What Is Life Insurance and How Does It Work?
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Originally designed to help cover burial costs and care for widows and orphans, life insurance is now a flexible financial product. Just over half of Americans have some sort of life insurance coverage, according to the latest ownership data from LIMRA, an insurance research organization.
What is life insurance?
Life insurance is a contract between you and an insurance company. In exchange for premium payments, the company pays a sum of money, known as the life insurance death benefit, to your beneficiaries when you die. Beneficiaries may include your spouse, children, or other people or entities you choose.
Life insurance typically covers natural and accidental deaths. Some policies also offer “living benefits,” which means they pay out a portion of the death benefit while you’re still alive, if you’re diagnosed with a covered chronic, critical or terminal illness.
There are two types of life insurance: term and permanent. Term life insurance covers you for a fixed amount of time while permanent policies can cover you until the end of your life.
Generally, term life insurance is cheaper to purchase than permanent life. However, permanent life policies, like whole life insurance, build cash value over time and don’t expire as long as you pay your premiums.
How does life insurance work?
Life insurance covers the life of the insured person. The policyholder, who can be a different person or entity from the insured, pays premiums to an insurance company. In return, the insurer pays out a sum of money to the beneficiaries listed on the policy after the insured person dies.
How term life insurance works
Term life insurance covers you for a period of time such as 10, 20 or 30 years. If you die during this timeframe, the policy will pay your beneficiaries the amount stated in the policy. If you outlive your policy, no one gets paid.
Term life is popular because it's the most straightforward and affordable option. It's useful for people who need coverage for a set number of years, such as while they’re raising kids or paying off their mortgage.
Most term policies are convertible, which means you can upgrade to a permanent life insurance policy later on if your needs change.
Why buy term life insurance?
You want to make sure your child has money to go to college if you die.
You want life insurance to cover large debts like a mortgage that you don’t want to saddle your spouse with after your death.
You want to replace your income if you die during your working years when people depend on you financially.
You want to protect your interest in a business. Term life insurance can fund buy/sell agreements or provide coverage for key people.
How permanent life insurance works
Permanent life insurance policies typically last your entire life, assuming you pay your premiums. Whole life is the best-known type of permanent insurance, but there are others, including universal life, indexed universal life and variable life.
Permanent life insurance policies build cash value as they age. When you pay your premiums, a portion is added to your policy's cash value, which earns interest at either a fixed or variable rate depending on the type of permanent coverage you have.
Once you've accumulated enough, you can use the cash value of your life insurance while you’re still alive. For example, you can borrow from it, make withdrawals or use the interest payments to cover your premiums. If you no longer need coverage, you can even cash in your policy.
All of these options can create complex tax issues, so be sure you talk to a fee-based life insurance advisor before tapping your cash value.
» MORE: 5 reasons to get life insurance
Whole life insurance
Whole life policies, with their guaranteed payouts, predictable cash value gains and fixed premiums, sound like great products, but that all comes at a cost — cash. You’ll pay a lot more for whole life insurance than you would for a term policy.
Be wary of thinking about whole life insurance as an investment. It’s simply a type of life insurance that builds a cash value over time, and you’ll likely find better returns with other investment vehicles.
Why buy whole life insurance?
You want to cover final expenses like funeral costs so your loved ones don’t have to.
You want to leave an inheritance and avoid having it go through your estate.
You want to build an investment to help cover expenses while you’re still alive.
Universal life insurance
Universal life insurance also provides permanent coverage, but it allows for some flexibility. The premiums are adjustable, so you can make larger or smaller payments, depending on your finances or how the policy performs. If things go well, you may be able to stop making payments and let the cash value cover the cost. If not, you may need to increase the amount you pay to cover the shortfall.
Other permanent life insurance options
Indexed universal life, or IUL, is a type of universal life insurance that allows you to allocate your cash value to index funds chosen by the insurer. IUL policies are more complicated than plain universal life policies, often including caps on returns and complex fee structures.
Variable universal life is more flexible and more complex than IUL. It allows policyholders to funnel their cash value to investment subaccounts to increase their returns. However, those investments come with more risk.
Variable life is another permanent life insurance option. It sounds a lot like variable universal life but is actually an alternative to whole life with a fixed payout. Policyholders can use investment subaccounts to grow the cash value of the policy. Both variable universal life and variable life come with increased risk, and both are treated as securities — similar to stocks and bonds — by the federal government.
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How life insurance claims work
To get the death benefit after you die, your beneficiaries must file a claim with your life insurance company. They’ll generally need to provide a copy of your death certificate and fill out a claim form online, over the phone or by mail.
Once the claim is approved, the life insurance company may pay the death benefit in a lump sum or in installments. To learn more about these options, see how to file a life insurance claim.
Who needs life insurance?
Above all, life insurance is designed to replace your income when you die. If you have a spouse, kids or anyone dependent on you financially, your policy’s payout can help ease their financial burden.
Even if no one depends on your income, there will still be costs associated with your death. That can mean your loved ones will have to pay for burial and other end-of-life expenses. As you think about the amount of life insurance coverage to buy, consider your beneficiaries and what they’ll need.
» MORE: Who needs life insurance?
How much life insurance do you need?
The amount of life insurance you need depends on what you’re trying to do. If you’re just covering funeral and burial expenses, you won’t need as much as if you’re trying to replace lost income. The calculator below can help you estimate how much life insurance you need.
If you’re interested in a permanent policy, connect with a fee-only financial advisor. The advisor can help you understand how a life insurance policy fits into your financial plan.
How much does life insurance cost?
The cost of life insurance depends on the type of coverage you choose. If you compare average life insurance rates, you can see the difference. For example, $500,000 of whole life coverage for a healthy, nonsmoking 30-year-old woman costs around $3,861 annually, on average. That same level of coverage with a 20-year term life policy would cost an average of about $187 annually, according to Covr Technologies, an insurance brokerage firm.
There are many factors that go into setting life insurance rates. The biggest ones are your age and health. The younger and healthier you are, the less you’ll pay for life insurance.
» MORE: Compare life insurance quotes
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