How Does Life Insurance Work?

If you’re considering purchasing life insurance, that means you’re thinking of the steps you should take in order to protect the people you love in the event something happens to you.   

But the death benefit that life insurance is known for isn’t the only way a policy can help you and your family. Depending on the type of life insurance you get, it can also provide benefits that you can use throughout your life — becoming an asset to help you reach almost any goal.   

That makes life insurance a critical part of a financial plan. But when you start researching life insurance, it can be difficult to know where to begin. Here, we explore the basics, including what life insurance is, how it works and the different types of policies that exist.  

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 premium payments) in exchange for coverage and, with some policies, additional benefits. If you die while covered by a life insurance policy, the life insurance company will pay a death benefit in either a lump sum or installments to your beneficiary or beneficiaries — usually family members.   

In addition to paying out the death benefit in the event of your death, if you have a certain type of policy you may also accumulate cash value on a tax-deferred basis. You’ll be able to access this cash value at any time for any purpose while you’re alive, although it will reduce your death benefit to do so.  

Types of life insurance and how they work 

As long as you pay your premium every year (or semiannually, quarterly or monthly, if you choose) 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 period of time (the term). If you die during that time frame, then your beneficiaries will receive your death benefit. If your term ends, there is no payout for your beneficiaries. (Some policies you may be able to renew, while some will simply end at the end of your term.) 

There are two types of term life insurance: Level term life insurance and annually renewable term life insurance.  

Annually renewable term life insurance typically offers the most death benefit at the lowest initial cost. However, the amount you pay for annually renewable term life insurance will increase in the future and can eventually become quite expensive. Annually renewable term typically lasts until you reach a certain age, like 80. However, most people cancel their policy before they actually reach that age.  

Level term life insurance refers to a life insurance policy that lasts for a certain number of years. It is called “level” because your premium payments remain the same over the entire length of the policy. That means you’ll initially pay higher premiums than you would with an annually renewable policy, but you’ll pay 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 is more expensive for the same amount of death benefit. That’s because the policy will pay a death benefit and accumulate cash value that you can use throughout your entire life. Some permanent life insurance policies also pay a dividend, which you can choose to receive (and spend) or reinvest into your policy to help it grow even more over time.  

There are three main types of permanent life insurance: whole, variable and universal.  

Whole life insurance offers a number of guarantees including the amount you pay for premiums and the death benefit. In addition, because cash value in a whole life insurance policy is guaranteed to grow and never decline in value, it can play a unique role in your financial plan as an additional source of funding during your working years. In retirement it can help you weather down markets and be more tax efficient.  

Universal life insurance offers some additional flexibility when it comes to the amount of premium you pay each year as well as flexibility with the policy’s death benefit. Over time, you can choose to keep a death benefit that grows or level it off. Doing so has unique benefits depending on the desired policy performance. It’s a good idea to talk to a financial representative for more detail.  

Variable life insurance is generally a form of universal life in that the premiums and death benefit are flexible. The primary difference lies in the cash value. With a variable life policy, you have the option of placing your cash value into various sub-accounts, which can be tied to market performance. When the market performs well, your cash value can grow faster. But if the market performs poorly, your policy may even lose value.  

How do life insurance policies pay out? 

After the death of the insured, the beneficiary needs to notify the life insurance company of the death and then submit the paperwork required (such as a copy of the death certificate) to initiate a claim. Once the claim has been processed, the insurer will get in touch to go over the payout and options for how you’d like to receive the money. How long it takes to receive the death benefit can vary greatly, depending on how quickly all the correct paperwork is submitted, but expect anywhere from a week to a month or more for payout. 

Apart from the death benefit, there is another way to potentially access cash from your life insurance policy while you’re alive. If you have a permanent life insurance policy, you have cash value that you can tap while you’re living if you need a source of liquidity — however, keep in mind that accessing your cash value could result in a full or partial loss of your death benefit. 

What do life insurance policies cover? 

Generally, there’s likely to be few restrictions on the types of deaths covered by a life insurance policy, but it also depends on the terms set by your insurance provider. Some may have a suicide clause that won’t cover suicide for the first two years, for example. Also, it’s important to be honest when providing information about health or lifestyle risks when you apply, because a death claim could be denied to your beneficiaries if you die of a previously undisclosed risk.   

How much life insurance should you 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. In addition to the immediate costs your family would have to cover without you, do you want to cover future goals like paying for your kids’ college or their future weddings? Are you trying to leave a legacy behind for extended family? This calculator can help you get started determining how much life insurance makes sense for your situation. 

How to find the right life insurance for your needs   

The death benefit of life insurance is critical to your financial plan. Not only does it help protect your family financially, but with permanent life insurance you’re getting additional benefits while you’re alive that can help you with other financial goals throughout your life, from helping pay for a down payment on a home to retirement. Now that you know a little more about how life insurance works, get connected with one of our financial advisors, who can show you how life insurance can work within your financial plan.