Life insurance can provide your loved ones with financial protection after your death as well as funds to cover your final expenses and any debt you leave behind. Some life insurance policies can even grow in value and offer financial resources you can access while you're still living. If you're considering buying life insurance, you may have some questions about how these policies work — and we've got answers.
How Does Life Insurance Work?
When you buy life insurance, you enter a contract in which the insurance company agrees to pay a benefit to your beneficiaries after you die in exchange for your premium payments on the policy.
The underwriting process life insurance companies use to assess their potential risk of having to pay out a death benefit often includes the requirement of a medical exam. This means the insurer will send a medical technician to your home or office to conduct an exam.
The healthier you are, the lower the insurance company's risk of making a payout before your policy expires. For that reason, your health is often a key factor in both your ability to obtain life insurance and the premium rates you pay when you do.
Under your life insurance contract, the insurance company is obligated to pay only the people you name as beneficiaries. When you buy life insurance, it's important to inform your beneficiaries of their status, the name of the insurance company and where to find a copy of the policy. That information will help ensure they receive the benefits you want them to have.
So, how will life insurance work for your beneficiaries? First, they'll need to contact the insurance company to start the process of making a claim. The insurer will usually require them to fill out a form and submit a certified copy of your death certificate. Once your beneficiaries receive a death benefit payment, they can use the money however they wish. In most cases, they'll pay no taxes on the death benefit.
What Types of Life Insurance Are Available?
The two general categories of life insurance are term life and permanent life. Term life insurance provides coverage for a specified period of time — or a term. Permanent life insurance provides coverage for the lifetime of the policyholder.
Term life insurance is significantly less expensive than permanent life insurance, in part because of its limited period of coverage. With both types, insurance companies offer a discount if you pay your premiums annually instead of monthly. Some insurance companies also allow you to pay semi-annually or quarterly, but with no rate discount.
Here's more of what you need to know about each type.
Term Life Insurance
Insurance companies typically sell term life policies covering 10, 15, 20, 25 or 30 years. Whichever option you choose, your premiums will remain the same for as long as your policy is in effect. Guaranteed renewable term life policies allow you to extend your coverage, one year at a time, after your initial term ends. But with each renewal, your premium will go up.
Permanent Life Insurance
Permanent life insurance will cover you for as long as you live if you keep up your premium payments. In addition to lifelong coverage, permanent life insurance policies also include a savings component that allows you to build their cash value. You may also be able to borrow money from the policy's cash value account and use it to pay your premiums. The savings you accumulate are tax-deferred.
Permanent life insurance comes in three basic categories.
Whole life insurance: This type of permanent life insurance provides a fixed death benefit and cash value growth at a guaranteed rate of return. It's the most common type of permanent life insurance. Burial or final expenses insurance is a type of whole life policy that pays a small death benefit meant to cover only those end-of-life costs. Simplified issue and guaranteed issue are two types of whole life insurance that don't require a medical exam — the application for simplified issue life insurance includes a medical questionnaire in lieu of an exam, while there is no medical underwriting at all for guaranteed issue life insurance.
Universal life insurance: Sometimes called adjustable life insurance, this kind of policy offers more flexibility than whole life. Some policies allow you to increase the death benefit if you pass a medical exam or let you lower your premium payments after you've built up enough cash value to cover the cost. Most universal life policies offer a savings component that earns a money market interest rate. A subcategory called indexed universal life insurance ties its cash value earnings to a stock market index such as the S&P 500.
Variable life insurance: This type of coverage lets you invest your cash value account in stock, bonds and money market mutual funds. With that provision, you have both the potential to grow the policy's value quickly if your investments do well and the risk of decreasing its value if the investments do poorly. Some variable life policies include a guarantee that your death benefit will not fall below a certain level, no matter how the market performs.
Now that you know how the different types of life insurance work, the next step is to figure out what kind of policy is best for your needs.
How Do I Choose the Right Type of Life Insurance?
Term life insurance might be a good choice if:
You need a large amount of insurance on a limited budget.
You're looking for insurance to cover you during your working years and provide a death benefit that will replace your income for family members who depend on it.
You want to leave funds for your loved ones to pay your debts or other expenses — like your children or grandchildren's college educations — that will occur within a specific time period.
Permanent life insurance might be a good choice if:
You want the additional savings element that allows you to grow and use the cash value of your insurance policy while you're still living.
You can afford the higher premiums compared to term life insurance.
You want a small amount of insurance to cover your final expenses.
You need a "no medical exam" option because of your health condition.
How Do I Choose the Right Amount of Coverage?
Follow these steps to calculate the amount of coverage you need your life insurance policy to provide:
Estimate the financial needs your beneficiaries will have after your death. These might include paying for your funeral and other final expenses, repaying your debts and replacing your income.
Consider what other financial resources your loved ones will have available to them, including survivor Social Security and retirement plan benefits, group life insurance and other assets.
Subtract the amount of your beneficiaries' financial resources from the amount of their financial need. Your life insurance policy should have a death benefit large enough to cover the difference.
You have lots of options when buying life insurance. The most useful answer to "How does life insurance work?" depends on what you decide is best for your unique situation.