How Does Life Insurance Work?
Life insurance protects the people you love most
Life insurance is a contract you make with an insurance company. You agree to pay a premium and the insurer agrees to pay a death benefit to one or more beneficiaries when you pass away—if you die within the coverage period and the policy is still in force.
Buying life insurance is an important aspect of any financial plan. The proceeds of a life insurance policy can help your family continue their lifestyle, achieve their goals, and replace your income, or simply pay your funeral and burial expenses.
The insurance industry offers several types of life insurance policies. Choosing the right type of policy, and the best level of coverage, isn’t always easy. Understanding the different types of life insurance and how they work can help you decide which, if any, are best for your needs.
Types of Life Insurance
Life insurance policies fit into two categories: term life insurance and permanent life insurance. Both policies pay a death benefit to your named beneficiaries, but term policies cover you for a specific period, while permanent policies can cover you throughout your life. Both types of policies require that you pay sufficient premiums to keep them in force.
Term Life Insurance
- Protection is limited, lasting for the specified policy term (typically from one to 30 years).
- It’s more affordable than permanent life insurance.
- It may be renewable once the term expires, without taking a medical exam.
- Some policies offer a “return of premium” rider, which refunds a portion of your premiums if the death benefit isn’t paid.
Permanent Life Insurance
- Permanent policies feature lifetime protection.
- Permanent life policies earn a tax-deferred cash value.
- Once a cash value accumulates, you may be able to borrow against it or withdraw from it.
- Cash value earns interest in various ways, depending on the type of policy.
- Some permanent life policies enable you to alter your premium payment, increase your death benefit, or both.
Types of Term Life Insurance
Term insurance is not designed to last a lifetime. It’s often considered “pure” insurance because it has no cash value “savings” component.
Level term: These policies feature a fixed death benefit and fixed premiums throughout the specified term.
Decreasing term: These policies feature a decreasing death benefit (often chosen to cover a mortgage).
Convertible term: These policies allow you to convert your term policy to permanent life insurance, and typically have higher premiums.
Types of Permanent Life Insurance
Permanent life policies incorporate a savings component, called the cash value, which can be borrowed against or withdrawn from. However, doing so can impact the policy and may have tax consequences.
Whole life insurance: Whole life is one of the most common types of permanent life insurance. It features a guaranteed level premium and guaranteed death benefit as long as premiums are paid. These policies contain a nonforfeiture value in the event the policy lapses.
Universal life insurance: This type of policy earns a cash value based on a money market or similar rate of return, and guarantees a minimum interest rate.
Universal life insurance enables you to change your premium payments after accumulating a cash value, and may allow you to increase your death benefit.
Indexed universal life insurance: An indexed universal life insurance policy works like regular universal life insurance, but instead of earning a cash value based on a money market rate of interest, it’s linked to an index of investments, such as the S&P 500, and features an interest rate guarantee.
Variable life insurance: Variable policies allow you to invest the cash value component in the stock market, usually via mutual funds offered within the policy. However, if your investments perform poorly, your cash value will decrease, and you risk your premium increasing and possible policy lapse. To minimize these risks, some insurers offer death benefit guarantees and no-lapse features. Some policies allow you to adjust the death benefit and premiums.
Guaranteed issue whole life insurance: Typically only offered to people aged 50 to 85, it doesn’t require you to answer health questions or take a medical examination. Designed to cover final expenses, guaranteed issue life insurance usually caps coverage at $25,000.
Borrowing against your cash value doesn’t cancel your policy or reduce your death benefit, as long as you pay back the loan and continue to make sufficient premium payments.
How Much Does Life Insurance Cost?
The cost of life insurance varies widely. For example, a $250,000 20-year term policy for a healthy 25-year-old might cost $12 per month, while the same policy for a 45-year-old smoker could cost $111 per month. The type of policy and amount of coverage, or face value, you purchase also determines how much you’ll pay for life insurance. Face value is the amount that your beneficiaries receive if you die.
Since permanent life policies incorporate a cash value, which increases premium payments, they’re more expensive than term life policies with the same coverage amount, or face value.
A portion of each premium payment for a permanent policy builds cash value in the policy—an outlay that term insurance doesn't require.
Life insurance companies price policies based on the level of risk they must incur. Typically, a young, healthy person pays less for life insurance than an older person with a history of medical problems. Insurers base life insurance premiums on several factors, including:
- Health history
- Family health history
- Tobacco use
According to the Centers for Disease Control and Prevention, men and women have life expectancies of 76.2 years and 81.2 years, respectively, based on 2018 data. Since women tend to live longer, they may get a better life insurance rate than men.
Factors such as smoking, dangerous jobs, a history of reckless driving, or hazardous hobbies, such as rock climbing or skydiving, increase carriers’ risk, which they mitigate by charging a higher insurance premium.
Some providers also consider factors like your financial record, or whether you’ve filed for bankruptcy, as well as your criminal history and driving record.
Regardless of what type of life insurance you purchase, you’ll get the best rate by buying a policy when you’re young and healthy.
How to Buy Life Insurance
The purchasing process can vary, depending on the type of life insurance you buy.
Buying Through Your Employer
Many employers offer group life insurance in their benefits packages. Group plans typically provide term life insurance, but some employers also offer permanent life policies. A group life insurance policy may cap the death benefit at, for example, one to two times your annual salary, but usually doesn’t require you to take a medical examination, making this form of coverage ideal for those who would otherwise be considered uninsurable.
Typically, you can enroll in a group life insurance plan through your employer’s human resources office. When you leave your employer, some insurers allow you to keep your insurance coverage through what's known as insurance portability.
Buying an Individual Policy
When you buy a term or permanent life policy, the insurer typically requires you to complete an application that includes questions about your medical history and your family medical history. The provider may also require you to take a medical examination to determine eligibility.
During the examination, the nurse or physician will take blood and urine samples to evaluate your blood sugar levels, test for nicotine use or substance abuse, and screen for conditions such as an abnormal liver or HIV. If you qualify for coverage, the underwriting process may take days or a few weeks to complete, after which the carrier will issue your policy.
Guaranteed issue insurance is the exception to the general rule in that it is written with no medical exam and minimal or no health questions. Insurers can do this because coverage is typically capped at $25,000.
In the age of COVID-19, some insurers have adopted accelerated and simplified underwriting processes for certain applicants. Intended to help people avoid the risk of coronavirus exposure, the accelerated process allows qualified applicants to forgo a medical examination, but still obtain coverage.
How Life Insurance Pays Out
When the insured dies, the beneficiary must file a claim with the insurance company, which requires submitting a certified copy of the deceased’s death certificate. Typically, the insurer will pay the death benefit in one lump sum. If you take out a loan against your cash value and die before paying it back, the carrier will deduct what you owe from the death benefit.
When you purchase your policy, you may choose how the death benefit is paid. Or the policy’s beneficiary may choose an alternative to receiving a lump sum payment. Payout options include:
- Lump sum: The death benefit is paid out in full, in one lump sum payment.
- Installments: The insurer pays out the death benefit, along with interest earned, in installments over a set period, such as five years.
- Interest income: The beneficiary receives regular payments for interest earned on the insurance policy, while allowing the insurance company to hold on to the death benefit. The beneficiary assigns a secondary beneficiary to receive the death benefit when the original beneficiary dies.
- Lifetime income: The insurer pays the beneficiary a fixed monthly payment for the remainder of his or her life, based on life expectancy. Payments end when the beneficiary dies, so in some cases, a beneficiary may receive more or less than the policy’s death benefit. There are variations that guarantee a minimum number of annual payments (period certain) or that pay a lifetime income based on two lives (joint life with survivorship).
Typically, beneficiaries do not have to pay federal income tax on the proceeds of a life insurance payment. However, if you choose an interest-earning option, the IRS requires you to report any interest received on your tax return.
Who Needs Life Insurance?
Buying life insurance makes sense for most people. If you’re single with no children, you may only need enough coverage to pay your final expenses. However, you may want to consider purchasing life insurance if you anticipate having an insurance need in the future and are young and healthy now.
Whether you purchase a term or permanent policy will often have to do with the reason you’re purchasing insurance and the amount of coverage you can afford.
Married people, especially those with dependent children, often buy life insurance to pay for their children’s education, to replace their income, or to cover an outstanding mortgage. Permanent life insurance policies can provide a nest egg for a surviving spouse, an inheritance for children, and a tax-deferred cash asset as well. You can also purchase life insurance for members key to the continuation of your business, such as a business partner.
Reasons to purchase insurance run the gamut.
If you want to insure the life of someone other than yourself, you need to prove to the insurance company that you have an insurable interest (such as a family relationship or substantial economic interest) in the individual who would be insured. If you can, you can likely purchase a policy.
You can also purchase a combination of term and/or permanent policies to satisfy a range of life insurance needs and/or ones you anticipate changing as years go by.