Like all other forms of insurance, life insurance is meant to soften the financial blow of an incident. Unlike other forms of insurance, life insurance is meant to benefit someone other than the policy holder. So, what are the meaning and purpose of life insurance?
All personal finance decisions revolve around balancing your many different needs and wants. Life insurance alters that equation a bit, as the ultimate beneficiaries are different than the individual holding the policy.
Keeping these beneficiaries front and center in your decision-making processes is paramount. Life insurance–at the end of the day–is designed to take care of them and help in the transition to a life when you are no longer around. Your family and their future interests are the true meaning and purpose of life insurance.
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What Is Life Insurance?
Before delving deeper into the meaning and importance of life insurance, it is important to understand what life insurance is.
Life insurance is a contract between a policy holder and a financial institution. In exchange for premium payments (generally on a monthly basis), the financial institution will guarantee a death benefit if the policy holder passes away.
There are a number of different life insurance policies, though these can be broken down into two different types of arrangements: term life and whole life insurance policies.
Term life is an insurance policy for a finite period of time, usually in increments ranging between 10-30 years. In exchange for the aforementioned premium payments, your family will receive a death benefit if you die while the policy is active. If you outlive the term of this arrangement, no benefit will be paid. (This is akin to holding auto insurance and never being involved in an accident.)
Whole life is a much more complex financial instrument, as the policy never expires. Whole life also has a cash benefit component that grows at a guaranteed rate; the policy holder can even borrow from this cash value during their lifetimes. For this reason, it is a significantly more expensive policy to hold.
What Is the Meaning of Life Insurance?
Simply put, the meaning of life insurance is to help support your family after you die. Drilling down to its very essence, its purpose is to help replace the financial value that you contribute to your household. This could be the regular salary that you are earning or the amount of money that it would cost to replace the childcare provided by a stay-at-home parent.
However, life insurance is meant to extend beyond your immediate income replacement. Most of us have obligations that reach well into the horizon, such as mortgage payments, other debts, and estimated education expenses for our offspring.
Therefore, the death benefit that you choose should be designed to help your family offset these future costs. Though trying to put a price tag on how much your life is worth can feel a bit morbid, there are ways to make this a more pragmatic and practical exercise.
To calculate your desired death benefit, you could use the DIME approach, whereby you aggregate your future Debts, Income, Mortgage, and Education expenses to better understand the level of financial support your family will need going forward. Or, you could choose a more simplified method, taking your current salary and multiplying it by a factor of ten (this is known as the 10X rule).
Balancing Competing Interests
It is important to remember that none of us have unlimited resources. The higher the death benefit, the higher your premium payments will be.
There are both short- and long-term costs to every financial decision. In addition to the amount that you are paying for the product or service, there is an opportunity cost for what you are foregoing.
Life insurance policies are meant to serve as a cushion to support your family if you die during the period when they are acutely dependent on you. As you get older, and your children become more and more independent, they will be less financially reliant on you. (This calculus is changed if one has a child or beneficiary that will need lifelong care, of course.)
Looking at the purpose of life insurance through the prism of income replacement, it is easy to see why term life insurance makes the most financial sense for most individuals.
The significantly more expensive whole life insurance is about more than just income replacement, and it is often used as an investment vehicle. However, because the costs are so much higher, many financial advisors would counsel purchasing term life insurance and placing the money you save in other investment opportunities.
As always, it is a good idea to speak with a licensed professional before embarking on any financial decisions.
Conclusion: Considering the Purpose of Life Insurance
The product is called life insurance, not death insurance. It is about the ones you are leaving behind, as you provide them with a financial cushion to help them transition to a life when you are no longer present.
So, how should we consider the purpose of life insurance? Simply put, it is doing what you can in life to protect the ones you love if the unfortunate occurs, and you are no longer around to do so yourself.
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