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What Is Life Insurance (Explained: All You Need To Know)

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What Is Life Insurance

Life insurance is a type of insurance policy where a person (the insured) pays an insurance company a certain amount of money (premium) during his or her lifetime to an insurance company in order for the designated beneficiaries to receive a sum of money (death benefits) following the insured’s death.

The reason why it’s called “life” insurance is that the insurance policy guarantees the payout of a death benefit when the insured’s life ends.

Fundamentally, a life insurance policy is a legal contract between an insurance company and the insured where the insured agrees to pay premiums during his or her lifetime in exchange for the payment of the policy face value upon the event of death.

Types of Life Insurance

There are essentially two main types of life insurance policies that you can get:

  • Term life insurance
  • Permanent life insurance

Term life insurance is a type of life insurance that is taken for a specific period of time (it has a defined term like 10 years, 20 years, or 30 years).

Someone taking term life insurance will generally pay lower premium and can have a good policy face value.

However, if the policy expires and the insured is still alive, there will be no payouts by the insurance company.

You have a few subcategories of term life insurance, such as:

  • Decreasing term life insurance
  • Convertible term life insurance
  • Renewable term life insurance 

The second type of life insurance policy you can take is permanent life insurance.

Permanent life insurance is a life insurance policy that is valid for the entire life of the insured.

It’s much more expensive to purchase permanent life insurance than term insurance as the insurance company commits to paying death benefits for the entire life of the insured, therefore taking more risk.

You can find subcategories of permanent life insurance like:

  • Whole life insurance 
  • Universal life insurance
  • Indexed universal life insurance
  • Variable universal life insurance 

Life Insurance Terms

There are certain terms that you must be familiar with when dealing with life insurance. 

Here are the main ones.

Beneficiaries: These are the people or entities that are designed to receive the policy death benefits.

Cash value: Permanent life insurance policies have a cash value that accumulates over time and can be used by the insured to borrow against it or cash it out.

Death benefit: This is the amount of money that the insurance company will pay the beneficiaries upon the insured’s death.

Insured: The person whose life is being insured under the policy.

Insurer: The company providing life insurance. 

Policy term: The period of time the life insurance policy is in effect.

Policyholder: The person or company who has purchased the policy.

Premium: The amount that the policyholder must pay the insurer.

What Is Life Insurance Used For

Life insurance is used for providing financial protection to the people you care about.

By getting life insurance, you know that upon your death, your insurance company will pay your beneficiaries a certain amount of money.

The money your beneficiaries receive can be used in different ways but mainly to pay expenses such as:

  • Debt
  • Student loans
  • College expenses
  • Living expenses 
  • Burial expenses
  • Caregiving expenses
  • Estate taxes
  • Medical expenses 
  • Mortgage 

The death benefit can also be used as a means of providing your heirs with an inheritance.

Every person’s reason for getting life insurance is unique and you should speak with your insurance agent or representative to assess your true needs.

Benefits of Life Insurance

There are many benefits to taking life insurance.

For most people, the main reason for taking life insurance is to provide financial protection to their family and beneficiaries should something happen to them.

Someone who has recently purchased a home and had children may want to take life insurance to protect his or her family members against possible financial hardship upon death.

In addition to the protection against financial hardship, others may find value in life insurance in order to strategically take advantage of tax-deferred growth in its cash value, the possibility of getting tax-free dividends, and for the beneficiaries to get tax-free death benefits.

Investors and more wealthy individuals may include life insurance policies as part of their overall investment portfolio taking advantage of different products and investment instruments to generate better returns or minimize tax exposure.

For example, a person may purchase life insurance through trust in such a way that should he or she die, the tax-free death benefits can offset the estate taxes that will eventually be owed.

Life Insurance Costs

Insurance companies have a complex method of calculating the premiums to charge a person to provide life coverage.

There are many variables taken into consideration by the insurance providers to assess the “risk” they are taking by insuring a specific person’s life.

In general terms, here are the different factors that will likely have an impact on your life insurance costs:

  • Your age
  • Your gender
  • If you are a smoker or not
  • Your overall health condition 
  • Your lifestyle 
  • Your family medical history 
  • Your driving record 
  • Where you live 

What Is Life Insurance Premium

Life insurance premium is the amount of money that a policyholder agrees to pay an insurance company during the insured’s lifetime in exchange for receiving a death benefit payout once the insured passes away.

In essence, the life insurance premium is what the life insurance will cost you.

In certain cases, the premiums can be paid as a single upfront payment and in other cases, they can be paid regularly over time.

Although most people are familiar with the regular monthly payment of premiums, the premiums can be paid in different ways suitable for the insurance provider and policyholder.

Depending on the nature of the policy you purchase and who is being insured, the life insurance premiums will vary.

Insurance companies have a complicated process of assessing the value of the premiums to charge policyholders in order to provide coverage.

Fundamentally, the premiums charged by the insurance company is a sum of money the charge to assume the risk of having to make a payment as per the terms of the policy linked to the “life” of the isured.

What Is Life Insurance Definition

According to Investopedia, life insurance is defined as:

A life insurance policy guarantees the insurer pays a sum of money to named beneficiaries when the insured dies in exchange for the premiums paid by the policyholder during their lifetime.

As you can see from this definition, life insurance is:

  • A legally binding contract
  • Where the insured pays the insurance company premiums during his or her lifetime
  • In exchange for the insurance company to pay his or her beneficiaries the face value of the policy or death benefits
  • Upon the policyholder’s death 

Now let’s look at how life insurance works.

What Is Life Insurance And How Does It Work

Let’s look at the main aspects of what is life insurance and how it works.

Why Get Life Insurance

What are the main reasons why someone may want to get life insurance?

In essence, life insurance can be an important tool to achieve many goals, such as:

  • Replace your income when you die to protect your dependents
  • Give your beneficiaries the financial means to pay for your final expenses 
  • Provide your heirs with an inheritance 
  • Allow you to pay for your final state and federal taxes 
  • Make charitable contributions
  • Create a source of savings during your lifetime

Choosing Your Life Insurance

The first decision you’ll need to make when getting life insurance is to decide if you want permanent life insurance or term life insurance.

You may want to get term life insurance if:

  • You only want life insurance coverage for a specific period of time
  • You cannot afford expensive premiums 
  • You don’t mind not having a cash value in your policy 

You may want to get permanent life insurance if:

  • You want your coverage to last your entire life 
  • You want to build a cash value in your policy 

Purchasing Life Insurance

Once you have decided on the type of policy you want to get, the next step is to qualify for the policy.

Every insurance company will have different qualification factors and can possibly charge different premiums for the same level of life insurance coverage.

To get a life insurance quote, you can directly contact insurance companies, answer their application questions, and get a quote or you can work with insurance brokers who will help you in the process.

Generally, life insurance will be more affordable the younger and healthier you are.

On the other hand, individuals with certain illnesses or conditions, older people, those who live adventurous lives, will end up paying more for their life insurance and will have a harder time qualifying.

Life Insurance Coverage

Getting life insurance requires that you decide how much life insurance coverage you need and what is right for you.

It’s important to think about the right amount of coverage for your life insurance so you can provide your beneficiaries the financial protection against future hardships.

One way to assess how much life insurance coverage you need is to:

  • Calculate the total expenses you want your policy to cover 
  • Determine how much assets your family will have to pay for the expenses you want covered
  • From the total expense you want covered, subtract the assets available to your family to cover those expense
  • The net result should be approximately what you may want to get in life insurance coverage in an ideal world

Once you have calculated how much you may need in coverage, the next step is to get quotes to see if you can qualify for that amount and if the premiums can fit in your budget.

Life Insurance Costs

Every person’s life is different and so every life insurance taken by different people will have a different cost associated with it.

The first factor that affects your life insurance cost is the type of life insurance policy you will want to purchase.

Generally speaking, if you go for permanent life insurance, you should expect to pay significantly more in premiums than term life insurance.

The second factor that affects your life insurance cost is the insured.

In other words, the insurance company will need to assess the insured’s life, lifestyle, health, age, sex, and other factors to assess how much to charge that person for required coverage.

Your age, your health, and your lifestyle are the most important factors driving the overall cost of your policy.

The younger you are, the healthier you are, and if you adopt a low-risk and healthy lifestyle, the less you’ll end up paying in premiums.

Life Insurance Cash Value

Permanent life insurance policies like whole life, universal life, indexed universal, and variable universal allows you to accumulate cash value during your lifetime.

The cash value can be used for many reasons, such as:

  • Help you borrow against it
  • Pay for policy premiums 
  • A sort of savings during the life of the policyholder 
  • Source of retirement funding 

Some cash value components will earn interest, others will let policyholders earn a fixed or equity-index rate of return, and others could be invested more flexibly.

What’s interesting is that the cash value component of your life insurance can grow in a tax-deferred manner helping some make strategic decisions to take on life insurance.

It’s important to keep in mind that the cash value of a policy is a living benefit that will eventually remain with the insurer (it will not be paid out to the beneficiaries).

Upon the insured’s death, only the face value of the policy (or death benefits) will be paid out (without the cash value).

As such, the cash value can be used by the policyholder to save, borrow against it, or provide a source of retirement funding.

What Is Life Insurance Policy Takeaways 

So there you have it folks!

What is life insurance in simple terms?

Life insurance is a contract entered into between an insurance company and a person where the insurance company agrees to pay a certain amount to the person’s beneficiaries upon death and the person agrees to pay premiums to the insurance company during his or her lifetime.

Once the insured passes away and the insurance company pays out the death benefits, the beneficiaries can use that money to pay for funeral costs, pay outstanding medical bills, pay off debt, pay for school tuition, invest it, or whatever they choose.

The main reason why someone takes life insurance is to provide financial safety and protection to his or her family and beneficiaries upon death.

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

It’s important that you speak with a professional insurance representative to assess your needs, determine your needs, choose the proper life insurance product, and ensure that you fully understand what you are getting.

I hope I was able to answer your question relating to what is life insurance, what it is used for, and how it works.

Good luck!

Let’s look at a summary of our findings.

What Is Life Insurance Summary

  • Life insurance is essentially a contract between a policyholder and an insurer 
  • The policyholder pays the insurer premiums in exchange for a lump-sum payment (death benefits) to the policyholder’s beneficiaries upon the death of the insured 
  • Typically life insurance policies are taken to provide financial security to the beneficiaries by allowing them to replace lost income and to pay for the bills and expenses 
  • There are two main types of life insurance policies: permanent life insurance covering the insured’s entire life and term life insurance providing coverage for a specific period of time (usually 10, 20, or 30 years)
Burial insurance 
Cash value 
Convertible term life insurance
Death benefits 
Decreasing term life insurance
How much life insurance do you need
How to make a life insurance claim 
Indexed universal life insurance
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Life insurance quotes 
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Tax avoidance
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Term life vs whole life 
Universal life insurance
Variable universal life insurance 
What is a life insurance company
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Accelerated benefits
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Best life insurance policies
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