What is Life Insurance and How Does it Work? - AstroWealth Skip to main content

What is Life Insurance?

Life insurance is a legally binding contract between an insurer and a policyholder, which guarantees the insurer pays a sum of money, known as the death benefit, to named beneficiaries when the policyholder dies. In exchange, the policyholder pays a number of premiums during their lifetime.  

There are two types of life insurance: term life insurance and permanent life insurance. Term life insurance only lasts a fixed number of years based on your chosen term length. Common terms are 10, 20, or 30 years. Permanent life insurance remains in force for the policyholder’s entire life unless they stop paying the premiums or surrender the policy. Term life insurance is typically more popular due to its affordability compared to permanent life insurance. Examples of term life insurance include decreasing term, convertible term, and renewable term life insurance.

Difference Between Life and Health Insurance

The main difference between life and health insurance is that health insurance covers medical expenses while the policyholder is still alive, whereas life insurance covers costs when you pass away. Health insurance can help pay for expenses such as doctor’s visits, hospital stays, medications, and procedures, for example. In contrast, life insurance provides a cash sum to your beneficiaries when you die, which can help pay for joint mortgages, funeral expenses, and everyday living expenses. Most people will need both types of protection, especially if you have dependents.

How Does Life Insurance Work?

Life insurance requires the policyholder to pay a series of premiums throughout the length of their policy term in return for the death benefit issued by the insurer. The cost of the premiums is determined by a number of factors such as the policyholder’s age, gender, smoking history, health conditions, lifestyle, family medical history, and driving record. Combined, these factors help determine the insured’s life expectancy, which dictates the likelihood the insurer will have to pay the death benefit. 

The death benefit is the amount of money the insurer guarantees to the policyholder’s beneficiaries when they die. The insured chooses their desired death benefit based on the amount they estimate their beneficiaries will need to maintain their standard of living. You can name multiple beneficiaries and decide how much each of them will receive. 

Permanent life insurance also has a cash value component. The cash value of permanent life insurance acts as a savings account that the policyholder can use during their life. Cash is accumulated on a tax-deferred basis. 

How to Get Started 

  1. Analyze your financial situation – Before applying for life insurance, take some time to analyze your financial situation and determine how much money your beneficiaries would require to maintain their standard of living if you passed away. Consider expenses such as mortgage payments, college tuition, funeral expenses, and income replacement. 

  2. Prepare necessary information for the application – You may need to provide personal and family medical history, a medical exam, history of moving violations, DUIs, and dangerous hobbies such as auto racing. Compile the necessary documents as well as beneficiary information before applying. 

  3. Choose a policy type – Based on your individual situation and needs, determine if you want to purchase a term life or permanent life insurance policy. Term life might be better if you only want to cover your working years as “income replacement” if you were no longer around, for example. Whereas, permanent life is better if building cash value is important to you as only permanent life insurance provides this option, or you have dependents who require life long support. 

  4. Compare policy quotes – Gather multiple quotes from different providers to find the best premium costs and company rating. 

Pros of Life Insurance

  • Financial protection for your family – life insurance provide financial support to your loved ones if something were to happen to you.

  • Tax-deferred cash growth – permanent life insurance policies provide an investment component that allows you to grow wealth on a tax-deferred basis, meaning you don’t pay taxes on interest, dividends, or capital gains.

  • Peace of mind – you’ll get some peace of mind knowing your beneficiaries will receive a set sum of money when you pass away.

  • Life insurance completes your financial plan – life insurance helps you save and reach your financial goals by protecting yourself financially as you age.

  • Accelerated benefits – you may be able to receive some of your permanent life insurance policy’s death benefit before you die if you develop a specified condition such as heart attack, stroke, invasive cancer, or end-stage renal failure. Accelerated benefits allow you to pay your medical bills and possibly enjoy a better quality of life in your final months.

Cons of Life Insurance

  • Cost – one of the largest drawbacks of life insurance is the cost. Although you can tailor your policy to your budget, life insurance is another additional cost to consider.

  • Weak investment vehicle – the cash value component of permanent life insurance is a weak investment vehicle compared to other savings accounts.

  • Easy to be misled – if you’re not well informed, it can be easy to be misled. Therefore, it’s important to do your research and ask for multiple quotes before committing to one provider.

Want to learn how to define your financial goals? Get started here.

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