Life insurance is a tool that can help you protect your loved ones or yourself. Get a basic life insurance definition below and find out some other facts about this tool so you can make a more educated decision in buying a policy.
Basic Life Insurance Definition
Life insurance refers to an insurance policy on your actual life. It's a contract between you and the insurance company that says you will pay a certain amount each month (or quarter, year or other agreed-upon period). In return, the insurance company agrees to pay your beneficiary a certain amount if you die while holding a policy that is in force.
How Does Life Insurance Work?
While the types of plans vary, most life insurance works roughly as follows:
- You purchase a plan and agree to make certain premium payments.
- You select and document one or more beneficiaries.
- You pay the premium payments as agreed to secure the life insurance policy.
- If you pass away while you own the policy, the insurance company issues the total amount agreed upon to your beneficiaries.
In most cases, you can change the beneficiary at any time. Life insurance also doesn't go through probate in an estate because the asset isn't something you own once you die. The monetary asset passes into ownership by the beneficiary and can be paid directly to them. This is known as payable on death.
Can You Buy Life Insurance on Someone Else?
You can buy life insurance on someone else, but there are caveats. You can't take out random insurance policies on other adults, effectively betting on their deaths. If you take out life insurance on an adult, you usually need their permission. You at least need to be able to prove a relationship with them that would leave you suffering financially if you die.
Parents can take out life insurance on their minor children without permission. Some do so to cover burial benefits and other expenses should an unfortunate and terrible circumstance arise. Others use whole life plans as a sort of investment vehicle for their kids.
What Happens to Your Life Insurance if You Don't Die While Holding a Policy?
When you purchase a life insurance policy, you don't pay in premiums what your beneficiaries might get in benefits. For example, if someone buys a $250,000 term life policy and only pays $50 a month, it would take 416 years of payments to equal the benefit amount.
So, the life insurance company is taking a bit of a gamble. It's betting that most people holding a policy won't die while the policy is in effect. The premiums you pay during that time go to fund other payouts and the business expenses of the insurance company.
This is the same principle that's at play with any type of insurance company. For example, auto insurers are betting every month that only a small fraction of their customers will have accidents.
What Are the Three Types of Life Insurance?
Life insurance can get complicated and does come in three major categories. They are:
- Term life. You purchase this type of insurance for a specific period, or term. The insurance agrees to a premium amount that's locked in for the term. For example, you might purchase $100,000 of coverage for $10 a month for 10 years. After the 10 years is up, your policy is discontinued and you would have to sign up for a new one — at a new rate. Typically, this is the most affordable type of life insurance.
- Universal life. You purchase this type of insurance and renew it periodically, often each year. The cost does tend to go up as you age. However, you get a small cash-value benefit from your premiums in the form of interest added to your account each year. In a properly designed universal life insurance policy, that cash benefit can help cover the extra costs of the premiums as you age.
- Whole life. This is often the most expensive life insurance policy because it comes with a guaranteed cash benefit for those who pay premiums as agreed the entire term. Once you finish paying for the original term of the policy, you also own the policy for the rest of your life. This provides peace of mind for many people, though some financial experts aren't fans of whole life because they see other investments as more profitable.
The type of insurance that is right for you and your loved ones depends on numerous individual factors. Working with a professional to understand your needs and what insurance products might meet them can be a good idea when you're shopping for a new life insurance policy.