How Does Life Insurance Work? (2024)

Life insurance is a contract between an insurance company and an individual. Its purpose is to provide financial support for the policyholder’s loved ones if the policyholder dies during the plan term.

The policyholder agrees to make regular premium payments and names a beneficiary—typically a spouse, child or another dependent. In return, the insurance company agrees to pay a certain amount of money to the beneficiary when the policyholder dies. 

Depending on the type of policy, this agreement remains in effect as long as the premiums are paid (for permanent life insurance) or until the term expires (for term life insurance).

During their lifetime, policyholders pay premiums to their life insurance provider. Once the policyholder dies, the insurance company pays out the death benefit to the beneficiaries.

To understand what all this means, it may be helpful to define a few key terms.

• Policyholder: The policyholder is the person who purchased the life insurance policy and is responsible for paying the premiums. The policyholder is almost always the insured. However, it is possible to take out a policy on another person with whom you have a relationship, such as a spouse, child, parent or business partner. However, doing so requires the consent of the insured.
• Beneficiaries: The beneficiaries are the people or organizations who will benefit from the life insurance policy. The policyholder can name a single beneficiary or multiple beneficiaries. Most often, the beneficiaries will be individuals, typically family members. However, you may also name a charity, business or trust as the beneficiary.
• Premiums: The premium is the amount the policyholder must pay to maintain the policy. Premiums may be paid monthly, quarterly or annually, depending on the policy. If the policyholder falls behind on these payments, the policy will lapse, leaving the policyholder uninsured and preventing your beneficiaries from receiving death benefits.
• Death benefit: The death benefit is the amount that will be paid to the beneficiaries upon the insured’s death. The death benefit may also be referred to as the face value or the coverage amount.
• Cash value: Some permanent life insurance policies have a cash value in addition to the face value. The cash value functions as a savings or investment account that earns interest. As the cash value grows, the policyholder can borrow against it to take out a loan. Some types of policies allow the policyholder to use the cash value to adjust premiums or death benefits. Typically, the cash value goes to the insurance company after the policyholder’s death and will not be paid to your beneficiaries.

What Does Life Insurance Cover?

Life insurance provides financial protection to your loved ones in the event of your death. All life insurance policies pay a death benefit to beneficiaries of your choosing after you’re gone. Some plans, usually permanent life insurance policies, also feature a cash value component you can take advantage of while you’re alive.

Once a death benefit is provided to your beneficiaries, they can use the payout for anything. Typical financial obligations after a loved one’s death include funeral expenses, medical debt, mortgage payments, tuition and everyday living costs.

Do you have loved ones who rely on you for financial support? If not, do you plan to one day get married or start a family? If so, investing in life insurance may be something to consider.

If you’re the primary or sole breadwinner of a household, your dependents could be left with debt they can’t pay after you’re gone. A life insurance payout can go toward any number of outstanding expenses like mortgage payments, credit card debt and even daily lifestyle costs.

If you own a business with a partner(s) who would be financially impacted by your death, life insurance might be a wise investment to cover expenses or debts in your absence. Even if nobody else relies on you financially, life insurance might be a good idea. For example, if you don’t have the savings to cover your debts or death expenses, life insurance can make sure a family member won’t be burdened with those costs.

We recommend consulting a licensed financial advisor or life insurance agent to determine whether you need life insurance.

Life insurance comes in two main types: term life insurance and permanent life insurance. Which one you choose depends primarily on your needs and budget. If you want coverage that lasts your entire life, choose a permanent policy. If you need a budget-friendly option, consider a term policy.

Term Life Insurance

Term life insurance provides coverage for a certain period of time, known as the term. This policy only pays out a benefit if the covered individual dies during the term. As a result, term life insurance tends to be more affordable than permanent life insurance, with a fixed rate that lasts for the entire term.

As the original term draws to a close, you may have three options for continued coverage:

• Let the policy expire and replace it with a new policy
• Renew the policy for another term at an adjusted rate
• Convert your term life insurance to whole life insurance

Not all term life insurance policies are renewable or convertible. Some policies include a decreasing term, which means the coverage decreases over time. Although the term for most policies will be a predetermined number of years, such as 20 or 30 years, there are some exceptions. Below are a few examples.

• Group life insurance: This is the complimentary life insurance typically offered by an employer. You choose your beneficiaries and have coverage as long as you are an employee or group member.
• Supplemental life insurance: An employer often provides this coverage as an add-on to complimentary group life insurance.
• Mortgage life insurance: This type of policy, which lasts until a mortgage is paid in full, covers a mortgage’s full or partial balance if the borrower dies before paying it off.
• Credit life insurance: This type of policy also lasts until a debt is paid in full, with the payout going to the lender instead of the survivors paying the balance.

Group Life Insurance

The complimentary life insurance you receive through your employer is a type of group life insurance. Group life insurance might also be provided by your church or another organization to which you belong. Although the employer or organization is the policyholder, covered individuals choose their own beneficiaries. Coverage is typically guaranteed but only lasts as long as you belong to the group or remain employed at the company providing the coverage as an employee benefit.

Supplemental Life Insurance

Supplemental life insurance is often available as an add-on to group life insurance. Supplemental coverage is usually cheaper and easier to obtain than other types of insurance, but, as the name suggests, it is meant to supplement rather than replace an individual policy. Most supplemental life insurance policies expire when the associated group life insurance does. That means you will likely lose this coverage when you leave or lose your job, stop paying dues or otherwise sever ties with the group policyholder.

Additionally, supplemental coverage is typically limited and sometimes requires medical underwriting.

Mortgage Life Insurance

Mortgage life insurance covers a mortgage’s full or partial balance if the borrower dies before paying it off. This type of policy lasts until the mortgage has been paid in full. Although it is designed to protect the borrower’s family from the burden of mortgage payments, the beneficiary is actually the mortgage lender. Mortgage life insurance does not require a medical exam.

Credit Life Insurance

Like mortgage life insurance, credit life insurance covers a specific debt and lasts until the debt has been paid. Typically, the premiums for this insurance are rolled into the loan payments. The payout goes to the lender rather than any survivors to pay off the remaining balance. Because credit life insurance is so targeted, it is easier to qualify for than other options.

Permanent Life Insurance

As long as the policyholder pays the premiums, permanent life insurance never expires. Because it covers the insured’s entire life, premiums are higher than a term life insurance policy. These policies typically have a cash value that grows over time.

Read more about the different types of permanent life insurance below.

Whole Life Insurance

Whole life insurance is what most people think of when they consider permanent life insurance. It pays out no matter when the policyholder passes away and has a cash value that increases over time, similar to a savings account. 

While the policyholder is still alive, he or she can draw on the policy’s cash value. However, a withdrawal from the cash value functions like a loan and must be repaid with interest. If the policyholder dies before repaying the loan, the insurer will deduct the remaining principal and interest from the death benefit before paying any beneficiaries.

Universal Life Insurance

Universal life insurance, also known as adjustable life insurance, may differ from whole life insurance in three ways:

• Flexible premiums: The policyholder may be able to adjust their premiums and death benefit as needed, within certain limits. 
• No fixed rate: The interest rate may rise and fall based on market conditions, though the policy does guarantee a minimum rate. 
• Decreasing premiums: The cash value can become high enough to cover the policy premiums, leaving the policyholder with zero out-of-pocket costs.

The terms of universal life policies vary. Before purchasing a universal policy, be sure to understand exactly what it does and does not guarantee and how the costs and benefits might change over time.

Variable Life Insurance

Like other types of permanent life insurance, variable life insurance carries both a death benefit and a cash value. The key difference is the policyholder’s ability to invest the policy’s cash value. Depending on the performance of that investment, the cash value may rise or fall over time. Throughout all this, the policyholder must maintain a high enough cash value to cover any policy fees. Otherwise, the policy will lapse.

If investments perform poorly, the policyholder may need to pay higher premiums to make up the difference and avoid a policy lapse. On the flip side, the earnings from a high-return investment could cover some or all of the premium costs. Another benefit is that, unlike with most policies, the cash value of a variable policy can be added to the death benefit.

Final Expense Life Insurance

Final expense life insurance, also known as burial or funeral insurance, is meant to cover bills that will be charged to the policyholder’s family or estate. Examples include medical and funeral costs plus any unpaid debts, such as a mortgage or credit card balance. Because the death benefit typically falls between $5,000 and $25,000, this coverage may be less expensive and easier to obtain than other permanent life insurance policies.

Survivorship Life Insurance

A survivorship life insurance policy covers two people, typically two spouses. As a joint policy, it does not pay out until both covered individuals have died. This type of policy may cost less than two separate policies. It is a particularly attractive option if one party has health issues that make an individual policy unaffordable. However, it is less common than other types of permanent life insurance.

The cost of life insurance can vary dramatically based on several factors. The most obvious factors are the type of policy you choose, your age and your health. As noted above, term life insurance policies are generally more affordable than permanent ones. However, prices can vary even within those categories. The longer the term and the higher the coverage amount, the more a policy will cost.

Further, certain factors can cause the same policy to cost significantly more for one person than another. Insurance companies base their rates on how soon or likely a payout might be. As a result, anything that might lower your life expectancy or increase your risk of serious illness or death will negatively impact your life insurance rates.

• Age: As you age, it becomes less likely that you will pay enough to cover the full death benefit of your policy. This makes you riskier to insure and leads to higher premiums.
• Gender: According to 2021 data from the National Center for Health Statistics (NCHS), the life expectancy for males in the U.S. is about 6 years shorter than that of females. As a result, life insurance rates tend to be higher for males than females. One exception might be if you obtain insurance during a high-risk pregnancy.
• Height and weight: Insurance companies may ask for your height and weight to calculate your body mass index (BMI), a measure of body fat. According to the Centers for Disease Control and Prevention (CDC), a high BMI is associated with an increased risk of several diseases and health conditions, including heart disease and stroke.
• Past and current health: You can expect insurers to seek information about your current health and medical history. Certain preexisting conditions may lead to higher rates or a denial of coverage. Depending on the company and policy type, you may also have to submit medical records or undergo a medical exam.
• Family medical history: Insurers may ask about your family’s medical history to determine your risk of certain hereditary diseases. For instance, if one or more of your immediate family members have been diagnosed with cancer or diabetes, you carry a higher risk of developing those conditions.
• Occupation and hobbies: People who work in dangerous professions or regularly engage in high-risk recreational activities can expect to pay more for life insurance. Examples include active-duty military members, first responders, miners, construction workers, race car drivers, rock climbers and skydivers.
• Substance use: Smoking and tobacco use can heavily impact your rates because of the associated health risks. Likewise, a history of alcoholism, heavy drinking and other types of substance abuse will result in higher rates. Marijuana use, even for medical reasons, may also be considered a risk factor.
• Other lifestyle factors: Insurers might also consider your driving record and financial history as they evaluate your risk. A criminal background or frequent international travel may also weigh against you. Although a single incident might not disqualify you, a pattern of risky behavior could.

Some of these factors, such as your age and family medical history, are outside your control. However, you can make lifestyle changes to improve your health and obtain lower life insurance rates.

Generally, the younger you are when you apply for life insurance, the less expensive it will be. You can also lower your rates by avoiding high-risk activities, proactively managing preexisting conditions and maintaining a healthy lifestyle.

As you shop for a life insurance policy, your needs and budget will play major roles in selecting coverage. Age is the most important factor in getting accurate life insurance quotes, along with your health history and lifestyle.

How much coverage do you need? If you have dependents or a spouse who would be impacted financially in the event of your death, here’s a basic rule of thumb: Calculate your annual income by how many years your family would need support, then add any anticipated debts. Subtract total savings and other assets, and you have your total coverage need.

Term life insurance could be your best option if budget is the biggest concern, or if the rates quoted for permanent life policies are more than you can afford. We recommend working with a licensed life insurance agent who can walk you through plan options, pricing and the fine print of various policies.