How Does Life Insurance Work?


Life insurance is one way you can provide financial support for loved ones after you die. When you open a policy, you will pay a regular premium – often monthly or annually – in exchange for coverage. As long as your policy is active when you die, the insurance company will pay out a lump sum, also known as a death benefit, to the policy beneficiaries.

Even though many life insurance policies work the same way, each type has significant differences that further define how they work, including how long the coverage lasts, if the policy includes an investment component, and whether or not you can access funds before your death. Understanding these differences can help you select the best policy for your needs.

What Does Life Insurance Cover?
Unlike other insurance policies, which typically dictate how the policyholder can use a claim payout, life insurance benefits can cover a wide variety of expenses. In many cases, policyholders invest in a policy to replace their income and ensure that their beneficiary can meet financial obligations, including:

End-of-life expenses, such as funeral and burial costs
Mortgage payments
Tuition payments
Personal debt, including outstanding loans or credit card bills
Day-to-day expenses, like groceries
Financial obligations aren’t the only way to use death benefit funds, however. Some individuals choose to open a life insurance policy to build an inheritance for their children or make a charitable donation to the policyholder’s organization of choice.

Depending on the policy you choose, you may also be able to use the funds to manage expenses while you’re alive. For instance, if you have a whole or universal life policy, your insurer will likely let you borrow against it to fund expenses like your child’s college tuition or make a down payment on a house. However, keep in mind that if you do borrow against your account, the full death benefit may not be available if you die before paying back the funds.

What Doesn’t Life Insurance Cover?
Life insurance covers most causes of death, including natural and accidental causes, suicide, and homicide. However, some caveats may prevent your beneficiaries from receiving their payout.

Steven Weisbart, who served as the chief economist at the Insurance Information Institute until his retirement in 2020, says there are two common reasons why an insurer may deny a life insurance claim: a lapse in payment or misrepresentation of the insured’s health.

If health information is misrepresented or omitted, insurance providers may deny a claim. That is particularly true during the contestability period, which is typically a two-year window after the policy begins.

In addition to those common causes, an insurer may deny a claim based on the circumstances of the death. For instance, if the insured dies by homicide, the insurer may not cover the claim if the beneficiary is responsible for or involved in the victim’s death.

Life insurance policies also frequently include what’s known as a suicide clause, which voids coverage if the covered individual dies by suicide within a specific period, often two years, after opening a policy.

Finally, some insurance providers will deny claims if the insured dies while engaging in a high-risk activity, like skydiving, at their time of death. As such, it’s important to discuss life insurance coverage limitations with your agent or broker before purchasing a policy.

What Type of Life Insurance Do I Need?
Which type of life insurance you need depends on several factors, including your reason for purchasing a policy, your finances, and any investment goals you may have. Below are some of the most common life insurance policies available as well as when they may suit your needs.

Term Life Insurance
A term life policy lasts for a specific period, typically from one to 30 years. During the term, the policyholder makes fixed premium payments in exchange for a guaranteed death benefit.

Under a term life policy, coverage ends at the end of the term. However, some insurance companies allow policyholders to extend the coverage to another term or convert it to a permanent policy.

Term life insurance is often the most affordable policy available.

Learn more about Term Life Insurance.

Whole Life Insurance
Whole life insurance is one type of permanent life insurance. As long as the policyholder pays their premium, the policy will remain active for the insured’s entire life. In most cases, the policy premium and death benefit are fixed, and you will pay the same premium as long as you have the policy.

Whole life insurance also has a separate cash value component, which grows as the insurer pays dividends, a portion of the insurance company’s revenue that is paid to policyholders. Policyholders may be able to withdraw from or borrow against the cash value portion of their policy to fund expenses while they’re living.

Based on our analysis of current costs, a whole life policy is typically more expensive than a term life one, but it may be a good option if you don’t want a policy limited by term lengths. It also may be a good option if you’d like a savings component incorporated into your policy.

Learn more about Whole Life Insurance.

Universal Life Insurance
Like whole life insurance, universal life insurance covers you for your entire life, as long as you make regular premium payments, and has a cash value. However, cash value growth depends on market growth.

When market interest rates are strong, the cash-back value of a universal policy will grow at a higher rate. The opposite is also true: when markets are performing poorly, the cash value will grow at a slower rate. Standard universal policies will usually have a guaranteed minimum interest rate.

You can also borrow against or withdraw funds from this account to pay your premium or to fund expenses like weddings, educational expenses, or a down payment on a new home.

Unlike whole life insurance, universal life insurance offers more flexibility because you can typically change your death benefits and premiums to accommodate changing circumstances. As such, it may be worth considering if you’re looking for a policy that provides more flexibility.

Learn more about Universal Life Insurance.

Other Options
Though the policies above are the most common, today’s robust insurance market provides consumers with many policies to choose from, including variations of those listed above. For instance, some providers offer no medical exam policies. That means you may be able to get a policy without a physical examination, something traditionally required by many insurers.

Likewise, you can also choose from variable life insurance. Like a whole life insurance policy, variable policies have a cash value and death benefit. However, the cash value of a variable life policy is built through investments, like mutual funds, bonds, and stock options. That means the cash value may grow quickly in a good market, but there is also more risk when the markets perform poorly as your cash value could decrease.

There are also insurance providers that offer variable universal life policies, which combine characteristics of variable and universal life policies. For instance, you’re allowed to make changes to the death benefit and premiums as your needs or circumstances change.

Understanding your needs and long-term goals and discussing them with a trusted insurance agent or financial advisor can help you determine which type of policy best suits you and your beneficiaries.

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Is Life Insurance Worth It?
Whether or not life insurance is worth the investment depends on several factors, including your finances, your retirement goals, the needs of your beneficiaries, and the type of policy you choose.

If you have loved ones that depend on you for financial stability, a life insurance policy may be well worth the investment. Regardless of which policy type you choose, the death benefit can help your family cover a wide range of costs, including mortgage payments, tuition, and day-to-day expenses.

The death benefit can also cover funeral and burial costs, taxes, and any personal or medical debt that remains after you die.

The benefits of a life insurance policy aren’t limited to covering expenses after your death, however. According to the Insurance Information Institute, some types of insurance, like universal and whole life policies, offer a cash value that you can borrow (e.g., a loan) or withdraw from to cover expenses, like college tuition or a new home, before the insured dies. As such, a policy may also supplement your existing savings or retirement account. However, if you’re using the cash value to cover your premiums and the amount isn’t enough to make the payments, your policy may lapse.

When Isn’t Life Insurance Worth It?
If you don’t have dependents or your loved ones can cover end-of-life expenses with your existing savings or investments, a life insurance policy may not be necessary.

Is Life Insurance a Good Investment?
Depending on the policy type you choose, life insurance may help supplement your existing investment strategy, but it may not be the right investment tool for everyone.

The tax benefits of permanent life insurance policies with a cash value component can lead some policyholders to view this as a good investment. For example, when you pay your premium for a whole life policy, the cash value can grow as a tax-deferred investment, meaning the funds aren’t taxed before they go into your account and they grow tax-free until you withdraw them.

Beneficiaries can also receive tax-free advantages. Though there are some circumstances where a beneficiary may be required to pay taxes on the death benefit, for the most part, the money isn’t taxed and your beneficiaries receive the full policy payout. That can be an efficient way to invest when you intend to transfer wealth to a beneficiary.

However, there are other ways to invest and build wealth. America’s Institute of CPAs advises consumers to weigh additional investment options, like stocks and bonds, which may yield better returns. To do so, consider your long-term goals, whether it’s providing a financial safety net for loved ones or leaving behind an inheritance for your heirs. Ask if life insurance or other investment vehicles will best help you reach these goals.

If you’re considering life insurance as a way to invest your money, it’s wise to consult a financial planner. They can help you determine what investment opportunities are right for you and where life insurance fits in your overall strategy.

How Much Life Insurance Do I Need?
One of the best ways to figure out how much life insurance you need is to consider your reasons for taking out a policy in the first place.

If your goal is to provide loved ones with financial support after your death, consider a benefit amount that replaces your income and covers any additional end-of-life expenses your family may incur. These may include funeral expenses and any outstanding debts your family will be required to pay in your absence, such as your mortgage or other loans.

In addition to these immediate expenses, you may also want to consider any additional long-term expenses you’d like to cover in the future. For instance, some individuals may purchase enough life insurance to pay off their home, manage a child’s long-term educational expenses, or provide their spouse with enough money to cover medical or retirement costs.

The amount of money necessary to support your loved ones or reach your financial goals can vary based on several factors, like inflation, other insurance or investment accounts you have, and your partner’s anticipated income.

It’s a good idea to discuss life insurance death benefits with a financial advisor. An advisor can analyze your current and future earnings and determine if life insurance payouts will be enough to help you reach your goals or protect your loved ones.

How Much Is Life Insurance?
Life insurance costs vary from person to person, as is the case with most insurance policies. Here are a few factors that can impact your insurance premiums:

One of the leading impacts on your life insurance premiums is your age. Life insurance is significantly less expensive for younger individuals, particularly those who are in generally good health. As you get older, premiums on a new policy will increase.

Healthier individuals will often receive better rates than those considered unhealthy or at higher risk for health problems. To determine this, your insurer may look for proof of pre-existing conditions or serious illnesses, like cancer or heart disease. They may also evaluate specific health metrics, like your weight, blood pressure, and cholesterol levels.

Historically, men have paid higher rates than their female counterparts. In part, this is because men have a shorter life expectancy than women. This leads many life insurance companies to charge men higher premiums.

Smoking & Tobacco Use
According to the Centers for Disease Control and Prevention (CDC), smoking and tobacco use can lead to numerous health conditions, including asthma, cancer, chronic obstructive pulmonary disease (COPD), heart attacks, and strokes. As such, smoking increases your premium payments.

Policy Type
As indicated in the tables below, the type of policy you choose can drastically affect your life insurance premium. According to the data we’ve collected, term life insurance policies are typically cheaper, with longer-term policies costing slightly more than short-term ones. Permanent life insurance policies, including whole and universal, often cost more because coverage lasts for the insured’s entire life.

Occupation and Hobbies
Some occupations and hobbies can have a higher risk of death. For instance, truck drivers, construction workers, and law enforcement officers have an increased risk of fatal injury. Similarly, some hobbies, like skydiving or scuba diving, also increase the chance of death. If you’re engaged in a high-risk activity, whether it’s occupational or leisure, you may pay a higher premium.

The comparison charts below provide a snapshot of how life insurance rates can change based on the above factors.

Cost Comparison By Life Insurance Policy Type for Women

Life insurance premiums tend to be more expensive for males. Our sample male doesn’t use any tobacco products, is in the Standard Plus risk category with average health, and is buying a $1 million policy. For a 30-year-old male, the sample cost of a 20-year term policy is $63.49 per month. This same policy for our 30-year-old sample female is $50.80.

Cost Comparison By Life Insurance Policy Type for Men

Cost Comparison By Life Insurance Policy Type for Smokers and Non-Smokers
Your life insurance premiums are based on your assigned risk category. There are four main groups for nonsmokers: Preferred Plus Nonsmoker, Preferred Nonsmoker, Standard Plus Nonsmoker, and Standard Nonsmoker. For smokers, the categories are similar in name and qualifications.

The Preferred Plus is the diamond tier, reserved for those who are currently in excellent health. These individuals fall within normal ranges for weight, blood pressure, and cholesterol and have a clean bill of health. They don’t have any parents or siblings who died from cancer or heart disease before the age of 60. There is no record of risky behaviors, and their driving record has no convictions for moving violations, collisions, or drunk driving.

You fall into the Preferred group if you are generally in good health overall but closer to the upper limits when it comes to your weight-to-height ratio or your blood pressure. Just as with the Preferred Plus class, there can be no history of death from heart disease or cancer by a close family member under the age of 60.

Individuals in the Standard Plus category may be receiving treatment for a medical diagnosis, but all of their health metrics are still within the normal range.

Most people fall into the Standard group. Some allowances are made for medical treatments or for being overweight, as well as for the death of one close family member before 60 from cancer or heart disease.

If you fall outside of the typical health or life expectancy profile, the insurance company may assign you a Table Rating. Each level gets a letter (A, B, C, and so on). As you move up each level, your life insurance premium increases by 25%.

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