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

Life insurance takes care of your affairs after you pass away by providing a financial safety net for your family.

Life insurance will pay a predetermined amount to the policy's beneficiary if the insured person passes away while the policy is in place. In exchange for this coverage, insurance companies charge a fee, called a premium.

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

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  • Life insurance provides financial security for your loved ones after your death.
  • There are no restrictions on how beneficiaries use money provided from a life insurance policy.
  • Policies are less expensive when you’re younger and in good health and get more expensive as you get older.

How does life insurance work?

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

When you decide to get life insurance there will likely be a series of questions the insurance company will ask to assess your health and the riskyness of your lifestyle. Most insurance companies also require a brief medical exam. These assessments will help them determine the rate you will pay.

With term life insurance, you will 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 that 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.

Permanent life insurance works a little differently. Instead of choosing the amount of time you want the policy in place for, 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 where you can borrow from the policy during your lifetime.

Here's more about the differences between term and whole life insurance.

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.

There isn’t a right or wrong time to purchase a life insurance policy. How much life insurance you need, and how much your life insurance coverage will cost, depends on a number of factors. The younger and healthier you are, the cheaper the policy will be — so when you get life insurance matters.

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. It’s a way to quantify the financial value of your life so that when you pass, your loved ones have the financial resources they need to cover your funeral and carry on life without you.

A claim on a life insurance policy can be made in the event of your death. Most causes of death are covered by life insurance policies. This includes 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 from financial hardship when you’re gone, and each family’s needs will be different.

How does life insurance work? 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. This allows your loved ones to start using the proceeds while you are still alive. 

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

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.

Becoming uninsurable

It is possible to become ineligible for life insurance. This will happen if you are diagnosed with a major medical condition or if you have risky behaviors. For example, if you have a history of DUI's or regularly go skydiving.

Because no one knows if or when you'll be diagnosed with a serious medical condition it's a good idea to get life insurance while you still can.

Related: How to life insurance companies make money

Man holding an insurance document: Guide on how does life insurance work and do you really need it?

Main types of life insurance

There are two primary types of life insurance you can choose from permanent life insurance and term life insurance. Choosing which type of life insurance to get will largely depend on the financial needs of your family upon your passing. 

Related: How Much Life Insurance Do I Need For My Family

How does life insurance work: Term life insurance

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

How does life insurance work: 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 extremely 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.

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 kept 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. Here are some key ones you should know.

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 that is 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 you happen to pass away within this timeframe and the insurance company discovers that you provided false information during the application, such as crucial details about your health, they may reject claims made against your policy or 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 does life insurance work: Term life insurance

Term life insurance provides a set amount of coverage for a specific time. Your beneficiaries will receive a payout if you die during the policy’s term. This coverage is inexpensive and the appropriate choice for most people.

How does life insurance work: Permanent life insurance

Also referred to as whole life or universal life insurance, permanent life insurance provides coverage during the course of a policyholder's life. Permanent life insurance policies come with a high cost, but they accumulate a cash value that the policyholder can access during their lifetime.

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.

How does life insurance work: 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

How does life insurance work: 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.

How does life insurance work: 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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I'm an award-winning lawyer and personal finance expert featured in Inc. Magazine, CNBC, the Today Show, Business Insider and more. My mission is to make personal finance accessible for everyone. As the largest financial influencer in the world, I'm connected to a community of over 20 million followers across TikTok, Instagram, YouTube, Facebook and Twitter. I'm also the host of the podcast Erika Taught Me. You might recognize me from my viral tagline, "I read the fine print so you don't have to!"

I'm a graduate of Georgetown Law, where I founded the Georgetown Law Entrepreneurship Club, and the University of Notre Dame. I discovered my passion for personal finance after realizing I was drowning in over $200,000 of student debt and needed to take action-ultimately paying off my student loans in under 2 years. I then spent years as a corporate lawyer representing Fortune 500 companies, but I quit because I realized I wanted to have an impact; I wanted to help real people and teach them that you can create a financial future for yourself.

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Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.