How Does Life Insurance Work? Everything You Should Know

Life insurance is an important part of any financial plan, providing a safety net for your family in the event of your death. A life insurance policy can help ensure your loved ones are taken care of financially if something were to happen to you. In this article, we’ll discuss how life insurance works, what types are available, and how to determine which is the right fit for you.

What is life insurance?

Life insurance is a contract between a person — also known as the policyholder — and an insurance company. The policyholder pays the insurer a premium — an agreed-upon sum. If the policyholder dies while the policy is in effect, the insurance company must pay an agreed-upon sum, called a death benefit, to the beneficiaries (usually family members) of the deceased person. This money can help alleviate some of their financial burdens and provide some much-needed security during a difficult time.

Types of life insurance policies

Various types of life insurance policies are available to suit different needs. Three main types are whole life insurance, term life insurance, and universal life insurance.

Whole life insurance

Whole life insurance is a type of permanent policy that provides coverage for your entire life with premium payments that typically remain level. It also typically builds “cash value” that accumulates over time.^[1] 

Your premiums will stay the same for as long as you have the policy, and as your cash value accumulates, you can borrow against it to cover unexpected expenses. However, whole life is generally the most expensive type of life insurance. And you may have to pay fees or penalties to borrow against your cash value.

Learn More: How Much Life Insurance Do I Need?

Term life insurance

Term life insurance is a temporary form of coverage that provides death- or illness-related expenses for a predetermined period of time, such as 10 or 20 years. It has no cash value and expires at the end of the term. 

Term life insurance offers flexibility in coverage amounts and lengths of policy, and it’s generally more affordable than other types of life insurance, such as whole life. However, term life insurance doesn’t provide any cash value in the event of outliving the policy’s lifespan, and a lapse in payments can result in a cancellation of the policy.

See Also: Types of Term Life Insurance

Universal life insurance

Universal life insurance is a type of permanent life insurance. It has a cash value that accumulates over time, which can be used to pay premiums at a later date. Premiums can be lower than whole life insurance because the cash value of universal life insurance earns interest according to the market rate. So, if the market fluctuates, your premiums can fluctuate. Thus, universal policies offer more flexibility than either whole or term life policies. However, there’s no guarantee of returns, since the interest rate is based on the market rate, and it’s possible your policy will get more expensive as you age.

How to pick the right life insurance policy

When it comes to picking the right life insurance policy, it’s important to consider all your options and decide which type best fits your needs.

• Evaluate how much coverage you need. Take into account both current and future financial obligations as well as any major expenses that you or your family may face in the future.^[2]

• Consider your budget. Look at both short-term and long-term costs associated with each policy, taking into account premium payments.

• Research providers. Shop around to find an insurer that offers competitive rates, reliable customer service, and a variety of products that meet your needs.

• Read the fine print. Understand what each policy covers, as well as any riders or additional features.

• Talk to an expert. Speak with a financial advisor or insurance broker who can help you understand the different types of life insurance policies available and choose one that fits your requirements.

Keep Reading: How Much Does Life Insurance Cost?

Deciding on your coverage amount

Here are factors a prospective policyholder should consider when deciding on their life insurance coverage amount.

• The size of your family: The more dependents you have, the higher coverage amount you likely need.

• Your income: If you’re the primary bread-winner, your family will need your death benefit to offset the loss of your income. Your coverage amount should at least replace your annual income.

• Other sources of income: If your family has other sources of income, you may be able to reduce your coverage amount.

• Debts and liabilities: Certain types of debt can pass on to your family after you die. If you have a large mortgage or other transferable debt, make sure to factor that into your coverage amount.

• Your lifestyle: If you want your family to be able to maintain a certain lifestyle — such as your spouse staying home or keeping your kids in private school — factor that into the amount you think your family will need.

• Funeral costs: Don’t forget to include the cost of a funeral and other related expenses in your coverage amount. The median cost for funerals was $7,848 in 2021, according to the National Funeral Directors Association.^[3]

• Inflation: Make sure to take into account inflation when calculating your coverage amount.

• Current and future financial obligations: Consider any outstanding debts that need to be covered, as well as any educational or living expenses that may come up in the near future.

Read More: 10 Best Life Insurance Companies

How to file a life insurance claim

First, contact the insurer as soon as possible after a death has occurred and provide them with information about the deceased, such as their name and date of birth. You’ll also likely need to supply a death certificate or other documentation to prove that the death was covered by the policy. Your insurer will typically require additional evidence or documentation to verify your identity and the relationship between you and the deceased person, such as marriage certificates or legal documents.

Once these items are provided and everything is in order, then the claim is usually processed quickly.

How to find the right life insurance policy for yourself

Shopping around for different policies and comparing quotes can help consumers find the best policy for them at the most reasonable price. It’s also important to read through the fine print of each policy to understand what each covers and what it doesn’t.

Some key factors to consider when shopping for a life insurance policy are the type of policy needed, the amount of coverage desired, and payment terms.

In addition to understanding the various types of policies available, it’s important to know how much coverage you need. This will depend on your age, family size, lifestyle, income level, and other factors specific to you. As a rule of thumb, it’s a good idea to have a death benefit that’s at least five times your annual salary to help your survivors cover major expenses, such as a mortgage or student loans, in case of your death.

Life insurance FAQs

Life insurance can be confusing, as there are many different types, terms, premiums, and other aspects to consider before choosing a company or policy.

Here are answers to some of the most frequently asked questions about how life insurance works.