How does life insurance work?

What is life insurance, how much do you need and more FAQ

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Life insurance is designed to support loved ones after a person dies. These policies are not for the sole benefit of a person while they're living; instead, they provide financial help to a named person, called a beneficiary, following the policyholder's death. Life insurance helps minimize the financial burden of a wage earner in the home. Some policies can help even during the policyholder's life.

After you purchase a life insurance policy, you pay a regular premium to the insurance provider. If the policy is in place when you die, a death benefit is paid to your chosen beneficiary or beneficiaries. The beneficiary can use those funds, which are usually tax-free, for any purpose.

How does life insurance work?

Life insurance is an agreement between a policyholder and the insurance company. A person pays a regular premium to the life insurance provider. As long as that payment is made, the policy maintains a guaranteed death benefit. If the person dies with the policy in place, the plan pays out a lump sum to a beneficiary or beneficiaries. The policyholder chooses the amount of the death benefit when signing up for the policy.

There are several types of life insurance. The two main kinds are term life insurance and permanent life insurance.

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How does term life insurance work?

Term life insurance is in place for a specific length of time, called the term. If the policyholder dies during the term, the insurance company pays the death benefit. On the other hand, if the policyholder outlives the term, the policy expires; there are no refunds of premiums in this scenario.

Term policies commonly last from 10 to 30 years. The advantage of term policies is that they are more affordable than permanent policies. They also provide flexibility in choosing term lengths and coverage amounts. A term life policy is often good for someone who has a significant debt to pay, such as a mortgage, or has dependents and doesn’t want to leave loved ones behind with a financial burden.

Once the term policy ends, the policyholder then must determine if they want to renew the policy, obtain a new policy or let the policy expire. If you renew, the costs and flexibility may change. It may also be possible to convert a term life policy into a permanent life insurance policy.

How does permanent life insurance work?

Permanent life insurance differs from term life insurance in that it remains in place throughout a person's lifetime as long as they pay their premiums. These policies also typically have a savings component, or cash value, to them that gains over time. That value is on top of the death benefit. The cash value gives the policyholder options they can use during their lifetime, like the ability to withdraw from or borrow against the cash value.

There are several types of permanent life insurance. They include the following:

  • Whole life insurance is the most popular type of permanent life insurance. It features fixed premiums and a cash value that grows slowly.
  • Universal life insurance is a bit more flexible than whole life. The cash value typically earns a money-market rate of interest. Over time, it is possible to change your premium payments as long as there is enough value in the account to do so. You can also modify the death benefit amount over time.
  • Variable life allows the policyholder to invest the funds of the savings component into investments such as stocks and bonds. This may allow the balance in these accounts to grow faster. However, there's also the risk that the value of your account can decrease. Variable life insurance policies sometimes guarantee that the death benefit won’t fall below a certain level.
  • Variable-universal life is a permanent life insurance option that combines variable and universal life features, giving the policyholder investment and premium flexibility.

What does life insurance cover?

Life insurance covers most causes of death, including death by natural causes (e.g., heart attack, cancer, old age) and accidental death (e.g., car accident, choking). However, policies have exceptions for certain types of deaths. It's important to check the details of your life insurance policy so you know the circumstances in which the insurer will not pay the death benefit.

The most common situations in which life insurance will not pay out include:

  • Suicide, if it occurs within a specific time frame (contestability period) after the policy starts
  • If there was fraud on the application, such as a failure to disclose a medical condition or participation in a dangerous hobby (like skydiving)
  • If the policyholder dies in the course of committing a crime
  • The policyholder has term life insurance and outlives the policy
  • The policyholder didn’t stay current with premium payments

It’s important to be as truthful as possible on your life insurance application and read the fine print of your policy carefully so you know when the insurer can deny a death claim benefit by your beneficiary. If you have specific questions, ask the life insurance company.

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How are life insurance premiums calculated?

Insurers set costs for their policies based on a host of factors. These include:

  • The type of life insurance policy
  • The term length and coverage amount
  • The applicant’s age
  • The applicant’s health
  • The applicant’s lifestyle

The cost of life insurance increases as you get older; you can lock in lower rates by getting a policy at a younger age. Gender is also a factor; men, on average, pay more than women for life insurance.

The type of life insurance policy you select also plays a role in cost. Term life insurance is cheaper than permanent life insurance. As you choose a higher benefit or a longer term, you can expect premium costs to increase.

Insurers also take your health and lifestyle into account when setting costs. In many cases, a medical exam is required as part of the sign-up process. You’ll likely pay more for life insurance if you have conditions such as high blood pressure, high cholesterol, obesity, cancer or a mental illness. Having a higher-risk job or dangerous hobbies also adds to the cost of life insurance.

How much life insurance do I need?

Choosing a life insurance policy is challenging because of the many factors to consider. You need to decide the type of policy you want, the length of the policy (if it’s term life insurance) and the coverage amount.

The amount of life insurance you buy should be enough to protect your beneficiaries from your loss of income. You should consider your salary, your dependents and any future expenses and current debts you may owe, like a mortgage, funeral costs and education loans for your children. You should also total the assets you would leave behind. 

Recommendations vary on how to calculate how much life insurance to buy. Experts recommend multiplying your salary by numbers ranging from five to 20 to get an amount you should purchase. It may help to speak with a financial advisor about your plans to buy a policy and analyze your finances so you make the most informed choice for your family.

» READ MORE: How much life insurance do I need?

How does life insurance pay out?

Life insurance pays out a death benefit, which is the amount a beneficiary or beneficiaries will receive at the time of the policyholder's death if the policy is in good standing. The beneficiary will need to file a claim along with a copy of a death certificate. The insurance company may give the beneficiary options on how to receive the death benefit, such as in a lump sum or in annual installments. It can take from two weeks to two months for the life insurance company to pay out the death benefit.

What is a life insurance beneficiary?

A beneficiary is any person or other entity that the policyholder names to receive the death benefit. This does not have to be a spouse. It can be other family members, nonrelatives, a trust or charitable organizations. You can also have more than one beneficiary and name contingent beneficiaries, who receive the death benefit if the primary beneficiary cannot. Keep in mind that states have different laws regarding who can be beneficiaries.

Bottom line: Is life insurance worth it?

Life insurance gives many people the reassurance that if they die unexpectedly, their loved ones will be left with a financial safety net. When you’re determining if life insurance is worth the cost, consider what could happen if you died unexpectedly now or in the future. Could your spouse and family maintain their current standard of living? Life insurance helps to make that possible. There are options ranging from simple term life insurance to life insurance with an investment component and tax benefits. If you decide to buy life insurance, compare quotes, policies and reviews of different providers.

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