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What Is Life Insurance and How Does it Work?

What Is Life Insurance, and How Does it Work?

9 Minute Read

If you’re like some people, you probably have insurance for everything under the sun—your car, your home and maybe even your cell phone. But do you have insurance on your life?

Did you know that only 60% of Americans have some type of life insurance?(1) That includes term life insurance, permanent life insurance or even the group life insurance offered through a plan from their employer. That’s a pretty shocking statistic when you consider that, statistically, 100% of us humans on the planet are going to die one day!

What Is Life Insurance?

Life insurance is a contract between you and an insurance company that, in exchange for your monthly payments, guarantees a prearranged sum of money for your loved ones when you die. A good rule of thumb is to get a policy for yourself that provides 10–12 times your annual salary (More about how you can figure out your number later).

It may feel like a bummer of a topic, but providing life insurance on yourself is a beautiful act of love for your family. Just focus on this: You buy life insurance not because you are going to die, but because those you love are going to live and you want them to be financially secure after you’re gone!

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How Does Life Insurance Work?

Once you sign on the dotted line and start paying monthly, what you’ve really bought is peace of mind—peace that you’re providing financially for your loved ones even after your death.

But before you start talking to the insurance agent, here’s a breakdown of some life insurance lingo you’ll want to know so you don’t go in blind:

  • Policy – the contract between you and the insurance company

  • Premiums – the monthly or yearly payments you make to buy the insurance policy

  • Policyholder – the owner of the policy, which would normally be you (the one insured), but you could buy a policy for another person

  • Death Benefit – the money given out when you die

  • Beneficiary – those you choose to receive the death benefit of your policy

So, basically, once you start paying your premiums, the insurance company is guaranteeing they’ll pay out the death benefit to your beneficiaries when you die. Usually, this would be to your spouse or your children, but it could be to anyone you choose.

Life insurance exists for the unthinkable—the death of you or your spouse. It will cover loss of income, funeral expenses and other financial needs that might come up after you pass away.

Types of Life Insurance

When it all boils down, there are basically two different types of life insurance options based on the duration of the policy—one that is in force for a predetermined term and one that lasts through your entire life. These two types of life insurance are commonly known as term life insurance and permanent insurance.

1. Term Life Insurance

Term life insurance provides coverage for a specific amount of time (think presidential term or term of service). If you or your spouse pass away at any time during this term, your beneficiaries will receive the death benefit from the policy.

Term life insurance plans are much more affordable than permanent life insurance plans. That’s because the term life policy is only focused on providing the death benefit—no other bells and whistles, such as cash value investments, are added to bloat your premiums.

Of course, the hope here is that you’ll never have to use your term life insurance policy at all, but if something does happen, at least you know your family will be taken care of.

2. Permanent Life Insurance

As you can imagine, permanent life insurance is called “permanent” because it lasts throughout your entire lifetime. Other variations you may find are universal, variable or whole life insurance—each with its own distinctions. 

You might think it’s a good thing to have life insurance coverage for that long, but here’s the truth: If you practice the principles we teach, you won’t need life insurance forever. Ultimately, you’ll be self-insured. Why? Because you’ll have zero debt, a full emergency fund and a hefty amount of money in your investments. Sweet!

Besides the insuring-your-life part, permanent insurance adds an investing-your-money piece to your policy called “cash value.” The insurance company takes a chunk of your premium to start an investment account.

A lot of people think the cash value included with permanent life insurance will help them retire wealthy. But the truth is, cash value life insurance is one of the worst financial options out there! Dave Ramsey often calls it “the payday lender of the middle class.” You can find a ton of better places to invest that will give you a much better return for your dollars.

On top of all that, the premiums on cash value life insurance are generally much more expensive than term life insurance. Remember, they tack on that extra cost in order to invest. But keep in mind that a life insurance policy shouldn’t be an investment or money-making scheme. The down-to-earth purpose of insurance is to provide security, protection and peace of mind for your family should the unthinkable happen.

Do I Need Life Insurance?

Almost everybody needs life insurance. Don’t believe us?

Life insurance can be important, no matter what stage of life you’re currently in. We’ll break it down for you.

The Young Professionals

You may have some credit cards and student loan debts that will need to be paid after death. But if you’re completely debt-free, with no dependents, then all you really need to worry about here is burial costs. That said, you probably have enough coverage with the life insurance policy offered through your employer, so you may not need life insurance at all yet.

The Newlyweds

Congratulations! You’re just starting your new life together. But if the two of you are paying off debt, your untimely passing would mean your new spouse would be stuck paying the entire amount all on their own. Yikes! Don’t leave your soulmate unprepared to deal with your student loans, car notes and credit card bills—piled on top of the deep grief of losing you. Get enough life insurance to make sure they’re taken care of.

The Parents

If you have children, you and your spouse need to be covered, no matter if you have an outside-the-house job or not. The absence of a stay-at-home parent would impact the family budget greatly. Child care costs aren’t cheap these days!

So, consider what it would take to run the household for ten years or so, provide for the children (including college), and possibly pay off your home in the years following your death or the death of your spouse. Trust us—you want (and need) this peace of mind.

The Retirees

At this point, you might already have a hefty retirement savings in place. You could even be well on your way to becoming self-insured and don’t need any life insurance! That’s a great place to be!

But let’s say you’re still paying off your house and trying to add to your retirement savings. If you died today and your spouse no longer had your income to rely upon, would the amount in your savings be enough to take care of them?

Understanding the Cost of Life Insurance

The cost of your life insurance is determined by several factors. The life expectancy charts (actuarial life tables) for insurance companies are uber-specific, and your agent will use them to determine the rate for your insurance premiums.

They track not only your age, gender and family medical history, but they also get downright personal. They ask for your weight, your own medical history, whether you smoke or not, if you have any dangerous hobbies (skydiving, shark wrestling and the like), or if you travel to risky parts of the world. After all this, the insurance company will likely have you take a physical exam.

Armed with this information, your agent will throw it all in a magic math machine to come up with your “rating classification.” That’s how they’ll land at the amount of your monthly insurance premiums.

Helpful hint: If you want to lower your insurance premiums, change some of those things you can change. Lose weight, stop smoking, trade in the parachute for a pair of hiking boots. Make those changes and rates go down. 

Let’s say John, a 30-year-old man in reasonable health, wants to check out two policies: a 20-year term policy and a whole life policy. He’s married and doesn’t smoke but is about 15 pounds overweight. He fills out all the paperwork, and the insurance broker comes back with the comparison. The whole life policy is $100 per month while the monthly cost for the term life policy is only $18! How much money do you think John could make by investing $82 (the difference in the policies) each month over 20 years? No brainer!

How Much Life Insurance Do I Need?

The short and sassy answer to this question is . . . just enough. Dave recommends setting your death benefit at 10–12 times your annual salary. He didn’t just pick this number out of thin air. It has to do with interest rates. 

Say your beneficiary invests that amount (10–12 times your annual salary) into mutual funds that average at least 10% growth. That way, the interest your family peels off each year would cover your annual salary. The original amount could stay there indefinitely as they live off of the interest.

For example, if you make $100K a year and take out a policy for $1M ($100K x 10) and you die, your family could invest the $1M in a mutual fund making 10%, which would yield $100K per year—your original salary. See? Just enough!

Is Life Insurance Worth It?

So, you know it’s time to take the next step and get life insurance, but maybe you still aren’t sure what step to take next. The answer is simple: Get term life insurance. Remember, life insurance is protection and security for you and your family—not an investment. Let the mutual funds handle that part!

Now that I know what I need, where can I get it? Our friends at Zander Insurance can give a quick and free quote on a term life policy in a few minutes. Don’t put it off another day. Keep the momentum going, and get started today!

Do You Have the Right Coverage? 

Do You Have the Right Coverage? 

Find out with our free 5-Minute Coverage Checkup!
Take the Coverage Checkup

Do You Have the Right Coverage?  

Find out with our free 5-Minute Coverage Checkup!
Take the Coverage Checkup