What Is Life Insurance? Choose the Type That's Right for You

What is life insurance? Life insurance is a legally binding contract between you and an insurance company. In exchange for premium payments (and if your policy is active when you die), the insurance company will pay a lump sum of money — referred to as a death benefit — to your chosen beneficiaries. It's one way to make sure your loved ones are financially protected after you pass away.

However, not all life insurance policies are the same. To best help your family cope financially when you pass, you'll need to choose a policy that's right for you, and to do so you'll need to understand the different types of life insurance.

There are two main types of life insurance: term and permanent.

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Term life insurance

Term life insurance covers you for a set period of time, usually 10, 20 or 30 years. If you die within this time frame, your beneficiaries will be paid the amount specified in the policy. However, if you outlive your policy, no one receives a pay out. Term life insurance is typically the cheapest option for life insurance, and has no cash value component. There are a few types of term life insurance policies.

• Renewable term insurance: According to the National Association of Insurance Commissioners (NAIC), "renewable term insurance guarantees the policyholder the right to renew at the end of the contract period without evidence of insurability as long as the premium is paid."
• Decreasing term insurance: With a decreasing term policy, coverage decreases over the life of the policy at a set rate. This form of insurance can be useful for paying down loans, like a mortgage, that decrease over time.
• Convertible term insurance: A convertible term insurance policy allows an individual to convert a term policy to a permanent policy.

Permanent life insurance

Permanent life insurance as the name suggests, covers you for the remainder of your life — as long as you keep up with the premium payments. Although more expensive than term life policies, permanent life insurance policies build cash value over time. The most well-known form of permanent life insurance is whole life insurance.

• Whole life insurance: Whole life insurance offers a fixed death benefit when the policyholder dies. Both the death benefit and the premium are designed to remain constant throughout the life of the loan. With a whole life policy, a portion of each premium payment is put into a savings component referred to as the cash value. According to the National Association of Insurance Commissioners (NAIC), "Whole life policies are designed to build tax deferred cash value, which is the accumulation of premiums collected less applicable expenses and applicable insurance charges and they allow for borrowing against the cash value of the policy."

Cost of life insurance

Several factors go into how much your life insurance premium will cost.

• Age: The sooner you purchase life insurance, the cheaper it is. This is because when you’re young, you pose less of a risk to insurance companies due to your good health. For this reason, purchasing life insurance in your 20s, as opposed to your 50s, can save you thousands of dollars over the course of the policy.
• Current health: Your health plays a big factor in determining how much your health insurance policy will cost. Are you a smoker? What's your family medical history like? Past, current and potential health issues will be considered.
• Gender: On average, women live five years longer than men do. Insurance carriers factor this into their underwriting when assigning costs.
• Lifestyle: Do you have any high risk hobbies, like auto racing or sky diving? What about a dangerous job? If you smoke or have many driving violations (speeding, DUI, etc.) they could also influence your costs.

You'll also need to calculate how much coverage you'll need, which can be a complicated affair. While there are standard formulas and online calculators available for your use, they aren't always appropriate. You may be better off taking a systematic approach to determine how much coverage you'll need.

To start, add up all final expenses you intend to cover, like a funeral or burial. Also, consider mortgages and other debts, rising college expenses and income replacement for your loved ones.

Related Content

• Should You Buy Life Insurance? Four Cases When You Should or Shouldn't
• How to Figure Out How Much Life Insurance You Need
• Retirees, It's Not Too Late to Buy Life Insurance