How Does Life Insurance Work?

Life insurance is a legally binding contract between you and an insurance company. As long as your premiums are paid, a death benefit will be paid to your beneficiary if you pass away while your policy is active.

According to a 2022 Insurance Barometer study conducted by LIMRA and Life Happens, 106 million adults lack proper insurance coverage. This is due to common misconceptions about life insurance, such as assuming it’s too expensive or confusing.

Your age, health and type of insurance you choose will determine the premium cost. A premium is the monthly cost of keeping your life insurance policy active. The older you are, and the more coverage you want, the more expensive your premiums will be.

People typically overestimate the cost of life insurance, thinking it will cost them thousands of dollars. But if you’re a healthy 30-year-old looking for $250,000 of coverage for a 10-year term, your premium could cost as low as $12.40 a month.

Understanding how life insurance works, along with what’s covered, can help you choose a life insurance policy.

Life insurance policies cover natural and accidental deaths.

However, some policies have conditions that deny coverage in specific situations. For example, if the policyholder passes away from committing suicide within the first two years their policy was instated, then they may be denied coverage. You should discuss the guidelines of coverage with your insurance provider before you purchase a policy.

If you choose a type of permanent life insurance, you can borrow from your policy while you’re still alive. The funds can go toward anything from retirement goals to unexpected medical costs. If your beneficiary receives the death benefit, they can use it to cover a variety of expenses.

Account for all the expenses you need covered if you were to pass away. If you don’t, your family members could be financially unprepared for your loss.

There are two main types of life insurance — permanent and term life. The main differences between each type are the coverage length and policy flexibility.

Term life insurance has limited coverage up to 30 years. All permanent policies have lifetime coverage. Several key terms can help you understand how each type of life insurance works.

A term life policy has a fixed premium and death benefit amount. Term life policies do not have a cash value component.

There are two main types of permanent life insurance — whole and universal. They have different rules when it comes to their premiums and death benefit, but both have a cash value component.

Term life insurance only offers coverage for a limited amount of time. These are called term lengths. You can typically choose a term length between 10, 20 or 30 years of coverage.

Your death benefit amount and premium cost is set with a term life policy. Premiums for a term life policy are more affordable compared to a permanent policy.

If the policyholder passes away during the term length, the beneficiary will receive a death benefit. If the policyholder outlives the policy’s term length, there will be no death benefit.

Universal life insurance offers lifetime coverage with a tax-deferred cash value component.

With a universal policy, you have a flexible premium and death benefit amount. You can even skip premium payments if you wanted to.

Since universal life insurance has flexible premiums and coverage that never expires, your death benefit comes with little risk.

But because universal life insurance policies offer flexible lifelong coverage with a cash value component — premiums can be expensive.

Similar to universal life insurance, whole life insurance also offers lifetime coverage, with a tax-deferred cash value component.

But with a whole life policy, your premiums and death benefit amounts are fixed. If your premiums are paid on time, you have guaranteed coverage for life.

Because whole life insurance policies offer lifelong coverage with a cash value component, the premiums can be expensive.

Whole life is the most popular type of permanent life insurance policy, according to the Insurance Information Institute.

Life insurance can pay out in one of four ways — in a lump-sum payment, specific income payout, annuity or a retained asset account. If you include all essential paperwork when filing your payout claim, you should receive your death benefit payment within 30 to 60 days.

Remember that insurance companies have regulations in place for payouts. For example, if the policyholder was murdered, there could be roadblocks with getting your insurance payout.

This doesn’t mean most life insurance policies don’t pay out. In 2021 alone, life insurance death benefits payouts totaled $97.1 billion.

The biggest pro of all life insurance policies is that they financially protect your family once you’re gone. Without a life insurance policy in place to provide a death benefit, your loved ones may not be able to cover expenses without your income.

A disadvantage of life insurance is the cost. Premium prices are often unaffordable for a permanent policy. While there are affordable options, like a term policy, you may be paying for a policy that won’t protect your loved ones in the long run.

There are other pros and cons as well, depending on what type of life insurance you choose.

A simple rule to estimate how much life insurance you need is by taking your annual income and multiplying it by seven or 10. For example, if you make $60,000 a year, you should get a life insurance policy with at least $420,000 of coverage.

If you want to get more detailed, you could follow the DIME rule for a coverage estimate. The DIME rule is an acronym which helps you remember what to account for.

You can also use a life insurance calculator if you need help calculating how much life insurance you need.