Personal Finance

What Is Life Insurance and How Does It Work

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Life Insurance

Definition

Life Insurance is a contract signed with an insurance company wherein the insured person agrees to pay premiums (monthly, quarterly, annually or even a single premium) in exchange for the life insurance company paying out a death benefit to the beneficiaries selected by the insured.

Also known as:  life assurance

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Having a life insurance policy is a must for anyone who wants to ensure the financial security of family members and surviving loved ones. Life insurance proceeds can help families in many ways — from replacing income they would ordinarily lose upon the death of a breadwinner to covering college tuition or funeral expenses.

This guide will walk you through what life insurance is and how it works. And, if you’re already looking for a provider, check out our list of the best life insurance companies to help you select the best policy for your needs.

Table of Contents:

  • What is Life Insurance?

  • How Does Life Insurance Work?

  • What can you pay with a life insurance death benefit?

  • Types of Life Insurance

  • Who Needs Life Insurance?

  • How to Get Life Insurance

  • How Much Does Life Insurance Cost?

  • Life Insurance Key Takeaways

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What is Life Insurance?

Life insurance is a way to protect the financial future of your family or business (and your own peace of mind). There are different types of life insurance policies, but they all have one thing in common: they’re designed to pay money, usually as a lump sum, to your chosen beneficiaries in the event of your death.

How Does Life Insurance Work?

Once you sign up for a policy and pay your premiums, life insurance companies agree to grant a payment known as a death benefit to beneficiaries once the policyholder dies. Policyholders choose their beneficiaries, which can be one or more individuals, a trust, an estate or even an organization.

Some types of policies will let you access a portion of your life insurance funds while you are still alive if you’re diagnosed with a terminal illness, provided you have an insurance rider known as an accelerated death benefit. You’ll need to have evidence of a condition or situation that qualifies per your life insurance contract.

Life insurance payout options

Common life insurance payout options include:

  • Lump Sum Payout: A lump sum payout allows the beneficiary to receive the entire death benefit at once. This is the most common form of disbursement for life insurance proceeds. It allows greater flexibility in how beneficiaries use it and isn’t taxable.

  • Installments or Annuities: With this option, the beneficiary regularly receives proceeds and accumulated interest over a period of time. Since interest income is subject to taxation, some people find they’re better off getting a lump sum of money rather than being paid in installments, depending on how large the policy’s death benefit is.

  • Retained Asset Account: These work similarly to a checking account held by the insurer, with the initial balance being the death benefit. The beneficiary can write checks against the balance in the account and the amount deposited accrues interest over time. Unlike checking accounts, retained asset accounts do not allow deposits.

What can you pay with a life insurance death benefit?

Your beneficiaries can use the payment from your life insurance for just about anything. Your survivors can use the funds to pay for final expenses, pay off a mortgage or use it in the future to pay for college tuition. Providers pay out death benefits claims for natural and accidental deaths, as well as in cases of suicide or homicide. However, most policies have exceptions and exclusions, so make sure to learn what your policy will cover before you purchase.

Examples of what life insurance can pay for

Once disbursed, beneficiaries can use the money from the life insurance policy for whatever they want. Typical uses include:

  • Covering everyday expenses like groceries or household essentials

  • Paying off a mortgage or other outstanding debt

  • Covering burial costs or end-of-life medical care

  • Putting someone through college or any other major education expenses

  • Paying for child or dependent care or replacing care provided by a spouse

The payment from a life insurance policy may also function as a safety net by ensuring that a family can stay in their home and pay for the things that were planned before the policyholder’s death.

When do providers pay out death claims

Life insurance companies must be contacted following the death of the insured individual to begin the claims and payout process. So long as your policy is still active at the time of your death and you’ve paid your premiums on time, your provider will most likely pay out.

  • Natural causes, such as a heart attack, old age, or illnesses like cancer

  • Accidental death, including accidental drug overdose

  • Suicide, after the policy’s suicide clause period ends

  • Homicide, unless the beneficiary played a role in the murder

Common exclusions

Specific exclusions are often written into life insurance contracts to limit the insurer’s liability. If there’s evidence of fraud, criminal activity, lack of payment or other specific situations, your beneficiaries might not receive the policy’s death benefit.

  • Expired policies: Policies only stay active as long as you make your premium payments on time.

  • Fraud: Your insurer can cancel your policy while you’re alive or deny or reduce the benefit after your death if it finds out you lied on your application.

  • Criminal activity: If you die while committing a crime (or your beneficiary committed a crime to access your insurance money), your insurer won’t pay out.

  • Other exclusions: Insurers typically exclude high-risk sports and hobbies from coverage. If you died while skydiving, for example, your insurer might not pay out.

Types of Life Insurance

There are two main types of life insurance: term and permanent coverage. A term life insurance policy provides financial protection for a specific time. Permanent life insurance, such as whole or universal life, provides coverage throughout your life as long as your premiums are paid.

Term life insurance

The most affordable type of life insurance policy is term life insurance, and it is widely available and easy to understand.

This type of policy is best for people with temporary financial obligations who want coverage for a specified period or “term.” This term is the period of time during which the insurance policy is active and would pay out a death benefit to the insured’s beneficiaries. If the policyholder is alive by the end of the policy term, it will expire — unless it features the option to convert it into a permanent policy.

Go for it

  • If you just need to replace your income or cover debts for a specific period, such as the duration of your mortgage

Skip it

  • If you have a child or relative who will depend on you for the long term

Term life premiums can cost as little as $35 a month. Coverage amounts can go up into the millions, and term lengths can span anywhere from a one-year (annually renewable policies) to 30 years.

For more in-depth information about term life insurance, take a look at our term life insurance guide.

Permanent life insurance

This type of life insurance is a policy that offers protection during your entire life. These policies stay active as long as the policyholder pays the monthly premium payments and can offer a cash value component.

A permanent life insurance policy can be whole or universal. The difference between the two is that whole life insurance has fixed premiums and guaranteed cash accumulation, while the premiums and returns for universal life insurance can vary depending on different factors. This variability makes universal life insurance typically more affordable.

Go for it

  • If you have a lot of disposable income and have exhausted other investment options

Skip it

  • If your financial situation is likely to change in the future

Whole life insurance

A whole life insurance policy is the most expensive type, as it guarantees your beneficiaries a death benefit for the entirety of your life and offers cash value accumulation.

One of the main benefits of having a cash value component is that you can borrow against your whole life insurance policy. Some companies pay out dividends on whole life policies that can cover premium payments or purchase additional coverage.

For more information, take a look at our guide to whole life insurance.

Universal life insurance

A universal life insurance policy is the most flexible type of permanent life insurance because of its variable premiums. Policyholders can increase or reduce premiums at any time which will in turn, lower or increase their death benefit. This flexibility also affects the policy’s cash value – a savings component that earns interest.

Universal life policies are subject to market fluctuations because the cash value component of universal life policies is invested in stocks or bonds.

In low-interest-rate environments, the cash value account won’t grow as intended, and you may not be able to cover future premiums with those funds.

If you’re interested in this type of policy, read our universal life insurance guide.

No-exam life insurance

Most life insurance companies require that applicants take a medical exam to assess the risk of insuring them and set a premium accordingly. No-exam life insurance allows applicants to bypass this step, making the process more convenient. However, because providers don’t know how risky applicants are to insure the premiums they charge tend to be higher.

Policies of this type include accelerated underwriting, simplified issue and guaranteed issue. The first two require that applicants answer a series of questions about their health, family medical history, financial situation and lifestyle. Guaranteed issue does not require the applicant to answer questions, but it does take into account the applicant’s age.

Who Needs Life Insurance?

The quickest way to answer whether life insurance is a worthwhile investment is by asking yourself whether your death would financially impact the people in your life. If the answer is yes, consider including life insurance in your financial plan.

People who could benefit from having life insurance include:

  • Parents with young children or special needs dependents – Life insurance can ensure that children, especially those who require lifelong care, will have their needs met even after their parents die. The policy’s death benefit can also be used to fund a special needs trust managed by a fiduciary for the child’s benefit.

  • Older adults without savings – Older adults who want to provide financial coverage for their families or caretakers but lack substantial savings can leave them a death benefit.

  • Young adults who want to lock in low rates – Because age and health factor into life insurance premiums, younger adults are offered much more favorable rates.

  • Adults with private student loans – Private student loan debt is transferred to cosigners if the borrower dies. Life insurance can ensure your loved ones don’t get stuck paying off the rest of your debt.

  • Business owners – Firms, companies, and organizations can purchase a life insurance policy on employees whose passing would create severe financial hardship for the company.

When should you get life insurance?

It’s never too early to start thinking about your life and long-term care insurance needs.

You should consider buying life insurance when:

  • You’re young and healthy

  • You reach certain life milestones, such as starting a family, planning your retirement, and buying a home or car (or otherwise accumulating debt)

If you’re in your 20s and are already looking into life insurance policies, take a look at the main steps to buying life insurance for young adults.

Life insurance for income replacement

Income replacement is one of the main reasons to get life insurance. Life insurance provides your loved ones with an additional source of income if you are no longer around to provide for them.

This is very important for people whose families depend on their income as part of their budget. Having life insurance means that you can make sure they have the financial support they need to maintain the lifestyle they’re used to, even after you die.

Life insurance for final expenses

Older adults without any dependents might not need traditional life insurance coverage. However, they still have to plan for their funeral, which can cost anywhere from $7,000-$10,000 — not including other end-of-life expenses such as medical bills.

However, if that is your main concern, final expense (or burial) insurance might be a better option. Take a look at our selection of the best life insurance for seniors for other alternatives.

Life insurance to cover debt

Individuals who are worried about passing on debt to their loved ones should consider credit life insurance. Unlike traditional life insurance, this type of insurance is uniquely designed to pay off a borrower’s debt after death.

You may receive an offer to take out a credit life policy after a major purchase, such as a home or expensive vehicle. The value of the policy will correspond to the value of the loan it’s intended to pay off. Credit life insurance is easier to qualify for than traditional life insurance but has limited use and loses value if the outstanding debt it insures increases beyond the death benefit of the policy.

How to Get Life Insurance

Life insurance policies are typically purchased by the person whose life is meant to be insured. However, spouses, family or anyone else can also take out a policy for another person if they prove that they have an insurable interest – that is, they would experience financial hardship if the insured person dies.

To purchase life insurance, consumers will need to complete an application and phone interview. They must also present several documents, such as proof of identity, residency and income, and get a medical examination, unless they opt for a no-exam life insurance policy.

We recommend talking to a financial planner before purchasing life insurance. Additionally, obtain and compare multiple life insurance quotes to make sure you’re getting the lowest rate.

Eligibility requirements

The eligibility criteria required to buy life insurance vary from company to company. However, there are two main requirements that nearly every company will ask for when you apply.

Medical checkup

Unless you are applying for a no-exam life insurance policy, you’ll be asked to undergo a medical exam before taking out a life insurance policy.

Documents

To complete the application of a term insurance policy, the policyholder must present all the needed documents. The documents required are:

  • Proof of identity citizenship, and age – Drivers license, birth certificate or valid passport. Noncitizen residents may use their green card.

  • Proof of residency – For renters: signed lease or a rent receipt. For homeowners: mortgage bill or a property tax statement. A utility bill or a postmarked envelope is also acceptable.

  • Proof of income – Pay stubs, letter of employment, income tax return or an earnings statement from your bank. If unemployed: an unemployment letter or monthly statement.

  • Social Security number – Used for preliminary background checks into the applicant’s medical history, driving record and credit reports as well as criminal record if the applicant has one.

How to choose a life insurance beneficiary

When taking out a life insurance policy, choosing a beneficiary is one of the most important choices the policyholder will be asked to make. A beneficiary can be a spouse, parent, sibling, children, trust, estate, business partner or charity organization.

In addition to naming multiple beneficiaries, policyholders can also name secondary beneficiaries. The policy’s death benefit will be passed on to them if your primary beneficiary cannot claim it.

Make sure to update your beneficiaries as you undergo major life events to ensure that the payout doesn’t go to the wrong person or your estate. If the latter occurs, a court reviews a will, if there is one, and appoints an executor who will administer the assets of the estate.

How Much Does Life Insurance Cost?

The cost of life insurance varies widely depending on several factors. According to the insurance marketplace Policygenius, in 2022, the average monthly cost for a term life policy is around $30.66, the cost of a whole life policy is $517, and for a no-exam is $29.28. These prices are the estimated premium for a $500,000 policy for a 35-year-old man.

How much life insurance do I need?

You’ll need a benefit that’s large enough to cover your current and future financial obligations if you die. A common method is to multiply your income by 10, so if you earn $50,000 per year, you would ideally purchase a policy that has a death benefit of $500,000. However, this equation doesn’t take into account your full financial picture. In the end, the amount of money you need will depend on what you wish to cover and what you want your beneficiaries to receive.

While multiplying your income is a good starting point, adding expenses and debts to the formula helps you account for your beneficiaries’ needs and lifestyle. Therefore, many experts believe in using the DIME method.

DIME is an acronym for debt, income, mortgage and education and it’s broken down as follow:

  • Debt: Put down any loan under your name, such as car loans, personal loans, medical debt, credit card balances and your student loans.

  • Income: Multiply your annual salary by the amount of time you want the insurance benefit to replace it. A basic number is 10, but you can go higher especially if you’re younger because your income stands to increase as your career progresses.

  • Mortgage: This is possibly the largest debt to your name and having your life insurance benefit cover the remaining balance would lift a huge burden off your beneficiaries’ shoulders.

  • Education: Add an estimate of how much tuition, room and board will cost for your child or children.

Another expense you can add to the equation are final expenses. This includes the cost of funeral arrangements, casket, burial, embalming or cremation and the burial plot and headstone. Know that you have the option of purchasing a separate final expense insurance policy.

If you feel the base number you get after adding up your DIME is too high, you can round out the equation by subtracting current life insurance, 401ks, 529 college funds and other assets and tax-deferred savings.

Don’t forget that you can always use a life insurance calculator or consult a financial professional for help determining your life insurance needs. We also suggest you look at all options along with your dependents or beneficiaries so you can choose a policy and limits that works for everyone.

What affects life insurance premiums

Many factors affect the cost of life insurance premiums. It mostly comes down to the following factors:

  • Age: Older policyholders are seen as having a higher risk. When you buy a life insurance policy, the older you are, the more expensive it’ll be.

  • Gender: Men and women tend to pay different rates for all types of insurance. Men can expect to pay more for life insurance due to a shorter life expectancy.

  • Cigarette use: Because smokers are more likely to develop significant health issues, they require more coverage and will always pay a higher rate than non-smokers.

  • Weight: Life insurance companies may charge more for individuals with a higher BMI.

  • Health: Health concerns directly correlate to higher life insurance premiums. Pre-existing conditions, such as cancer, diabetes or heart disease might make it more difficult for you to get life insurance at an affordable rate — or at all.

  • Lifestyle: Frequently engaging in hazardous activities, such as skydiving or rock climbing, may increase the cost of your premiums.

Other elements that influence how much a life insurance policy costs are the policy type and the amount of coverage. Longer-lasting policies tend to have higher premiums, because the risk of death increases as people age. Premiums are also tied to the amount of coverage; the more coverage you get, the higher your premiums will be.

Life Insurance Key Takeaways

  • Life insurance is a contract between you, the policy owner, and an insurance company. In exchange for a monthly premium payment, the insurer will pay your beneficiaries a death benefit in the event of your passing.

  • Term, Whole, Universal, and No-exam are the most common life insurance policies.

  • Term life insurance is more affordable and easier to understand but has an expiration date.

  • Insurers require proof of residency, income and other documentation and a medical exam (for most policies).

  • Age, gender, cigarette use, health, lifestyle, family medical history, and driving record affect your life insurance premiums.

  • Depending on what you expect your death benefit to be used for, you’ll need more or less coverage. For example, a life insurance policy meant to replace your income should probably be larger than one meant for final expenses.

  • Under no circumstances should you lie in your life insurance application. Doing so could result in your policy being voided altogether.

Life Insurance related articles:

If you’re still on the fence about what type of life insurance policy is best for you, check out our comparison between term and whole life policies.

Life insurance can be even more difficult to navigate for the transgender community — check out our Guide to Life Insurance for Transgender People for essential information on how to make the process easier. .

Choosing the right insurance company is one of the most important decisions you’ll make regarding life insurance. Take a look at our selection of the 9 Best Life Insurance Companies.

Not sure how much life insurance you should get? Check our in-depth guide on How Much Life Insurance Do You Really Need.

© Copyright 2023 Money Group, LLC. All Rights Reserved.
This article originally appeared on Money.com and may contain affiliate links for which Money receives compensation. Opinions expressed in this article are the author’s alone, not those of a third-party entity, and have not been reviewed, approved, or otherwise endorsed. Offers may be subject to change without notice. For more information, read Money’s full disclaimer.

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