How Life Insurance Works and the 5 Top Reasons You Need It

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If you’re like most American adults, chances are high that you’ve heard of life insurance and know that it’s something you need. But what is it exactly, and how does life insurance work?

Life insurance is a way for you to leave money to people you care about in the event of your death.

At its basic level, it’s an agreement between you and a life insurance company. You agree to pay them and in turn, they provide you with insurance coverage. You can think of it like a subscription service: as long as you pay premiums, you’ll be covered.

Covered for what? Well that really depends on you. Maybe you want to make sure your spouse will be able to pay the mortgage, no matter what happens to you. Maybe you want your kids to afford college. Or you might simply want to make sure your people will be OK paying day to day bills if you’re not around to provide for them.

No matter your goal, the right kind of life insurance should be a simple and affordable way to reduce the risk of getting there.

Terms to Know

Premiums: The amount of money you pay in exchange for coverage.

The coverage amount (also known as face amount, death benefit or payout): The amount of money that goes to your people (beneficiaries) if you die. You set it in advance when buying a policy, and it passes to them tax free.

Beneficiaries: The people who will receive the coverage amount.

The term: The length of time your policy will be in effect for — usually 10, 15, 20, 25, or 30 years, but you can also choose to be covered for your entire life, depending on the type of insurance that’s right for you.

Filing a claim: The process by which your beneficiaries can claim the coverage amount if you die.

How Does Life Insurance Work?

Life insurance works like a subscription model: as long as you pay premiums, you’ll be covered. That means your beneficiaries should receive money (tax free) if you die, but it’s worth noting that claims can be denied for various reasons, like fraud or material misrepresentation (basically, not being honest on the application or the claim).

The amount you’ll pay in premiums depends on three big factors:

  • Your personal characteristics (age, health, gender, etc.)
  • The type of life insurance you choose, primarily between term and permanent
  • The coverage amount/size of your policy (how much money you want to leave your beneficiaries)

The life insurance company will collect all that information when you apply in order to determine your premium. That process is called “underwriting.”

Once you’re approved and have accepted your offer, you’ll start paying premiums. If you pass away while your policy is in place, your beneficiaries can file a claim to receive the amount of coverage you purchased.

Do I Need Life Insurance?

Now that you have the basics, you might wonder if you need life insurance. To find out, ask yourself the following question: would your absence cause anyone financial strain? If so, the answer is yes, you need life insurance. Let’s take a look at the five top reasons you may need life insurance.

1. You Contribute a Meaningful Portion of Your Family’s Income

You can think of life insurance as a way of replacing your income if you die during your policy’s term. If you support (or will support) a spouse, kids, parents, grandparents, siblings or others and the loss of your income would affect whether they can pay for costs like food, housing or childcare, you need life insurance.

2. You Have Kids

Anyone with children should consider life insurance, whether they earn a salary or not. Even if you don’t have lost income to replace, you likely provide care that your family would have to pay for in your absence. Life insurance can also meaningfully contribute to college savings.

3. You Have a Mortgage or Other Shared Debt

If you have a loan that someone else has co-signed, they may be required to make the full payments when you die. Consider life insurance if a parent has co-signed a student loan for you, for instance, or you co-borrowed a mortgage, personal loan or home equity line of credit with a spouse, partner or sibling.

4. You Run a Business

Life insurance can be extra important for small business owners. You might have taken on business debt using personal assets, like your home, as collateral. In that case, life insurance can help pay off debts that your family might otherwise have to cover.

Plus, if you co-own the business, a life insurance policy where your business partner is the beneficiary can allow him or her to buy out your share from your heirs at a price you decide on now. That can prevent a scenario in which your partner isn’t able to afford taking on your share of the business, and your children are left without income from the business or the proceeds from your portion’s sale.

You may want to consult with an attorney to ensure this is set up appropriately.

5. Your Life Insurance Through Work isn’t Enough

Most likely, it’s not. If you have access to a group life insurance policy at your workplace, there’s usually no harm in participating, especially if it’s included as part of your benefits package. But if you fall into any of the categories above, the death benefit included in your policy at work probably won’t be enough to adequately cover your beneficiaries’ needs.

Group life insurance through an employer usually maxes out at a low fixed dollar amount or one to two times your annual salary, as opposed to 10 to 15 times as often recommended as a rule of thumb by financial experts. You can calculate your needs more exactly using an online calculator, like the one offered by Ladder.

Read The Penny Hoarder review of Ladder life insurance company.

None of the Above Apply?

If you’re not in any of these groups, you may not need life insurance now, but make sure to reevaluate when major life changes happen, including when you take on debt. Also, keep in mind that buying life insurance when you’re younger can help you lock in a better price.

This is a guest column written for The Penny Hoarder by Liana Corwin, former director of communications and editor of the financial literacy blog at Ladder, a digital life insurance company that sells term life insurance at rates that can flex as customer’s financial needs change.