How Life Insurance Works

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Life insurance is a simple concept. You pay a company a little bit of money at a time, and it promises to pay your loved ones a lot of money when you die. But there are a lot of details to consider.

Here’s how it works.

The buying process

Most people buy individual life insurance through captive agents, who work for a specific insurance company, or independent agents, who sell policies from many companies. Many consumers also buy group life insurance through their workplaces.

Agents make commissions based on the type of policy and coverage amount you choose, something you should keep in mind when considering their advice. In some cases, this means your agent gets paid more if he or she sells you one company’s policy, or one type of policy, over another.

If you have any concerns about a company or agent, you can turn to your state insurance department. These departments license insurance companies and agents, ensure that policies and market conduct are fair and reasonable, monitor the financial health of insurers, educate consumers and investigate complaints.

When you decide to buy life insurance, you’ll choose an amount and length of coverage. Then you’ll submit an application, and the life insurance company will decide whether or not to issue you a policy and how much it should cost. Rates are based on many factors, most of which insurers believe relate to your life expectancy, including:

  • Age
  • Gender
  • Tobacco use
  • Medical history
  • Family health history (such as incidences of heart disease or cancer among immediate family members)
  • Dangerous hobbies (such as scuba diving)
  • Planned travel to risky parts of the world
  • Other risk factors, such as your driving record

Depending on the type of policy you buy, insurers might verify the information in your application through some or all of these methods:

  • Requesting your medical records
  • Having you undergo a life insurance medical exam, including blood and urine samples, and possibly an EKG
  • Viewing your past and current medications via a prescription history database
  • Checking your DMV report (generally for drunk driving convictions)
  • Reviewing your personal credit report (if you’re buying a high amount of life insurance)
  • Reviewing your business credit reports and running a criminal background check, in some cases

Companies typically take several weeks to review an application and issue a policy.

After the purchase

If you develop a medical condition, or even start smoking, after you buy the policy, you don’t have to tell the insurance company. Once you have coverage, new problems or habits can’t change your rate.

You’ll typically have several premium payment options, such as paying every month, twice a year or  annually.

Life insurance companies make money by investing premiums, hoping to make more than they’ll have to pay in claims or that the customer doesn’t die while the policy is in effect. They also profit from customers who stop paying for their policies, causing them to lapse and leaving the insurer with the premiums that have already been paid.

Policyholders designate beneficiaries who will receive the payout, called a death benefit. This can go toward funeral expenses, payments on mortgages and other debt, and college savings, among other uses. Historically, beneficiaries have had to find policies and make claims after a policyholder dies, but many state regulators now require insurers to check for death records of customers and then pay benefits to their families.

Once beneficiaries submit a life insurance claim, they’ll generally receive the check within a week or two.

Quick stats

According to the American Council of Life Insurers:

  • There were 850 life insurance companies operating in the United States, employing 339,200 people (not counting agents and brokers) at the end of 2013.
  • At the end of 2013, there were 144 million individual life insurance policies and 114 million group life insurance policies in force in the United States.
  • Life insurance companies paid $64 billion to beneficiaries in 2013.

Types of life insurance

There are two main types of life insurance: term and permanent.

  • Term life insurance pays the death benefit if the insured person dies during the term of the policy. When the term is over, the policy expires. Term life insurance costs less than other policy types, making it more attractive for buyers who want protection for a set period of time, such as until their children are grown.
  • Permanent life insurance such as whole life insurance combines insurance and an investment component. It provides coverage for the entire life of the insured person, as long as the premiums are paid. A portion of the premiums — called the cash value — is also invested. Eventually policyholders can borrow against the cash value or use it to pay premiums. Permanent life insurance offers some advantages, particularly for wealthy people looking for additional investments or hoping to avoid estate taxes. Consult a financial planner if you’re considering permanent life insurance.

Updated June 26, 2015

Aubrey Cohen is a staff writer at NerdWallet, a personal finance website.