How Does Life Insurance Work?

Sean McGinn is an assistant director of Product Positioning in the Insurance Solutions department at Northwestern Mutual.

The main purpose of life insurance is to protect your loved ones financially. If you're considering it, you're probably thinking about your family's well-being.

But the death benefit that life insurance is known for isn’t the only way a policy can help. Depending on the type of life insurance you get, it can also provide benefits that you can use throughout your life—becoming an asset that can help you reach many personal and financial goals. That makes life insurance a critical part of a financial plan.

When you start researching life insurance, you’ll find there’s a lot of information. Here, we explore the basics: what life insurance is, different types of policies and how they work.

What is life insurance?

Life insurance is a contract between you and an insurance company. Under the contract, you will owe regular payments (known as premiums) in exchange for coverage and, with some policies, additional benefits. If you die while covered by a life insurance policy, the company will pay a death benefit to your beneficiary—usually a family member. You may have multiple beneficiaries.

And some types of policies build cash value that can grow on a tax-deferred basis. Once you have accrued enough cash value in your policy, which will usually take several years of paying premiums, you’ll be able to access this cash value at any time. You can use it for any purpose while you’re alive. You can do this through a life insurance policy loan, which will need to be paid back, or by cashing out a portion of your policy—but this will reduce your death benefit.

How do different types of life insurance policies work?

As long as you pay your premium on time, you’ll maintain your coverage. However, exactly how your life insurance works depends on the type of policy you have. Let’s look at the differences below.

Term life insurance

Term life insurance is a policy that covers you for a preset timeframe (the term) and does not build any cash value. If you die during that period, then your beneficiaries will receive your death benefit. If your term ends before you die, there is no payout for your beneficiaries. You may be able to renew some term life policies, while others will simply end at the end of your term.

There are two types of term life insurance: Annually renewable term life insurance and level term life insurance.

Annually renewable term life insurance

Annually renewable term life insurance typically offers the most death benefit at the lowest initial cost. But the amount you pay for it will increase with each passing year, so it can eventually get quite expensive. Annually renewable term life insurance typically lasts until you reach a certain age. After that you can no longer renew your coverage.

A policy that expires when you turn 80, for example, would be referred to as “Term 80.” Most people cancel their policy or convert it to permanent coverage before they reach that age because it gets more expensive every year.

Level term life insurance

Level term life insurance lasts for a certain number of years. It’s called “level” because your premiums remain the same over the entire length of the term. That means you’ll initially pay higher premiums than you would with an annually renewable policy but less in later years.

The exact length of the term will depend on the specifics of your policy. Five-, 10- and 20-year terms are all common.

Permanent life insurance

Whereas term life insurance only covers you for a certain period of time, permanent life insurance covers you for life. So long as you pay your premium on time, your beneficiaries will receive the death benefit—no matter when you die.

Compared to term life, permanent life insurance premiums are higher because the policy will pay a death benefit no matter when you die and accumulate cash value that you can use throughout your entire life. Some permanent life insurance policies may also pay a dividend. You can spend it any way you’d like or reinvest it to boost your policy’s compounding growth.

There are three main types of permanent life insurance: whole, universal and variable. We explain each type below. Your Northwestern Mutual financial advisor can help you find the right type of insurance.

Whole life insurance

Whole life insurance offers a number of guarantees, including the amount you pay for premiums and the death benefit. While whole life insurance is not an investment, it can act like one as a part of your broader financial plan. That’s because the policy’s cash value is guaranteed to grow, potentially becoming a source of funds throughout your life. In retirement, it can help you weather down markets and can provide tax efficiency on withdrawals from your retirement accounts.

Universal life insurance

Universal life insurance offers additional flexibility on the amount of premium you pay and the policy’s death benefit. Over time, you can choose to keep a death benefit that grows or level it off. It all depends on your goals for the policy, which you can talk through with your financial advisor.

Variable life insurance

Variable life insurance also provides a flexible premium and death benefit. The primary difference between variable and universal life insurance is the control over how the cash value is invested. With a variable life policy, you have the option of placing your cash value into sub-accounts, which can be tied to market performance. When the market rises, your cash value can grow faster. But if the market performs poorly, your policy may underperform a non-variable policy—or even lose value.¹

Basic terms to know when buying life insurance

When you search for information, you’ll come across some common concepts related to life insurance. Here’s a quick rundown of terms you’ll need to know:

• Policyowner (or policyholder): This is the person who owns the policy—typically the person who pays for the policy and is insured by it. You can, however, own a policy that insures someone else (like your kids).
• The insured: The person whose life is covered by the policy.
• Underwriting: The process in which the life insurance company reviews your application to make sure that the company is able to insure you and keep the agreement laid out in your policy.
• Beneficiary: The person who’ll get the payout after the insured person’s death. You can name multiple beneficiaries.
• Death benefit: The money that will be paid out when the insured person dies. It’s also sometimes called the “face value” or “face amount” of a policy. When selecting your death benefit amount—or how much life insurance you need—you usually consider your income, monthly expenses and dependent needs.
• Premiums: The payments you make to keep your policy in place. Typically, these are paid monthly, but some policies allow payment less frequently (like one to four times per year).
• Coverage period: Also called the “policy term,” this is the amount of time that the policy is active for. For permanent life insurance, the policy term continues for as long as the insured person is alive (as long as premiums are paid when due). For term life insurance, this will be equal to a certain number of years, at which point the policy terminates.
• Dividends²: Funds returned to policyowners at the end of a year. Life insurance dividends are paid only by mutual companies—which are companies that are owned or exist for the benefit of their policyowners—and are not guaranteed.
• Cash value: Part of a permanent life insurance policy that grows over time. Once you have enough cash value, you can access it as a source of funds by borrowing against it or by surrendering some or all of your policy. While accessing your cash value will reduce your death benefit, this can become a great source of funding throughout your life and can be especially powerful during retirement³
• Riders: Optional add-ons for your policy that allow you to purchase additional coverage or other special benefits.

How much does life insurance cost?

Several factors influence your policy’s cost. We’ll give you a quick overview, and your financial advisor can help you with more details.

Type of policy

Term life insurance premiums are typically less expensive than permanent or whole life premiums because they cover you only for a set period of time, whereas permanent life insurance policies cover you for your entire life.

Age and health

Prices of policies are generally based on your probability of death in a given year. When you’re younger and healthier, it’s less likely that you’d die, so you’re usually able to get a less expensive policy. If you have a pre-existing health condition or you are older, your policy will be more expensive because the probability of you dying soon is higher.

Gender

According to 2023 statistics from the Centers for Disease Control and Prevention, women outlive men by about five to six years. Life expectancy is an important consideration in pricing, so if you’re a woman, your coverage may be cheaper than a man’s.

Hobbies and work

How much risk you take in your personal and professional life can also impact what you’d pay for life insurance. People with high-risk jobs or high-risk hobbies may find themselves paying a bit more—if they even can get coverage.

Death benefit amount

The higher the death benefit you select, the more you’ll pay for your policy.

Term length

The longer a policy covers you, the more it usually costs over time. With a longer policy, you’re paying for more years that a company will insure you—including years when you’ll be older and more expensive to insure.

What should I know about life insurance beneficiaries?

When you get a policy, you’ll choose the beneficiary. It’s often a spouse, parents, other family members, children or a charity. You can also designate a contingent beneficiary in case your primary beneficiary dies before you.

Here’s something to keep in mind if your kids are minors: You can name them as beneficiaries, but the money will be managed by their legal guardian until they get old enough to manage it themselves.

And we realize that life can be complicated. If you have a unique situation that impacts who you’d like to leave your money to, establishing a trust may be a good move. You can talk with an expert, who might recommend a type of trust called an Irrevocable Life Insurance Trust.

How do life insurance policies pay out?

After the death of the insured, the beneficiary notifies the life insurance company of the death and then submits things like a copy of the death certificate. These steps initiate a claim. Once the claim has been processed, the insurer will get in touch to go over the payout and options for how the money will be paid. This can include:

• A lump-sum payment (check, money wire or deposit),
• An income plan (interest income, lifetime income or other options), or
• A mix of the above.

How long it takes to receive the death benefit can vary greatly, depending on how quickly all the correct paperwork is submitted. You can expect anywhere from a week to a month or more for payout. At Northwestern Mutual, we strive to make the claims process as smooth and swift as possible.

What does life insurance cover?

Paying your premiums guarantees that you’ll receive a death benefit as long as a policy is in place. There may be a few exceptions. Regardless, the main purpose of life insurance policies is to protect beneficiaries in the event of the insured’s death.

What does life insurance usually not cover?

Your life insurance policy guarantees that your beneficiaries receive a death benefit, but there are some rare exceptions in which a death benefit may not be paid out. You may not receive a death benefit in the event of:

• Death by suicide—generally within the first year or two of owning a policy.
• Misrepresentation of information on a life insurance form—like not disclosing drinking/drug use or a condition as part of medical history.

How much life insurance should I purchase?

You may have heard general rules that say you should get enough life insurance to match your salary for 10 years, but how much life insurance you should purchase really depends on your needs. Think about the immediate costs your family would have to cover without you, along with goals like paying for your kids’ college or their future weddings. You might even want to leave a legacy for your grandchildren or donate to a charity.

Consider all of these factors and talk with your financial advisor before you settle on a coverage amount. Our life insurance calculator can help you get started.

How can I find the right life insurance?

The death benefit provided by life insurance is critical to your financial plan. Not only does it help protect your loves ones financially, but with permanent life insurance, you get additional benefits while you’re alive. These benefits can help you with other financial goals throughout your life—from helping you buy a house to income during retirement³. So, it’s important to view your insurance in the context of your broader financial plan.

Your Northwestern Mutual financial advisor can help you look at the big picture to see how your wealth is protected and how it could grow. After getting to know you and your goals, an advisor can point out blind spots and opportunities that might otherwise get overlooked. These might include life insurance, the importance of an emergency fund or investment options to help you reach your financial goals. Together with your financial advisor, you can get the right policies so that your family is protected.

1. Depending on the performance of the underlying investment options, the accumulated value available for loans and withdrawals may be more or less than the total premiums paid.

2. Dividends are not guaranteed.

3. Utilizing the cash value through policy loans, surrenders, or cash withdrawals will reduce the death benefit and may necessitate greater outlay than anticipated and/or result in an unexpected taxable event.