy has an initial fixed term, usually between 10 and 30 years. In most cases, it also has a level premium, meaning the premium never increases or decreases during the term. Notably, term life insurance rates aren’t pegged to inflation, so the real cost declines over time.

Term policies are appropriate for relatively young people who want the peace of mind that comes with life insurance but expect not to need it forever. Most life insurance companies accept term life applications from people between the ages of 18 and 60, give or take. 

If you’re over the age of 45, you should expect to pay higher premiums and submit to a medical exam. You also might not qualify for the maximum amount of coverage.

Permanent Life Insurance

There are several different types of permanent life insurance policies. The most common are whole life insurance, universal life insurance, and variable universal life insurance.

Permanent life insurance remains in effect indefinitely. As long as you keep paying your premiums, you’re covered, and your loved ones stand to receive your death benefit when you die.

Permanent life insurance coverage generally comes with a cash-value component. The policy’s cash value builds over time, from basically nothing during the first few years to a five- or six-figure sum later in life. 

Depending on the type of policy, the cash value may grow at a guaranteed rate or fluctuate with the prices of underlying assets, such as mutual funds. However, the overall return on your policy is unlikely to exceed the stock market’s long-term returns and could be much less.

As the policy’s cash value grows, you can take a loan against it, similar to a draw on a home equity line of credit. You can also use the cash value to pay your premiums, which can be helpful if money is tight. But your cash value is a living benefit, meaning the insurance company keeps it when you die. And any outstanding loan balance reduces your death benefit if not repaid before your death.

What Does Life Insurance Cover?

Life insurance covers almost all types of premature death. If you die while your life insurance policy is in effect, your beneficiary is very likely to get the death benefit.

There are only a few exceptions to this rule, but they’re important to understand. Your beneficiary might not receive your policy’s death benefit if any of the following circumstances apply:

  • You die by suicide during the first two years of the policy.
  • The beneficiary is liable for your death — that is, they murdered you or in some way contributed to your death so they’d get the money.
  • You lied or omitted important information on your life insurance application.
  • You or your beneficiary committed any other form of fraud during the application or claims process.

Life insurance companies refer to the first two years of a policy as the contestability period. If you die during the contestability period, the insurer is much more likely to scrutinize the circumstances of your death and the information you provided on your application. 

If anything seems suspicious about your death or application, the company might delay payment of the death benefit. Should these suspicions pan out after the investigation, the company could deny the benefit altogether.

Some life insurance policies provide additional coverage for accidental death — often double the death benefit. If you have an accelerated death benefit rider, you can also claim a portion of your death benefit during the last years of your life, but this typically doesn’t increase your total death benefit. 

Should You Get a Life Insurance Policy?

Most people need life insurance at some point in their lives. If any of the following situations apply to you or you have reason to expect they will in the future, life insurance could be a smart financial decision.

You Want to Provide for Your Dependents After You Die

Dependents can include:

  • Minor children
  • Adult offspring with special needs or health issues that prevent them from living independently
  • Aging parents
  • Any other family members or loved ones who depend on you for basic financial support

Regardless of your relationship or their needs, the common denominator is that they’d be in a bad way if you died early. By making them (or their next guardian) the beneficiary of your life insurance policy, you maintain their support and ensure they continue living with dignity.

You Have Significant Debts Held Jointly or With a Co-Signer

Jointly held or co-signed debts can include but aren’t limited to:

  • Mortgages
  • Student loans
  • Credit card bills
  • Home equity loans or lines of credit
  • Car loans

Depending on your circumstances, it could make sense to have multiple life insurance policies for different joint debt holders or co-signers. For example, you might make your spouse the beneficiary of a larger life insurance policy that covers your joint mortgage and car loans and your parents the beneficiaries of a smaller policy that covers the student loans they co-signed with you.

You’re the Primary Breadwinner in Your Household

If you earn the majority of your household income and your spouse or partner isn’t in a position to quickly increase their earning capacity after your death, you need to replace a significant portion of the income you won’t earn. Life insurance is perfect for that.

You Do Significant Unpaid Labor for Your Household

Life insurance isn’t only for breadwinners. No matter how much you earn from employment outside the home, if you do significant labor within your household, you’re valuable to the people you’d leave behind.

For example, if your surviving spouse has to hire a nanny to care for your kids while they’re at work, you need a life insurance policy large enough to cover that cost for however many years they need it.

You Want to Shield a Portion of Your Survivors’ Inheritance From Estate Taxes

Most folks don’t have to worry about the estate tax, which only applies to estates worth more than about $12 million. But if you expect to leave an eight-figure inheritance to your heirs, life insurance is an effective way to shield it from the taxman. 

You Want to Cover Your Funeral Expenses

On the other end of the spectrum, you might worry about dying with few assets of value — perhaps with a negative net worth. In that case, your survivors will have to scrounge up the money to pay for your funeral and burial unless you leave them with a small-dollar burial insurance policy, a type of whole life insurance that covers your final expenses.

You Don’t Own or Plan to Own a Home but Want a Source of Liquidity to Tap

This is one of the few situations in which it makes sense to purchase whole life insurance. Because whole life insurance builds cash value over long periods, it eventually becomes a useful asset to borrow against if you don’t have home equity to tap.

Life Insurance FAQs

Life insurance is a complex, far-ranging topic. These are some of the most common questions first-time life insurance applicants have.

How Much Does Life Insurance Cost?

The cost of life insurance depends on numerous factors. The most important are:

  • How much life insurance you buy — the policy’s death benefit
  • Your age when you enter into the life insurance contract
  • Your sex — women live longer than men, on average
  • Your health status, including preexisting conditions
  • Your family health history
  • Whether you smoke or use tobacco
  • Your occupation — a dangerous job can increase your premiums
  • Your driving record — insurance companies don’t like accidents and moving violations 
  • Other lifestyle factors, such as dangerous hobbies

How Much Life Insurance Do I Need?

You need enough life insurance to ensure your death doesn’t create a financial burden for your survivors.

This amount varies from person to person and family to family. In general, you need enough life insurance to:

  • Pay off any jointly held or co-signed debts, such as your mortgage balance
  • Replace some or all of your expected future earnings, depending on your partner’s earning power
  • Provide for children and other dependents left behind
  • Cover major expected future expenses, such as college tuition

For a quick-and-dirty life insurance calculation, multiply your current gross annual income by 10. For a more accurate calculation, you’ll need to add up your outstanding debts and future obligations, subtract your net worth, and add back the amount of future income you want to replace.

Where Can I Get Life Insurance?

Dozens if not hundreds of reputable life insurance companies sell life insurance in the United States. For a quick, all-digital application that may not require a medical exam, check out our guide to the best online life insurers.

Final Word

A common myth about life insurance is that you don’t need it if your net worth is positive and you don’t have kids or other dependents.

It’s true that you’re less likely to need life insurance if you’re unencumbered by debt or dependents, but there are still plenty of reasons to buy it sooner than later. 

Your spouse or partner might rely on your income for life’s necessities — or a reasonable standard of living. You might decide to have kids or stretch to buy a house later in life. You might simply worry about your final expenses creating a financial burden for your surviving loved ones.

If any of these situations apply to you or might in the future, life insurance could be a good investment.

Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.

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