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 and powerful financial product. Just over half of Americans have some sort of life insurance, according to the latest ownership data from LIMRA, an insurance research organization.
Life insurance can be issued as either an individual or group policy. We’ll be looking at individual policies, not the group life insurance commonly issued through work.
» MORE: 5 reasons to get life insurance
What is life insurance?
Life insurance is a contract between you and an insurance company. In exchange for premium payments, the company pays a life insurance death benefit to your beneficiaries when you die. 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 basically two types of life insurance: term life and permanent life. Term life covers you for a fixed amount of time while permanent life insurance 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, if you’ve paid your premiums.
What does life insurance cover?
The main purpose of life insurance is to provide money for your beneficiaries when you die. But how you die can determine whether the insurer pays out the death benefit. Depending on the type of policy you have, life insurance can cover:
Natural deaths. Dying from a heart attack, disease or old age are examples of natural deaths.
Accidental deaths. Accidents may include car crashes, drowning or falling. Some policies offer accidental death benefit riders, which increase the payout if you die in an accident.
Suicide. Most life insurance policies cover suicide, but only if it occurs after the policy's waiting period — typically the first two years of the policy.
Homicide. Life insurance often covers homicides, but the circumstances of the death can affect the payout. For example, if a beneficiary murders the insured person, the killer won’t receive the death benefit.
Illness or injuries. Some policies offer coverage for illness or injuries while you’re still alive. For example, a critical or chronic illness rider covers conditions like cancer, as well as conditions that permanently inhibit your daily activities. An accelerated death benefit rider provides access to your death benefit if you’re diagnosed with a terminal illness.
War or terrorism. Some life insurance policies may exclude death as a result of war or terrorism.
What does life insurance not cover?
Criminal activities. In general, if you die while committing a crime, your beneficiaries won’t receive the death benefit. This can apply to drug and alcohol abuse. For example, if you die while driving drunk — an illegal activity — the policy typically won’t cover the death.
High-risk hobbies. Some policies won’t pay out if you die while participating in a hazardous hobby, like skydiving.
Misrepresentation. If you lie on your life insurance application, the insurer may cancel your policy. Make sure you're as honest and open as possible when applying for coverage.
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.
How term life insurance works
Term life insurance covers you for a period of time chosen at purchase, such as 10, 20 or 30 years. If you die during the covered period, the policy will pay your beneficiaries the amount stated in the policy. If you don’t die during that time, no one gets paid.
Term life is popular because it offers large payouts at a lower cost than permanent life. It also provides coverage for a set number of years.
There are some variations of typical term life insurance policies. Convertible policies allow you to convert them to permanent life policies at a higher premium, allowing for longer and potentially more flexible coverage. Decreasing term life policies, such as mortgage protection insurance, have a death benefit that declines over time, often lined up with large debts that are slowly paid off.
What does term life insurance cover?
Reasons you may want term life insurance include:
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 cover you until death, assuming you pay your premiums. Whole life is the most well-known type of permanent insurance, but there are other flavors, including universal life, indexed universal life and variable life.
Permanent life insurance policies build cash value as they age. A portion of the premium payments is added to the cash value, which can earn interest.
The cash value of whole life insurance policies grows at a fixed rate, while the cash value within universal policies can fluctuate.
You can use the cash value of your life insurance while you’re still alive. You can borrow from it, make withdrawals or just use the interest payments to cover the premium later in life. If you no longer need coverage, you can even give up the policy and get the cash surrender value in return.
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.
Whole life insurance
Whole life policies, with their guaranteed payouts, potential cash value and fixed premiums, sound like great products, but that all comes at a cost — cash. Whole life premiums are a lot higher than term life insurance premiums.
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 $3,722 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.
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.
What does whole life insurance cover?
Reasons you may need whole life insurance include:
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
A universal life insurance policy also provides permanent coverage, but it allows for some flexibility. Universal life policies allow you to 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, participation caps 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 different. It’s an alternative to whole life with a fixed payout. However, 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.
Life insurance basics: Terminology, coverage needs and cost
Life insurance policies can differ widely. There’s life insurance for families, high-risk buyers, couples and many other groups. Even with all those differences, most policies have some common characteristics. Here are some life insurance basics to help you better understand how coverage works.
Common life insurance terminology
Premiums are the payments you make to the insurance company. For term life policies, these cover the cost of your insurance and administrative costs. With a permanent policy, you’ll also be able to pay money into a cash-value account.
Beneficiaries are the people who receive money when the covered person dies. Choosing life insurance beneficiaries is an important step in planning the impact of your life insurance. Beneficiaries are often spouses, children or parents, but you can choose anyone.
Death benefit refers to the total amount of money the beneficiaries will be paid when the covered person dies. You choose the life insurance face value when you buy a policy, and the amount is sometimes — but not always — a fixed value.
Riders are options you can add to a life insurance policy. You might want your premiums covered if you’re no longer able to work, or maybe you’d like to add a child to your policy. By paying for a life insurance rider, you can add those and other features.
Who needs life insurance?
Like all insurance, life insurance was designed to solve a financial problem. Life insurance is important because when you die, your income disappears. If you have a spouse, kids or anyone dependent on you financially, they’re going to be left without support.
Even if no one depends on your income, there will still be costs associated with your death. That can mean your spouse, child or relatives will have to pay for burial and other end-of-life expenses. As you think about the amount of life insurance coverage you need, consider your beneficiaries and what they’ll need.
If no one depends on your income and your funeral expenses won’t damage anyone’s finances, life insurance may be a thing you can skip. But if your death will be a financial burden on your loved ones immediately or in the long term, you may need a life insurance policy.
» 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 end-of-life 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 life insurance is priced
Your health is one of the most important parts of determining your life insurance premiums. Healthier people are less likely to die soon, which means companies can charge them less for life insurance. Younger people are also less likely to die soon, so life insurance is cheaper (on average) for younger buyers.
Women live longer, nonsmokers live longer, people without complex medical problems live longer, and on and on goes the list. People in these groups will normally get preferential pricing for life insurance.
» MORE: Compare life insurance quotes
Many applications require a life insurance medical exam. The insurer will check your weight, blood pressure, cholesterol and other factors to try to determine your overall health.
Some providers will issue life insurance without a medical exam, but you’ll typically pay more for coverage. You may also be limited to less coverage than you’re hoping for, with some insurers maxing out no-exam policies at $50,000.
If you need a small amount of coverage, you might be better off checking to see if your employer offers group life insurance as a perk. Employee life insurance can often cover basic end-of-life expenses and may cover some or all of your annual salary. Basic coverage usually doesn’t require an exam and may even be free.
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