Life insurance is critical if you have dependents or people who rely on your income, like children, a non-working spouse, or aging parents you support. If you don't have dependents but have debt or own a business, you might still want to consider it. Here are the basics of how life insurance works.
How does life insurance work?
Life insurance is a contract between you and the insurance company. In this contract, you agree to pay a premium (regular payments to the insurer) for a death benefit. A death benefit is a tax-free lump sum paid to your beneficiaries if you pass away after the effective date of your life insurance policy. Your loved ones can use it to replace lost income from your passing, cover your debts, or final expenses.
Types of life insurance policies
There are two types of life insurance: term life and permanent life.
Term life insurance
Term life insurance works by policyholders for a set period of time, usually lasting between 10 to 30 years, though you may find companies that offer shorter or longer terms. Because payouts aren't guaranteed, term life insurance is cheaper than permanent life insurance.
Term life insurance may be a good option if a permanent policy is out of your budget. It's often used to cover a period where your beneficiaries are particularly dependent on your income.
For example, you may take out a term life insurance policy while you have an active mortgage. So if you die before paying it off, your death benefit can cover the remaining balance, so your loved ones don't have to worry about paying it off.
You can read our guide to the best term life insurance.
Permanent life insurance
Permanent life insurance does not have an expiration date, so the death benefit is guaranteed as long as you make payments on time. Guaranteed death benefits make permanent life insurance more expensive than term life insurance.
The other main advantage of permanent life insurance is cash value. As you pay your premiums, a portion is set aside as cash value, which policyholders can use in their lifetime. Cash value accumulates as your policy ages and can grow and accrue interest depending on the type of permanent life insurance you have.
The two most common types of permanent policies are whole life and universal life insurance.
How life insurance beneficiaries get paid
When you apply for life insurance, you must choose your beneficiaries — the people who will receive your policy's proceeds. You can assign multiple beneficiaries and the percentages each will receive.
If you pass away, your beneficiaries must file a claim for your death benefit. To do so, they must complete a claims form and provide a death certificate. When approved, the insurer will pay your death benefit, typically as a lump sum. Beneficiaries can often choose how to receive the death benefit, either direct deposit or a check in the mail.
Life insurance companies typically take up to 60 days to process a claim, but some factors may affect processing times. For example, companies may delay payment if they suspect fraud.
How do life insurance premiums work?
When a life insurance company underwrites a policy, it's mainly assessing the risk of a policyholder dying. The higher risk a policyholder poses, the more expensive their policy. Here's a look at the main factors that influence your policy's premiums:
Age: Age determines how likely you are to die during your policy. Younger policyholders typically see the most affordable rates.
Sex: Life insurance policies for males are more expensive than equivalent coverage for females.
Health: Medical history is a significant factor in determining rates, as it also indicates your mortality risk. Underwriting also factors in whether you smoke, use drugs, or consume alcohol. Those in better health usually pay lower premiums.
While most policies require a medical exam for qualification, there are no medical exam life insurance policies, though you still have to answer a medical questionnaire.
Family medical history: While you may live a healthy lifestyle, you may be at-risk for certain hereditary/congential conditions. As such, your family's medical history is also a determining factor in life insurance underwriting.
Finances: Life insurance companies will also factor your finances into their underwriting procedures. This includes your income, assets, credit score, and any bankruptcies.
Policy type: Permanent life insurance tends to cost more than term life insurance because of its comprehensive features. Different types of term and permanent life insurance also result in differing rates.
Coverage Amount: The larger your death benefit is, the higher your premiums will be. Customizing your policy with riders or policy add-ons also increases your costs.
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- Term life and whole life
FAQs
Do I need life insurance?
You probably need life insurance if a spouse, child, aging parent, or anyone else relies on your income. This ensures your loved ones won't face financial hardship in the event of your unexpected death.
How much life insurance coverage do I need?
Add up your debts, income, mortgage, your children's future education expenses, and final expenses to get a ballpark figure of the amount you need. Online life insurance calculators can help with the process. However, the best way to get an accurate figure is to work with an insurance agent or a financial advisor to help you identify all your coverage needs.
How does life insurance offer financial protection?
Depending on how your life insurance policy works,
