When you buy life insurance, you pay a certain amount every month or year to an insurance company. If you die, the company will give a lump sum of money to the people you choose, who can use it to pay for things like funeral expenses, bills, or other financial obligations.
Life insurance is an important safety net for those you leave behind. If you’re considering buying a policy, it’s essential to understand how life insurance works. Here, we’ll break down the basics of life insurance and how different policies work so you can choose the proper coverage.
In this guide:
- What is life insurance, and what does it cover?
- Types of life insurance
- How life insurance payouts work
- How much does life insurance cost?
- Where do you get life insurance?
What is life insurance, and what does it cover?
Life insurance is a contract in which you pay your life insurance company a monthly or annual premium. In exchange, your insurance company agrees to pay a sum of money to your beneficiaries upon your death.
The people or entities you choose to receive the payout are called life insurance beneficiaries. The payout—also called the death benefit—can cover various expenses, such as end-of-life expenses, mortgage payments, tuition payments, personal debt, living expenses, and inheritances.
Life insurance can cover various instances of death, such as illness, disease, injury, accidents, and homicide. However, suicide is typically excluded from coverage for a certain period after the policy is issued.
Types of life insurance
The three main types of life insurance are term, whole, and universal. While 54% of Americans own a life insurance policy, one-third don’t know how it works. Let’s change that.
Here’s a closer look at how term, whole, and universal life insurance works:
How term life insurance works
Best for: People who want coverage for a specific period, such as when they have young children or a mortgage
Term life insurance covers you for a specific period of your choosing, usually between 10 and 30 years. If you die during the term, your beneficiaries get a lump sum payment. If you outlive the term, the coverage expires, and there is no payout.
Term life insurance may be worth it if you need coverage for a specific period, such as until your children are through college or your mortgage is paid off. Canceling life insurance is also most straightforward with a term policy.
How whole life insurance works
Best for: People who want lifelong coverage and know their needs won’t change
Whole life insurance covers the policyholder’s entire life as long as you pay your premiums. These policies build cash value and can be borrowed against or withdrawn while the policyholder is still alive.
This type of policy is more expensive than term life insurance but can be a good option for people who want lifelong coverage and a savings component. Whole life insurance may also be used for estate planning purposes, such as providing an inheritance or paying estate taxes.
How universal life insurance works
Best for: People who want lifelong coverage and the option to adjust their policy as needed
Universal life insurance is similar to whole life insurance in that it’s permanent coverage. However, its premiums and death benefits are a bit more flexible.
Policyholders can adjust their premiums and death benefits over time, which can be useful for changing financial circumstances. Universal life insurance also has a cash value component, but the growth rate is based on the performance of the policy’s investments.
How life insurance payouts work
When you pass away, your beneficiaries must file a claim with the insurance company to receive the death benefit. They will need to provide a copy of your death certificate and any other documentation requested by the insurance company.
The payout depends on your policy’s coverage and applicable fees or taxes. Generally, life insurance payouts are tax-free. However, if you have outstanding debts or taxes, those may be deducted from the payout first. Beneficiaries can receive payouts one of several ways:
- A lump-sum payment pays the entire benefit amount at once.
- An annuity pays the benefit out in installments over time.
- A retained asset account provides the beneficiary with a debit card linked to an account that holds the benefit amount.
Life insurance claims can be delayed if there are disputes over the policy’s terms, questions about the cause of death, or the policyholder fails to keep their beneficiaries up to date.
It’s important for policyholders to review their beneficiaries regularly to ensure their loved ones receive their payout promptly.
How much does life insurance cost?
How much you’ll pay for life insurance depends on your age, gender, health, and lifestyle. Generally, premiums are lowest if you’re young and healthy. A healthy individual in their 30s can expect to pay an average of about $30 per month for a basic term life insurance policy with $500,000 coverage.
Another factor that can affect the cost of life insurance is your policy type. Term life insurance is often the most affordable option, but coverage is temporary. Permanent life insurance offers lifelong coverage but often has higher premiums due to its cash value component.
Life insurance costs can also depend on which riders you choose. Life insurance riders are add-ons to a basic life insurance policy that provide coverage beyond what the policy normally offers.
Examples of riders include the accelerated death benefit, which allows you to access part of your death benefit early if you become seriously or terminally ill, and waiver of premium, which enables you to stop paying your life insurance premium if you experience a qualifying disability.
Where do you get life insurance?
There are several ways to get life insurance.
- Online. Many life insurance companies offer policies online. You can compare quotes from the best life insurance providers and purchase a policy directly from the website.
- Insurance agents. For a hands-on approach, you can work with a life insurance agent who can explain the different types of policies and help you find one that fits your needs.
- Employer. Some employers offer group life insurance policies as part of their benefits package. Check with your HR department to see if this is an option for you.
- Financial advisor. Your financial advisor may be able to recommend life insurance policies that fit your financial goals.
Getting a life insurance policy typically involves applying and answering a short health questionnaire, then taking a medical exam if one is required to complete the insurance underwriting process. Once approved, you must make premium payments to keep the policy in force.
To understand how life insurance works and what it’ll cost you, it’s best to shop around and compare quotes from multiple companies.