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How Does Life Insurance Work?

Life insurance pays a benefit to your loved ones, which can help replace income or pay off debts when you die.
July 13, 2020
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Life insurance is a contract between you and an insurance company. You make regular premium payments to the life insurance company. In exchange, the company pays a death benefit to your beneficiaries when you die.

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 covers 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. Term life policies have no value if you outlive the contract.

What is life insurance?

Originally designed to help cover burial costs and care for widows and orphans, life insurance is now a flexible and powerful financial product. More than half of Americans have some sort of life insurance, according to insurance research organization LIMRA.

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.

Life insurance terminology

Life insurance policies can differ widely. There’s life insurance for families, high-risk buyers, couples and many other specific groups. Even with all those differences, most policies have some common characteristics.

  • 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 you like.
  • Death benefit refers to the total amount of money the beneficiaries will be paid when the covered person dies. You choose a cash value when you buy a policy, and the amount  is sometimes — but not always — a fixed value. Permanent life insurance can also pay additional money if the cash account has grown and if you select certain options for your policy.
  • 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 rider, you can add those and other features to your policy.

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.

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 the total coverage you may need.

If you’re interested in a permanent policy (more on these below), you should also connect with a fee-only financial advisor. The advisor can help you understand how a life insurance policy fits into your financial plan.

How term life insurance works

Term life insurance is coverage that lasts for a period of time chosen at purchase. This type of life insurance commonly covers 10-, 20- or even 30-year periods. 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 frame, no one gets paid.

Term life is popular because it offers large payouts at a lower cost than permanent life. It’s also a temporary solution. It exists for the same reason temporary tattoos and hair dyes do — sometimes a little while is long enough.

Reasons you may want term life insurance include:

  • You want to make sure your child can go to college, even if you die.
  • You have a mortgage that you don’t want to saddle your spouse with after your death.
  • You can’t afford the higher premiums of permanent life insurance and still want coverage.

There are some variations on typical term life insurance policies. Convertible policies allow you to convert them to permanent life policies at a higher rate, allowing for longer, more flexible coverage. Decreasing term life policies have a death benefit that declines over time, often lined up with mortgages or large debts that are slowly paid off.

» MORE: Term vs. Whole Life Insurance: How to Choose

How permanent life insurance works

Permanent life insurance policies cover you until death, assuming you pay your premiums. Whole life is the most well-known version of this type of life insurance, but there are other flavors, including universal life and variable life.

Permanent life insurance policies build cash value as they age. A portion of the premium payments is added to a cash account, which can earn interest or be invested, depending on the type of policy you hold.

Cash value usually rises quickly at the beginning of a policy’s life, when you’re younger and cheaper to insure. Whole life policies increase their cash value at a fixed rate, while universal policies fluctuate with the market. It takes time to build the cash value in these accounts, which you should consider when buying life insurance.

You can then 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 your premium later in life. You can even surrender the policy, trading your death benefit for the value currently in the account, minus some fees.

All of these options can create complex tax issues, so make sure you talk to a fee-based financial 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 easily see the difference. For example, $500,000 of whole life coverage for a healthy 30-year-old woman costs around $3,750 annually, on average. That same level of coverage with a 30-year term life policy would cost an average of about $300 annually.

Be wary of thinking about a whole life insurance policy as an investment vehicle — there’s a temptation to see it as both an insurance and an investment product. Many savvy investors can find better options in the world of 401(k)s, individual retirement accounts, stocks or real estate.

» MORE: The complete guide to planning for retirement

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 investment account performs. If things go well, you may be able to stop making payments. If they go poorly, you may need to increase the amount you pay to cover the shortfall.

Universal life insurance depends on how the insurance company’s investments perform. If it makes the wrong choices, you may need to pay more than you originally planned.

Other permanent life insurance options

Indexed universal life is a type of universal life insurance that puts investments into index funds, designed by the insurer, which try to track the stock market. 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 invest in many other channels to try to increase their returns. However, those investments come with a lot more risk.

Variable life 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 stocks and other investments 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 — i.e., stocks and bonds — by the government.

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 money 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, non-smokers 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. They’ll 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 larger insurers maxing out no-exam policies at just $50,000.

If you just need a small amount of coverage, you might be better off checking to see if your employer offers 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 any exam and may even be free.

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