What Is Life Insurance?
New to buying life insurance? Learn how it works and what you need to understand to choose your coverage.
A life insurance policy is a contract with an insurance company. In exchange for premiums (payments), the insurance company provides a lump-sum payment, known as a death benefit, to beneficiaries in the event of the insured’s death.
Typically, life insurance is chosen based on the needs and goals of the owner. Term life insurance generally provides protection for a set period of time, while permanent insurance, such as whole and universal life, provides lifetime coverage. It’s important to note that death benefits from all types of life insurance are generally income tax-free.1
There are many varieties of life insurance. Some of the more common types are discussed below.
Term life insurance
Term life insurance is designed to provide financial protection for a specific period of time, such as 10 or 20 years. Typically, premiums are level and guaranteed for that time. After that period, policies may offer continued coverage, usually at a substantially higher premium rate. Term life insurance is generally a less costly option than permanent life insurance.
Needs it helps meet: Term life insurance proceeds are most often used to replace lost potential income during working years. This can provide a general safety net for your beneficiaries and can also help ensure the family’s financial goals will still be met—goals like paying off a mortgage, keeping a business running, and paying for college.
It’s important to note that, although term life can be used to replace lost potential income, life insurance benefits are paid at one time in a lump sum, not in regular payments like paychecks.
Universal life insurance
Universal life insurance is another type of permanent life insurance designed to provide lifetime coverage. Unlike whole life insurance, universal life insurance policies are flexible and may allow you to raise or lower your premium or coverage amounts throughout your lifetime. Like whole life insurance, universal life also has a tax-deferred savings component, which may build wealth over time. Additionally, due to its lifetime coverage, universal life typically has higher premiums than term.
Needs it helps meet: Universal life insurance is most often used as a flexible estate planning strategy to help preserve wealth to be transferred to beneficiaries. Another common use is long term income replacement, where the need extends beyond working years. Some universal life insurance product designs focus on providing both death benefit coverage and building cash value while others focus on providing guaranteed death benefit coverage.
Whole life insurance
Whole life insurance is a type of permanent life insurance designed to provide lifetime coverage. Because of the lifetime coverage period, whole life usually has higher premiums than term life. Policy premiums are typically fixed, and, unlike term, whole life has a cash value, which functions as a savings component and may accumulate tax-deferred over time.
Fidelity does not currently offer whole life insurance.
Needs it helps meet: In addition to providing lifetime coverage, whole life is commonly used to accumulate tax-deferred savings. Whole life can also be used as an estate planning tool to help preserve the wealth you plan to transfer to your beneficiaries.
Comparing Types of Life Insurance
|Universal Life Insurance||Whole Life
|Needs it helps meet||Income replacement in a lump sum||Wealth transfer, income protection and some designs focus on tax-deferred wealth accumulation||Wealth transfer preservation and tax-deferred wealth accumulation|
|Protection period||Designed for a specific period (usually a number of years)||Flexible; generally, for a lifetime||For a lifetime|
|Cost differences||Typically less expensive than permanent||Generally more expensive than term||Generally more expensive than term|
|Premiums||Typically fixed||Flexible||Typically fixed|
|Proceeds paid to beneficiaries||Yes, generally income tax-free||Yes, generally income tax-free||Yes, generally income tax-free|
|May help build equity||No||Yes||Yes|
How cost is determined
Insurers use rate classes, or risk-related categories, to determine your premiums; these categories don’t, however, affect the length or amount of coverage.
Traditional rate classes are:
- Standard: Good health, average cholesterol, relatively low-risk lifestyle
- Preferred: Very good health and family medical history, low cholesterol, low-risk lifestyle
- Super-Preferred: Excellent health and family medical history, very low cholesterol, low-risk lifestyle
Your rate class is determined by a number of factors, including overall health and family medical history and your lifestyle. Tobacco use, for example, would increase risk and therefore cause your premium to be higher than that of someone who doesn’t use tobacco.
Determining your coverage need
Learn strategies for choosing the right amount of coverage.