28 Jan What is life insurance?
What is life insurance anyways? Life insurance is a security blanket for your loved ones (but without the fleece and fringe trim). It’s designed to protect them from financial burden after you die.
The structure of a life insurance policy is pretty simple. You pay premiums (each month or year) to an insurance company over an agreed length of time. In return, the insurance company promises to give your loved ones a tax-free lump sum cash payment (the “death benefit”) if you die.
There are two types of life insurance products: term life insurance and permanent life insurance.
Type 1 : Term life insurance (our favourite!)
Term life insurance is the simplest and most affordable form of life insurance. It pays out a benefit to your beneficiaries only if you die within a specified timeframe, usually 10, 20, or 30 years. This is the best option if you want to cover “standard needs,” such as repaying your mortgage or paying expenses for your children while they’re young.
Term insurance is usually guaranteed renewable. In other words, if you still need the insurance after the term expires (for example, 10 or 20 years down the road), you can renew the policy without having to show proof of new health conditions or go through additional medical underwriting. This essentially provides you with some protection against getting sick because your renewal rates are guaranteed.
Term insurance premiums usually remain the same during the specified term but increase if you renew the policy.
Want to learn more? Read why we think term life insurance makes sense for most people.
Type 2: Permanent life insurance
In comparison, permanent life insurance pays out a benefit to your beneficiaries no matter when you die.Permanent insurance is much more expensive. Why? Because it guarantees that your beneficiaries will receive your death benefit. You can die young or die old, and your insurance company will still pay out your benefit.
There are two main types of permanent life insurance: whole life insurance and universal life insurance.
Permanent life insurance option 1: Whole life
Whole life insurance is a form of permanent life insurance. It includes a death benefit (just like a term life insurance policy does) and a cash surrender value. Before we explain what a cash surrender value is, let’s talk about premiums.
With a whole life insurance policy, the premiums you pay during the early years are usually higher than the amount needed to cover the risk of your death. These “excess premiums” form the policy’s cash surrender value.
In other words, your insurance company takes the amount of money that you’ve overpaid by during the early years and places it in a bank account with your name on it. Each year, the insurance company invests this money. This allows your account to accumulate interest, which increases your cash surrender value. As you get older, your probability of dying (and, therefore, the cost of your insurance) gets higher. (It’s no secret that you aren’t going to live forever).
When you reach a certain age, the premium you pay for your policy won’t be enough to cover the cost of your insurance. At this point, your insurance company will start pulling money out of your cash surrender value account to cover the difference.
This structure allows you to pay the same premiums every year throughout the policy, even though the cost of your insurance technically increases over time. If you decide to cancel your policy at any point, you’ll receive the cash surrender value of the policy (the amount of money that you previously overpaid by).
But be careful: cancelling a whole life insurance policy can come with penalties and additional charges (just like when you try to cancel your phone or cable plan).
These penalties and charges can significantly reduce the amount of money you get back.
Permanent life insurance option 2: Universal life
Although it can seem more complex, universal life insurance gives you more flexibility than whole life insurance policies do. It combines life insurance with tax-advantaged investing. Like with whole life insurance, part of your universal life insurance premium is used to cover your death benefit whereas the rest is invested.
The investments form the cash value of the policy. In this case, however, your insurance company gives you some flexibility to choose how and which funds you’d like to invest. Universal life policies are expensive. That’s why in general, you should use them for a combination of life insurance protection and long-term savings needs.
Expect to have the policy for at least 10–15 years before you start to cash out or shift investments. And remember that the value of your universal life policy will depend on how well the stock markets perform. So if risk makes you weak in the knees and you want something that’s fairly predictable, this may not be the policy for you.