Life Insurance Basics

Life Insurance Basics

Many financial experts consider life insurance to be the cornerstone of sound 

financial planning. It can be an important tool in the following situations:

1. Replace Income for Dependents

If people depend on an individual’s income, life insurance can replace that 

income if the person dies. The most common example of this is parents with 

young children. Insurance to replace income can be especially useful if the 

government- or employer-sponsored benefits of the surviving spouse or 

domestic partner will be reduced after he or she dies.

2. Pay Final Expenses

Life insurance can pay funeral and burial costs, probate and other estate administration costs, debts and medical expenses not covered by health insurance.

3. Create an Inheritance for Heirs

Even those with no other assets to pass on, can create an inheritance by buying 

a life insurance policy and naming their heirs as beneficiaries.

4. Pay Federal “Death” Taxes and State “Death” Taxes

Life insurance benefits can pay for estate taxes so that heirs will not have to liquidate other assets or take a smaller inheritance. Changes in the federal “death” 

tax rules through January 1, 2011 will likely lessen the impact of this tax on 

some people, but some states are offsetting those federal decreases with increases in their state-level estate taxes.

5. Make Significant Charitable Contributions

By making a charity the beneficiary of their life insurance policies, individuals 

can make a much larger contribution than if they donated the cash equivalent 

of the policy’s premiums.

6. Create a Source of Savings

Some types of life insurance create a cash value that, if not paid out as a death 

benefit, can be borrowed or withdrawn on the owner’s request. Since most 

people make paying their life insurance policy premiums a high priority, buying 

a cash-value type policy can create a kind of “forced” savings plan. Furthermore, 

the interest credited is tax deferred (and tax exempt if the money is paid as a 

death claim).

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Types of Life Insurance

There are two major types of life insurance: term and whole life.

1. Term Life

Term insurance is the simplest form of life insurance. It pays only if death 

occurs during the term of the policy, which is usually from one to 30 years. 

Most term policies have no other benefit provisions. There are two basic types 

of term life insurance policies: level term and decreasing term. Level term means 

that the death benefit stays the same throughout the duration of the policy. 

Decreasing term means that the death benefit drops, usually in one-year increments, over the course of the policy’s term.

2. Whole Life/Permanent Life

Whole life or permanent insurance pays a death benefit whenever the policyholder dies. There are three major types of whole life or permanent life insurance—traditional whole life, universal life, and variable universal life, and there 

are variations within each type.

In the case of traditional whole life, both the death benefit and the premium are designed to stay the same (level) throughout the life of the policy. The 

cost per $1,000 of benefit increases as the insured person ages, and it obviously 

gets very high when the insured lives to 80 and beyond. The insurance company keeps the premium level by charging a premium that, in the early years, is 

higher than what is needed to pay claims, investing that money, and then using 

it to supplement the level premium to help pay the cost of life insurance for 

older people.

By law, when these “overpayments” reach a certain amount, they must be 

available to the policyholder as a cash value if he or she decides not to continue 

with the original plan. The cash value is an alternative, not an additional, benefit under the policy. In the 1970s and 1980s, life insurance companies introduced two variations on the traditional whole life product: universal life insurance and variable universal life insurance.

Some varieties of whole life/permanent life insurance are discussed below.

• Universal Life: Universal life, also known as adjustable life, allows more 

flexibility than traditional whole life policies. The savings vehicle (called a 

cash value account) generally earns a money market rate of interest. After 

money has accumulated in the account, the policyholder will also have the 

option of altering premium payments—providing there is enough money in 

the account to cover the costs.

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Insurance Basics18 I.I.I. Insurance Handbook www.iii.org/insurancehandbook

• Variable Life: Variable life policies combine death protection with a 

savings account that can be invested in stocks, bonds and money market 

mutual funds. The value of the policy may grow more quickly, but involves 

more risk. If investments do not perform well, the cash value and death 

benefit may decrease. Some policies, however, guarantee that the death 

benefit will not fall below a minimum level. 

• Variable Universal Life: This type of policy combines the features of 

variable and universal life policies, including the investment risks and 

rewards characteristic of variable life insurance and the ability to adjust 

premiums and the death benefit that is characteristic of universal life 

insurance.