How Does Life Insurance Work and Do You Really Need It?

Life insurance provides a financial safety net for your family. It pays a predetermined amount to your beneficiary if you pass away while the policy is in place.

The younger and healthier you are, the cheaper your life insurance will be — so, you will want to get it sooner rather than later.

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How Does Life Insurance Work?

Life insurance is a type of insurance policy that provides financial support for your family after your death.

With term life insurance, you choose the coverage amount and length of time for which you want coverage. For example, you may choose a $500,000 policy for 20 years. This means if you die during the 20 years the coverage is in place, your beneficiary will receive $500,000.

While the policy is in place, you will be responsible for paying the premiums. If you fail to pay, the insurance company may cancel the policy.

With permanent life insurance, the policy stays in place for your whole life. It also includes an extra feature that accumulates a “cash value” from a portion of your premiums. This is a sort of quasi-savings account that you can borrow from during your lifetime.

If you die with a life insurance policy in place, your beneficiary (the person whom you have selected to receive the proceeds) will receive the death benefit. This money is tax-free, and individuals can spend it in any way they choose.

How the Life Insurance Application Process Works

A life insurance application consists of a few steps: completing a phone interview, naming beneficiaries, providing supporting documentation, and completing a medical exam. 

Phone interview

The phone interview is typically under 30 minutes and may cover: 

• Your health history including surgeries, medications, procedures, and weight history
• Your family’s health history including any history of heart disease or cancer
• Hobbies and lifestyle including extreme sports such as scuba diving or skydiving, smoking and drinking habits, and even international travel
• Financial situation including your job, assets, and debts

Designate beneficiaries

Beneficiaries are the ones who will receive the payout if you pass. This is typically a spouse or partner who you’d like to continue supporting in the absence of your income. 

Minors cannot be named beneficiaries, so if you’d like to support your children with life insurance, you can list their guardian as the beneficiary or set up a trust in their name. 

Provide supporting documentation

As a follow-up to the phone interview, the insurer may wish to verify your information. 

You may be asked to provide: 

• Proof of identity (e.g., passport, green card, driver’s license)
• Proof of income (pay stubs, tax returns, letter of employment)
• Proof of residency (signed lease, utility bill, mortgage bill, or property tax statement)

Complete a medical exam 

During the medical exam, you’ll complete a verbal questionnaire and a physical exam. 

The verbal questionnaire will ask questions about your health, lifestyle, and habits. The physical exam may include height and weight measurements, blood pressure, and blood and urine samples. 

The blood tests check for risk factors such as high cholesterol or blood pressure, HIV or hepatitis, problems with the kidney or liver, prostate cancer, and diabetes. 

Drug tests are testing for drug use, the presence of nicotine or cotinine as indicators of tobacco use, or diuretics which may signal the use of certain medications. 

READ MORE: How Much Does Life Insurance Cost?

What Life Insurance Covers 

A life insurance policy is meant to replace your future income if you pass away. It can also be used to cover final expenses or leave a legacy so that when you pass, your loved ones have the resources they need to cover your funeral and carry on without you.

Most causes of death are covered, including accidents, medical complications, murder, illness, old age, and other tragic events. 

There aren’t too many restrictions on how the funds from a death benefit payment can be used. A life insurance policy is meant to provide a safety net to protect your loved ones when you’re gone, and each family’s needs will be different.

Depending on your policy, life insurance can also be an asset you can use while you’re still alive. A terminal illness rider added to a policy, for example, allows you to claim benefits before your death if you've been diagnosed with a fatal condition.

Whole life and universal life insurance policies can also become assets with cash value. Your policy may allow you to borrow against the policy while you’re still alive for anything you’d like, ranging from putting a down payment on a house to sending a child to college.

READ MORE: How Much Life Insurance Do I Need For My Family

What Life Insurance Doesn’t Cover

Most causes of death are covered by a life insurance policy, but there are a few exceptions.

Many policies include a “suicide clause” that requires a waiting period before the policy will cover suicide. This prevents someone who is considering taking their own life from getting a policy just before their death so their family will benefit financially. 

There are also some exceptions for murder. For example, if a beneficiary murders a policyholder, the insurance company won’t pay the death benefit.

Other exceptions include committing fraud, high-risk activities, like paragliding, and engaging in illegal activities.

There are other, more administrative and technical reasons that your beneficiaries will not receive the death benefit. If you don’t make premium payments and the policy lapses, your beneficiaries won’t be entitled to make a claim.

There could also be instances where a policy won’t cover a policyholder’s death right away if there is a dispute about the policy itself or questions about the death of the policyholder.

There are also restrictions as to whose life you can cover. To buy life insurance on someone else's life you need to show “insurable interest” and their permission. For example, a wife could buy a life insurance policy for her husband and name herself as the beneficiary (or vice versa). Or a business owner could buy a policy on their business partner's life.

But you can't buy a life insurance policy for someone who has no financial responsibility in your life. For example, you couldn't buy a policy on your neighbor's life and make yourself the beneficiary. There is typically no “insurable interest” between neighbors.

RELATED: How Life Insurance Companies Make Money

Types of Life Insurance

There are two primary types of life insurance: permanent and term. Which type you should get largely depends on your family's financial needs. 

Term life insurance

Term life insurance is an affordable option that usually provides coverage for a specific period in a specific amount.

A term life insurance policy does not carry a cash value and will typically only pay out upon the death of the policyholder.

This type of life insurance is the appropriate choice for most people.

Permanent life insurance

Permanent life insurance is designed to provide coverage for the duration of your life.

There are two main types of permanent life insurance: whole life insurance and universal life insurance policies, which can grow in cash value. But these policies are expensive — sometimes as much as 20 times the cost of term life insurance.

Permanent life insurance policies are financial assets that not only provide a death benefit but can be leveraged while you’re still alive, too. Permanent life insurance policies also come with some tax benefits. Policies that increase in cash value aren’t taxed and the death benefit is paid out tax-free as well.

Which should you choose?

To determine which policy makes sense for you, figure out your cost of living, financial goals, and any savings gaps that might arise in the event of your death. The goal is financial protection for whatever your family needs.

For example, if you purchase a life insurance policy when you’re young, you might want to account for the cost of your mortgage or a child’s college education in your policy coverage.

The good news is getting a life insurance quote is free and it won’t hurt your credit score. You can price out any number of different scenarios to figure out how much coverage you want and the type of insurance policy that makes the most sense for you.

When Are Life Insurance Benefits Paid?

Payment for your life insurance benefits can vary based on the company you purchase a policy with and the type of policy you get.

These are a few different ways insurance companies pay life insurance death benefits:

• Lump sum payment after your death
• Funds in a retained asset account that accrues interest and can be accessed when needed
• Annuity payments during the beneficiary’s lifetime
• Installment payments that are broken out during a specific period

Benefits won’t be paid until a beneficiary files a claim with the insurance company. This includes providing a death certificate so the insurance company can confirm that the cause of death fits within the policy’s terms.

In some cases, like murder, there may also be an investigation into the claim to determine whether or not the benefit should be paid out at all.

How To Make a Life Insurance Claim

When a policyholder dies, it is up to the beneficiaries to make a life insurance claim. The insurance company may eventually find out, especially if a policyholder stops paying their premium, but isn’t always aware when an individual has passed away.

To begin a claim, you’ll need to prove that the policyholder has died. You can do this by providing the insurance company with an official death certificate.

Once a claim is processed and all the required paperwork is submitted, it can take a couple of weeks to finalize the claim. The sooner a claim is made, the sooner the claim will get paid out.

Depending on the cause of death, the insurance company may investigate the claim to make sure it is legitimate. In cases where a court is involved or a criminal investigation is taking place, it may take a while for the insurance company to finalize the claim.

Life Insurance Terms to Know

When you’re ready to review a life insurance policy, there are certain terms you’ll want to be familiar with.

Beneficiary

A beneficiary is an individual (or individuals) named in your life insurance policy. This can be a spouse, dependent, or other loved one.

The beneficiary is named on the policy and is able to make a claim when you pass and receive the death benefit payout.

Burial insurance

Burial insurance is a type of life insurance designed to exclusively cover funeral expenses.

This policy is designed for aging adults who don’t want to stick their loved ones with a funeral bill at the time of their passing. These typically have very low death benefits but are cheaper for that reason.

Contestability period

When you initially start a policy, there's a period known as the contestability period, during which your insurer has the chance to scrutinize the accuracy of the information provided.

If the insurance company discovers that you provided false information during the application, such as crucial details about your health, they may reject claims against your policy. Or, they modify the death benefit to align with the coverage you would have received based on the payments made.

Death benefit

This is the financial payout a beneficiary gets when they file a claim on your life insurance policy.

Recipients can typically claim death benefit funds tax-free through various methods once the payout is received.

Premium

This is the payment you make to keep your policy active. Failing to pay your premium can cause a lapse in coverage and result in your beneficiaries being denied a claim against your policy. 

Rider

A rider is supplemental coverage you can add to a policy for an extra fee. Common riders include long-term care accelerated death benefits that can cover costs incurred as a result of a terminal illness.

Slayer rule

Most life insurance policies have an exception known as the slayer rule, which bars a beneficiary from claiming a death benefit if there are suspicions of them killing the policyholder, particularly with the motive of obtaining the benefit.

How Much Does Life Insurance Cost?

Life insurance varies depending on your age, sex, overall health, coverage needs, and whether or not you participate in high-risk activities. The average term life policy for adults under 40 can range anywhere from $12 to $15 per month for a $250,000 policy.

Premiums are usually lower when you’re younger, assuming you’re in good health since insurers assume you won’t make a claim against the policy in the near term. As you get older and are likely to experience a decline in health, the monthly premium will increase. Once you hit 50, expect to pay a monthly premium anywhere from $30 to $75 for a $250,000 policy.

Whole insurance policies are more expensive than term-life policies. According to Policy Genius, a 30-year-old adult in good health with a $250,000 policy can expect to pay over $200 per month for their policy.

Factors that impact life insurance rates

Your lifestyle and the overall state of your health will also affect the price of your policy. Most policies require a medical exam before issuing one. Being overweight or having a drinking habit could result in a higher insurance policy quote compared to someone deemed healthier. 

Some common factors that affect costs are:

• Gender: Women tend to live longer than men and will pay lower premiums
• Smoking: Smoking adds a lot of risk factors to your health
• Weight: Those at healthier weights will pay less for life insurance.
• Other lifestyle factors: Dangerous hobbies or a high-risk job will cause your rates to rise.

The good news is you can lower your rate. Losing weight can reduce your risk for chronic diseases like heart disease. Cutting out bad habits, like smoking, can also signify to insurers that you’re making an effort to lead a healthier life.

People often overlook life insurance when they're young and believe they don't need it. Buying a policy when you’re younger can reduce your premium and provide your loved ones with financial security in the event that you die unexpectedly. Depending on the type of policy you choose, it can also be a financial asset that grows in value, tax-free.

FAQs

Does life insurance cover suicide?

Most life insurance policies do cover suicide after a waiting period. A common waiting period is two years, but you'll want to check your specific policy for details.

Do life insurance policies pay more if the person dies in an accident?

It depends. You can add this feature as a rider to a life insurance policy for an extra cost.

Should I get life insurance through my employer?

If your employer offers life insurance as a benefit, it's a good idea to sign up if it is free or extremely cheap. Or if you have medical conditions that make it impossible to get private coverage.

But it's also important to get your own private policy if you can. For one, it typically isn't very much coverage, usually one year of salary. Also, if you lose your job you will lose your coverage.

You never know when you'll develop a medical condition that will cause you to become uninsurable.

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