How Life Insurance Works

Not everyone needs life insurance. The general rule is that you only need life insurance if you have dependents. Typically, dependents are children who still live at home or have yet to graduate from college. But a dependent could be anyone who is financially dependent on you, like a spouse, sibling or an aging parent.

Life insurance is generally designed for younger, working people with families. Here's why: Life insurance is meant to replace your "value" to your family once you're gone. For a working parent, a big part of that value is your salary. If you die, you'll want your family to receive enough money to replace your salary for at least the next five to seven years [source: Money.com].

Even if you're a stay-at-home parent, you still have financial value to your family. Let's say you care for two small children. If you die, then your spouse will need to keep working, which means the kids will need a nanny or day care. You might not need a huge life insurance policy, but you can buy a policy that fits the financial needs of your family.

Some people buy life insurance policies when they get married, particularly if the insured person makes considerably more money that the spouse, or if either the insured or the spouse have other financial dependents, like parents or siblings. Most people buy life insurance when they get pregnant with their first child.

Once you've reached retirement age, there's less of a need for life insurance. Now your children are most likely financially independent and you're already living on retirement savings and investment income. One reason for an older person to keep a life insurance policy is to provide extra money for his or her spouse to cover unexpected medical and long-term care expenses later in life.

Some older people hold onto life insurance policies as a way to pay for "end of life" expenses like the cost of settling an estate. But the most basic reason for retaining a life insurance policy later in life is also the oldest reason: to cover the cost of your funeral and burial.

Another reason to buy life insurance to is to pay for a particular expense. If you buy a home, it's common to sign up for a 30-year mortgage. But what if you die in 10 years? There are special life insurance policies that are tied directly to mortgages, decreasing in value as you continue to pay off the mortgage debt.

A less common reason to buy life insurance has to do with business rather than family. Let's say you're a partner in a small business and the success of the business relies significantly on your ability to bring in clients and money. Some people buy life insurance policies that name their business partner as the beneficiary. This chunk of cash could help the business stay afloat while they learn to get along without you.

So now you have a better idea of who needs life insurance. But what type of life insurance policy should you buy? Are they strictly for emergencies or can they also be reliable investment tools? We'll talk about all of the different types of life insurance in the next section.