How does life insurance work?

What is life insurance?

Life insurance pays out a death benefit to loved ones or other beneficiaries when you die. There are many reasons people may want life insurance:

Pay funeral and final expenses
Take care of a mortgage
Provide money to help a family long-term
Pay for future college expenses
Leave a legacy for charities

There are various types of life insurance policies. The main categories are term life and permanent life insurance policy. Term life insurance lasts for a specified period of time. Permanent life insurance policies include whole life, which covers you until death, universal life and variable universal life policies. Universal life lets you vary your premium payments and adjust your death benefit as beneficiaries’ needs change. With a variable universal life policy, your cash value and death benefit are tied to a particular investment account with your cash value and death benefit increasing if the underlying investments perform well.

Traditionally, people have purchased life insurance primarily for the protection it offers to families through death benefits, Thompson says. "That’s as important today as ever," he says.

However, he says, some types of life insurance policies – such as variable universal life -- show that life insurance "can also do much more for you." For example, the right policy can provide benefits that assist with financial needs while you are alive, such as providing supplemental retirement income or helping to pay for long-term care expenses

It’s important to choose the form of coverage that makes the most sense for you while also looking for affordable life insurance.

Life insurance terminology

Life insurance is a complicated topic, and many people feel overwhelmed trying to understand it. The basic terminology is a good place to start.

Key terms include:

Beneficiary: The person you name on a life insurance policy who will collect the death benefit when you die. The primary beneficiary or beneficiaries are the people who receive the death benefit. You can also name a contingent beneficiary, who will only receive a payout if the primary beneficiaries cannot collect the death benefit. A beneficiary can also be an entity, such as a charity.

Death benefit: The money that’s paid out to beneficiaries after you die.

Rider: Offers an extra benefit that you add on to your life insurance policy. Popular life insurance riders include coverage for accidental death and dismemberment, critical illness and long-term care.

Term life insurance: This type of life insurance remains in effect for a specified number of years – or a “term” – and then expires. It doesn’t include a savings component.

Universal life insurance: A permanent policy similar to whole life, but with more flexibility. A universal life policy lets you alter your premium payments and death benefit.

Whole life insurance: This type of insurance remains in effect for your entire life as long as you continue to pay the premiums. It also offers a savings component, known as “cash value.” You can also usually add policy riders to help customize your policy.

When should you buy life insurance?

Life insurance can make sense at any point. Your individual circumstances will determine if this coverage is right for you.

However, there are situations where buying life insurance is especially important. Here are a few examples of when it’s wise to get life insurance:

Your loved ones depend on your income for their well-being.
You have a mortgage.
You provide care for your children.
You expect your children will have future college expenses.
Your child needs lifelong help with care.
You want to leave money to take care of funeral expenses and burial costs.

Any of those examples are a reason to get life insurance. Think about your family’s long-term financial situation if you were to die. If they would struggle to replace your income, life insurance could be a good bet.

The sooner you buy life insurance, the better. Younger people pay much lower premiums.

Who needs life insurance?

Many people – maybe even most – can benefit from a life insurance policy. “However, your life insurance needs can vary significantly depending on your age, stage of life or financial goals,” Stafford says.

If you have family members or other loved ones who depend on your income, life insurance will protect them.

Life insurance also can make sense if you want to leave money to charity or if you want to make sure your final expenses are covered upon your death.

Can you buy life insurance on another person?

“You must have an insurable interest when purchasing life insurance,” says Adam Solano, a Chicago-based financial advisor and Life and Annuity Certified Professional (LACP) with WestPoint Financial Group. “I can purchase a policy on my spouse, my child, or even my business partner because of the relationship.”

Purchasing a policy on someone else can make sense in some situations, such as if the death of the co-owner of your small business would cause you financial hardship.

“The other person does need to be involved and you do need their consent,” Solano says.

What does life insurance cover?

Life insurance offers a cash benefit to your loved ones after you die. This money can be used to cover many short-term and long-term expenses.

For example, your beneficiaries might immediately use life insurance to cover your funeral costs or pay your bills. Or, they might use it to pay daily costs, such as food and utility bills.

Life insurance also can cover longer-term expenses, such as mortgage payments or the cost of sending your children or grandchildren to college.

You additionally can use life insurance coverage to leave a sum to a charity, religious organization, or other cause near and dear to you.

How to choose a life insurance policy type

Selecting one option from the best life insurance policies takes time and research. There are many different types of life insurance plans and top life insurance companies offer several options. Choosing the right type of policy depends on your individual needs.

A term life policy makes sense if you think you only will need coverage for a period. Term life policies often run for 10, 20 or 30 years. Term life also tends to be more affordable than whole life, so it can make sense for those focused on staying within a budget.

“Term insurance is good for someone who has an insurance need for only a set number of years,” says Jason Wellmann, senior vice president of life distribution at Allianz Life.

For example, if you have 10 years left on your mortgage, you might want to purchase a term life policy for that period.

“You want to make sure your partner has enough money to cover the remainder of the mortgage payment if you pass away in that time,” Wellmann says.

However, term life products were the only type of life insurance that did not see gains in 2021, according to LIMRA.

Whole life insurance is a better choice if you want a policy that will last for your lifetime. Whole life insurance also makes sense for those who want to lock in one premium rate and maintain that cost for as long as they live.

“The death benefit remains in place for the entire lifetime of the insured, as long as sufficient premiums are paid,” Wellmann says.

Whole life also offers a "cash value" account that appeals to those hoping to accumulate a larger pool of savings. Money from a cash value account can be used for financial needs that arise in your life.

“Typically, those seeking a permanent life insurance policy are those who are looking for more than just the death benefit,” Wellman says.

You can access cash value in the form of a loan or withdrawal from the cash value. The money could be used for things such as:

Helping with a child’s college education
Funding retirement income
Paying for emergency expenses

How much life insurance do you need?

When purchasing life insurance, choosing the right amount can be challenging.

LIMRA has found that 60 million families are either uninsured or underinsured, with an average coverage gap of around $200,000.

Some experts suggest purchasing a benefit that will pay out seven to 10 times a policyholder’s annual income. Working closely with a life insurance agent can help you determine how much coverage you need given your unique situation.

How much does life insurance cost?

Average life insurance cost is hard to calculate because the cost of a life insurance policy can vary widely by person. The cost depends on the policyholder’s circumstances, including:

Age. Premiums on a new policy increase as you get older.
Gender. Women live longer, so they tend to pay lower premiums.
Health history. Healthier people pay lower premiums than those with some medical conditions.
Smoking status. You will pay higher premiums if you smoke.
Hobbies and lifestyle. People with high-risk hobbies -- such as skydiving -- may pay higher premiums.
Occupation. Jobs that involve more physical risks can result in higher premiums.

In addition, some types of coverage just naturally tend to cost more. If you’re looking for cheap life insurance, term life coverage is usually cheaper than whole life coverage, for example.

How to save on life insurance

The best life insurance policy is the one that fully meets your needs. Purchasing life insurance is always a balancing act between getting the coverage you need and finding the best life insurance rates.

Wellmann says the best way to save on life insurance is to make sure you understand your needs.

“Do your research and consider your options,” he says. “Identify what is important to your financial plan and review annually.”

Another important way to save is to compare life insurance rates. That way, you can find the best policy at the best price.

How to get life insurance quotes

You have several options for obtaining life insurance quotes. One method is to narrow a list to several insurers and to obtain individual quotes from each of them, either by calling their offices or using their website.

Working with an independent life insurance agent also can help you to gather quotes.

Getting life insurance quotes online is more popular than ever, with many life insurance companies handling the entire application process online as well. You can compare multiple quotes at once and find the best price.

In fact, it’s never been easier to secure a life insurance policy. “Today, it’s possible to apply for a policy and have it delivered completely electronically,” Thompson says.

He adds that you can sometimes have a policy in place within 24 hours.

Life insurance FAQs

How do you choose a beneficiary?

Your beneficiary should be someone you trust to use your death benefit in accordance with your wishes. For most people, it's a spouse or significant other.

Also, remember to keep your beneficiary up to date if life circumstances change -- such as after a divorce -- and consider naming backup (or contingent) beneficiaries.

How do my beneficiaries get paid after I die?

Your beneficiaries should have the option for how they would like to receive the policy's death benefit.

Options may include:

A lump sum: All of the death benefits arrive in a single payment.
Monthly installments: Some beneficiaries find it easier to get the money gradually over a period.
Retained asset account: Some insurers may allow a beneficiary to keep the death benefit in an interest-bearing account. Beneficiaries can then write checks against the money in the account.
Annuity: Beneficiaries may have the option of receiving guaranteed payments monthly for life. Unless the annuity is established for a set period, any remaining death benefit remaining when the beneficiary dies will return to the insurance company.

How does a beneficiary make a claim?

The process for filing a lice insurance claim differs by company. In most cases, the beneficiary will need to contact the company directly to request the correct forms, and then fill them out and provide any required documentation, like a death certificate.

Does life insurance cover suicide?

Typically, a life insurance policy will payout for any cause, even in the event of a suicide.

However, many policies have a contestability window that begins when you take out a policy. During that period, companies may investigate your death before deciding whether or not to pay out the benefit. In the case of a suicide, there is a good chance the death benefit would be denied during that period.

Is life insurance taxable?

Life insurance death benefits aren’t typically taxable to a beneficiary. The IRS says these benefits generally don’t have to be reported on a tax return.

However, a beneficiary must report any interest that’s received as taxable income. If you’re a beneficiary and unsure of whether you owe taxes, speak with a qualified tax professional.

What happens when a whole life insurance policy matures?

A whole life insurance policy remains in effect as long as the policyholder pays the premiums. However, there may be an age at which the life insurance policy "matures." For example, the policy might mature when the policyholder turns 100 or older.

When this happens, the insurer typically will pay out the full cash value of the policy to the policyholder and close the policy. Some insurers might offer an extension to the policyholder if he or she continues to pay premiums.

Can you cash out a whole life policy?

If you have a whole life policy and have built up cash value, you can withdraw this money to pay for expenses. However, if you withdraw the full amount of the cash value, you have essentially "surrendered" the policy. At this point, your life insurance will lapse and you will no longer have coverage.

If this occurs, you also may owe surrender fees and taxes on the money that you receive.

Another option for cashing out your policy is known as a life settlement, in which you sell the policy to a third-party investor and receive cash in return.

How do you withdraw money from a whole life policy?

If you have built up cash value in your whole life insurance policy, you typically can withdraw a limited amount of this money to use for your own purposes. Most withdrawals up to the amount of premiums you’ve paid into the policy will not trigger a taxable event. Withdrawals over that amount will be subject to taxes, however.

It’s also important to remember that the amount of money you withdraw from your cash basis will reduce your death benefit. And if you withdraw the full amount of cash value, your policy will expire.

Instead of withdrawal, you may decide to take a loan. But the loan itself will not be against the cash value. Instead, you will borrow from the issuer, and your policy will be used as collateral. You might owe interest payments on these funds.

Can you get life insurance with a pre-existing health condition?

Many people assume that a pre-existing health condition will preclude them from getting life insurance. But can you still get a policy even if you have such an issue?

In many cases, the answer is “yes,” says Heather Milligan, senior vice president and head of life insurance underwriting and new business and business innovation life solutions for Lincoln Financial Group.

"While underwriting guidelines will vary from life insurance company to life insurance company, generally speaking, it is possible to get life insurance with pre-existing conditions," she says.

Milligan notes that 90% or more of current Lincoln applicants qualify for some level of life insurance coverage. Policyholders may include people with hepatitis C, diabetes and coronary artery disease and those with a history of certain types of treated cancer.

It’s important to note that having a pre-existing condition might raise the price you pay for coverage. That can be true even for common conditions, such as:

High blood pressure
High cholesterol
Obesity
Anxiety
Heart disease
Gastroesophageal reflux disease

In some cases, you can get life insurance without a medical exam. But this coverage may not be as comprehensive as you would find in other policies, and it will be more expensive than a policy with a medical exam.