Life Insurance: What Is It & How Does It Work? | (Complete Guide)

Most people have heard of life insurance before, but many have no idea how a life insurance policy actually works. Life insurance is an integral part of financial and estate planning for most people. It helps to protect loved ones after someone’s death by providing a financial payout to help with funeral costs and other expenses. While almost everyone could benefit from life insurance, not everyone decides to purchase it. This could be due to the fact that they think it is more expensive than it really is or they just don’t fully understand how it works. Some people do not even realize that there are many different types of life insurance policies, so finding the one that is right for your situation is critical to protecting your family. Keep reading as we explain what life insurance is and how it works.

 

What Is Life Insurance?

Life insurance is a contract between the policyholder and the insurance company that will provide a death benefit upon the death of the insured. While that might sound complicated on the surface, it is actually quite simple. Now some policy types can get more complicated, but at its most basic level, life insurance works like this. The policyholder pays the insurance company a premium – usually every month. In exchange for these premium payments, the insurance company promises to provide a financial payment to the beneficiary when the policyholder dies.

That is basically all there is to it at a high level. Of course, we will get further into the details of the different kinds of policies in the next section. The amount of the death benefit and the amount of the premium payments are based on the age and health of the insured. Obviously, it will cost more to insure someone who is not in good health or is older simply because the odds are higher that the person will die while the contract is in existence. Insurance companies use complex mathematical formulas to try and determine the life expectancy of applicants so that they can appropriately set the premium rates and payments that will be due. There is a fine balance between the company remaining profitable and insurance getting too expensive to be affordable.

 

Types Of Life Insurance Policies

There are many different types of policies out there, and we will discuss a few of the most common types here. Different policy types have different rules, prices, and regulations. There are also differences in the period of time for which they are active. It is imperative that you select the type that works best for you and your family.

 

Term Life Insurance

This is one of the most common types of insurance out there. It is a common choice, especially among younger people. This type of insurance covers you for a specific amount of time at a specific amount of coverage, assuming that you continue to make your premium payments on time. The terms available will vary by insurance company, but they are commonly available in 10, 20, and 30 year terms. Suppose you purchase a $100,000 policy for a 10 year term. This means that your term life insurance policy will cover your life for a period of 10 years. If you die during this time, your beneficiaries will receive the $100,000 death benefit. If you live longer than 10 years, the term expires and the policy is no longer valid.

 

Whole Life Insurance

Whole life is a form of permanent life insurance policy. This type of insurance covers you for your entire life as long as you make the premium payments. In addition, whole life insurance policies often accumulate a cash value. Some people choose to use them as an investment vehicle because they can cash in the policy at some point in the future. Whole life is not usually as popular as term life policies because of the cost. Whole life policies can sometimes cost 10 times as much as a term life policy. These higher premiums are often not worth it as many people can find better investments through an IRA or 401k. Some people also choose to add a long term care rider to their policy which can help pay for long term care in the event that the insured requires care in a health facility.

 

Universal Life

A universal life policy also covers you for your entire life, although the premium payments are variable. You might decide to pay more initially and pay less later into the policy. These policies are also affected by the performance of the insurance company’s investments. If the investments do not perform well, then you might have to pay more premiums than originally planned.

 

Variable Universal Life

This is essentially a life policy that also serves as an investment avenue. There are many investment options available, and the performance of the investments affects how much premium you need to pay. You may choose to invest in stocks, bonds, mutual funds, or other investment options. You can choose to receive an annuity later in life with the balance in your account. Universal life insurance policies are quite flexible, though many people do not fully understand how they work.

 

Other Permanent Life Insurance Types

There are several other permanent life insurance types available. Indexed life insurance coverage and variable life are a couple of additional options. Indexed life places your life insurance premiums into indexed funds that can offer a more stable interest rate. Variable life and variable universal life policies are actually treated as securities by the government. They include a level of risk similar to purchasing stocks and bonds.

 

Choosing The Policy Type That Is Right For You

Most people find that their life insurance needs change over time. So, the type of policy that is right for you is really that one that is right for you based on your current needs. People typically start by deciding between a term life policy or a permanent policy. If you need a policy to cover you for a specific period of time, then a term policy will be right for you. Many young professionals choose this option. They select a policy that will cover them during their working years or until their children reach an age where they are likely to be able to take care of themselves. A policy like this can help replace your income, pay a mortgage, and maybe even pay for college tuition for your kids in the event of your death. Term policies are usually much cheaper than permanent policies.

If you prefer a policy that will cover you for your lifetime and build cash value, then a permanent policy might be for you. You should know that permanent policies usually do not provide both a death benefit and the policy’s cash value. In the event of your death, your beneficiaries will receive the death benefit, not the cash value of the policy. These policies are usually much more expensive, and the higher premiums are often not worth the investment.

 

Selecting The Right Coverage Amount

Selecting a coverage amount is a big decision when applying for life insurance coverage. Your life insurance agent should be able to help you decide how much is right for you. You will want to consider how much you need from the policy’s death benefit to provide peace of mind for you and your family. The more coverage you get, the higher your premium payments will be. However, you need to make sure that you get enough coverage to take care of your family after your death. You should also know that the IRS typically exempts life insurance proceeds from taxes.

On average, most experts believe that you need somewhere between 10 to 12 times your annual income in coverage. This helps ensure that your family can pay all your debts and continue the same level of lifestyle to which they are accustomed. While you might be able to get away with less insurance than this, it may put more of a financial strain on your family after your death. You should take into account the amount of money that you owe on your house, amounts owed on cars, any additional debts, potential college expenses, and any other financial needs that might arise. You want to ensure that you provide plenty of financial protection for your family, and the right insurance products are one way to do that. A financial planner can also assist with choosing how much life insurance you need when you are assessing your life insurance options.

 

How To Choose Life Insurance Beneficiaries

Most people choose an immediate family member as the beneficiary of their policy like a spouse or child. However, this does not have to always be the case. A beneficiary might be a business partner, a company, or even a trust or estate. If you name a real person as the beneficiary, then your life insurance proceeds will generally not be taxable. However, if your payout goes into your estate, then you might be forced to pay estate taxes on the amount received from the insurance company.

Creating an irrevocable life insurance trust is another way to avoid paying taxes on your insurance payout. This is also a way that allows the insured to control the manner in which the beneficiaries receive the money. They can use this type of trust to provide financial support to their beneficiaries for many years into the future. They may direct that the final expenses of their death be paid first, and then the trustee can manage the remaining funds for the benefit of the beneficiaries.

 

Cost Of Life Insurance

Life insurance rates vary by state, and there are many factors which affect the rate you might pay for your policy. The biggest factors are the health and age of the potential insured. Health issues will obviously cause the premiums to be higher. Non-smokers can also expect to pay less than tobacco users. In some cases, using tobacco might cause you to not be able to qualify for some of the main types of life insurance. Another thing that people often do not consider is their hobbies. If you engage in dangerous hobbies like motorcycle riding or rock climbing, then your premiums will be higher.

Your life insurance company will look into your medical records and perform background checks to verify the information that you provide on your application. Most insurers also require a medical exam to take place to verify your health, and your application will need to go through full underwriting. A healthy individual in his or her 20’s might be able to get a 15 year term policy of $1 million for less than $500 per year. However, that same policy might cost a 35 year old over $1,000 per year. Switch it to a permanent policy, and the premiums may rise to $5,000 or more for the year. If you want to pay a lower premium, then you will need to reduce the benefit amount or reduce the number of years for which the term is active. Some states like New York have many rules and regulations when it comes to insurance companies, so the state in which you live can also have an effect on the premium amount that you will pay.

Getting life insurance quotes is quite easy today. Many companies offer free online quotes by simply providing a few basic personal details. To get a more specific quote, you should contact an insurance company so that they can tell you exactly what they need to get you a quote. Once getting a quote, you can then decide whether you wish to purchase the coverage or not. So, what is an insurance premium? That is simply the amount that you must pay to keep the policy active. You might make payments monthly, quarterly, or yearly to maintain your policy.

 

Filing A Life Insurance Claim

When it comes time to file a claim, the process is generally the same regardless of your insurance company or policy type. You will need to notify the company and provide proof of death to begin the claims process. Here are the steps that you need to take when a loved one dies and you need to file a life insurance claim.

 

Notify Insurance Carrier

The claims process starts with notifying the insurance company. Most policies will list a phone number to call when you need to report a claim. If you are unsure of how to contact your insurance company, you can always find their general contact information on their website. You will need to provide some documentation to the company such as the name of the deceased, policy number (if known), death certificate, and other information. Most insurance companies require specific documentation and claims forms to be completed once a claim is started.

 

Payout Options

In some cases, you might get to choose what type of payout you receive. In other situations, the policy may specify the type of payouts available. The most common payout is the lump sum payment. This means that the beneficiary will receive the entire death benefit in a single lump sum. You might also choose annuity payments or other payouts like a retained asset account. This means that the insurer might retain the death benefit in a special account and pay you interest and payments from the account. Since you typically do not pay taxes on life insurance payouts, most people opt for the lump sum so that they get all the money at once and they get it tax-free.

 

Potential Payout Delays

So, how quickly will you receive the payout from an insurance policy? In some cases, you might be able to get the money in as little as a couple of weeks. However, you need to be aware of potential delays. These delays could happen for a number of reasons. First, if there are any suspicious circumstances surrounding the death, you can almost rest assured that the payment will be delayed. In addition, it depends on what your life insurance covers. If the event that caused the death is not covered under the policy, then no payout may occur at all. The policy will specifically list the causes of death that are covered under the policy and those that are not. Anything that raises suspicion will likely delay your insurance payout.

 

The Bottom Line

Life insurance is a powerful financial planning tool that almost everyone should consider purchasing. Knowing what type of policy and how much coverage is right for you is critical to making the right purchase. Your insurance agent or financial planner should be able to help you with these decisions. As your life insurance needs change over time, you should continue to perform assessments of your coverage and policies.

 

Frequently Asked Questions

How does life insurance work if you don’t die?

It depends on your specific policy. For a term policy, if you do not die during the term of the policy, then the contract ends and no death benefit is received upon your eventual death. Other policy types grow a cash balance. You might decide to cash in the policy and receive the surrender value in exchange for cancelling the death benefit.

 

What is the average life insurance payout?

It is difficult to find data on average life insurance payouts, although it seems that the average in the United States is somewhere around $100,000. Some policies pay much less than this. In some cases, you might find that a policy has a death benefit as low as a few hundred dollars. However, you also have the other end of the spectrum. Some policies might pay as much as several million dollars upon the death of the insured. It just all depends on the specifics of your policy.

 

Is life insurance a one time payout?

Not always. While a lump sum payment is a common option, you might also find payouts in the form of annuities or retained asset accounts. This will typically give the beneficiary a set amount each month or year for the rest of their lifetime. This can be a good option in some cases to help prevent the beneficiary from spending the entire amount at once. Many people will ask, “Do I have to file taxes on insurance payments?” The answer is usually no, although there might be some situations where taxes are due.

 

What is the difference between term life insurance and whole life insurance?

Term life insurance is only valid for a certain period of time. Policies may be available with a term of 5 years, 10 years, 20 years, 30 years, or any period of time for which the insurance company is willing to offer a policy. If the insured dies during this term, then the death benefit will be payable. If the insured lives past the expiration of the term, then the policy expires and no benefit will be payable. Whole life insurance is valid for your entire life as long as you pay the premiums. Whole life is usually much more expensive, and some companies might not even issue a whole life policy depending on your current age.

 

How are life insurance premiums calculated?

Life insurance premiums are typically calculated using actuarial tables. These tables allow an insurance company to determine the expected lifespan of an applicant as well as determine the overall health of the individual. These tables use age, health, hobbies, and other factors to determine how much that person will have to pay for life insurance.

 

How much life insurance do I need?

That depends on your personal financial situation. Most experts will state that you need to carry 10 to 12 times your annual salary in coverage. Your salary, level of debt, and expected lifestyle all play a role in determining how much coverage you need to select. You will want your family to be able to pay your debts and have plenty of money left over to maintain their current lifestyle and pay for future expenses.

 

Who needs to buy life insurance?

Almost everyone needs to buy life insurance in some amount. Some people need more than others. If you have minor children and a family, then you certainly need to purchase life insurance to protect them in the event of your death. If you are older or more wealthy, you might need less life insurance; however, that does not mean that you should not purchase insurance at all. If you have any questions, you should consult your financial advisor to help you determine how much insurance you need.

Elliot Marks

Elliot Marks

Author & Social Security Advisor

Elliot Marks has spent over 10 years providing clear and concise information to help Americans navigate the complex nuances of social security and many other government services in the United States. Elliot has a passion for helping those in need of these services to be able to find timely access to news and information that is relevant and helpful to their daily lives.