What Is Life Insurance and How Does It Work

Life insurance can serve many purposes, from replacing income and paying outstanding debt to covering college tuition or funeral expenses. Having a life insurance policy is a must for anyone who wants to ensure the financial security of family members and surviving loved ones.

This general guide will walk you through the process of understanding what is life insurance is and how it works. We’ve also put together a 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?
• Who Needs Life Insurance?
• Types of Life Insurance
• How to Get Life Insurance
• How Much Does Life Insurance Cost?
• Life Insurance Key Takeaways

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). Like other forms of insurance, it’s a contract between you (the policyholder) and an insurance company.

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 “named beneficiaries” in the event of your death.

How Does Life Insurance Work?

In exchange for a premium, life insurance companies will grant a payment known as a death benefit to beneficiaries once the policyholder has passed away. A beneficiary can be one or more individuals, a trust, an estate or even an organization.

In some cases, such as after a terminal illness diagnosis, you may access a portion of your life insurance funds while you are still alive with an insurance rider known as an accelerated death benefit. You’ll need to have evidence of a qualifying condition or situation according to your life insurance contract.

What does life insurance cover?

Once disbursed, beneficiaries can use the money from the life insurance policy for whatever they want. Examples 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.

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, your provider is obligated to pay out — with a few notable exceptions. Providers will pay out death claims due to:

• 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

Specific exclusions are often written into life insurance contracts to limit the insurer’s liability. In cases of an expired policy, fraud, criminal activity or certain other exclusions, your beneficiaries may not receive your policy’s death benefit.

• Expired policies: Policies only stay active as long as you keep up with premium payments.

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

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 products. It allows greater flexibility and is tax-free income.

• 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, you might be 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 accrue interest over time. Unlike checking accounts, retained asset accounts do not allow deposits.

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 your estate or the wrong person.

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 adult dependents - Life insurance can ensure that children 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 adult 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?

Regardless of age, 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 don’t need traditional life insurance coverage. However, they still have to plan for their funeral, which can cost anywhere from $8,000-$10,000 — not including other end-of-life expenses such as medical bills.

Your funeral costs may be covered entirely by taking out final expense (or burial) insurance. Take a look at our selection of the best life insurance for seniors for other alternatives.

Life insurance for covering 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 death benefit is larger than your outstanding debt.

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, can provide coverage for a lifetime.

Term life insurance

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

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.” If the policyholder is still alive by the end of the policy term, it will expire — unless it features the option to convert it into a permanent policy.

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

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

A permanent life insurance policy can be whole or universal. These policies are permanent if the policyholder meets the monthly premium payments and can offer a cash value component.

Whole life insurance

A whole life insurance policy is the most expensive type, as it covers you for your entire life. It features fixed premiums and guaranteed cash value accumulation on top of a death benefit.

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

Universal life insurance is the most flexible permanent life insurance option. Policyholders can pay premiums at any time and reduce or increase their death benefit. In turn, this lowers or increases their premiums.

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 suitable premium. No-exam life insurance allows applicants to bypass this step, making the process more convenient at the cost of higher premiums.

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.

How to Get Life Insurance

Life insurance policies are purchased by the person whose life is meant to be insured. However, spouses, family or anyone else who can prove that they have an insurable interest in the person can also take out a policy for them.

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

As with every financial decision, 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, it’s compulsory 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, 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.

How Much Does Life Insurance Cost?

The cost of life insurance varies widely depending on several factors. According to 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.

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, as the risk of death is greater, and the more coverage you get, the higher your premiums will be.

Life Insurance Key Takeaways

• Life insurance is a contract between you, the policyholder, 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.
• Proof of residency, income and other documentation, including a medical exam for certain policies, is required to purchase life insurance.
• 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.
• It’s better to opt for a more expensive policy if it’s from an established company with a history of meeting its financial obligations.
• Be prepared to answer questions about anything related to your health and lifestyle habits.
• Under no circumstances should you lie in your life insurance application. Doing so could result in a lower payout amount or 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 our comparison between term and whole life policies.

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 best life insurance companies.

Not sure if having a life insurance policy is the right financial move? Check our 7 ways to pay less for a life insurance policy.