What Is Life Insurance & How Does It Work?

Life insurance provides financial security and protection for your spouse, children, or anyone you designate as a policy beneficiary. Upon your death, these beneficiaries receive a sum of money called a “death benefit,” which can be used to pay off a mortgage or other debts, fund higher education, handle day-to-day expenses in your absence, or anything else.

There are several things to consider when buying life insurance, including what a policy covers, which type of policy best suits your needs, how much insurance to buy, and the cost of a policy.

What does life insurance cover?

Your beneficiaries can use the policy’s death benefit for various expenses. These may include:

• Medical costs, funeral costs, and other expenses related to the end of your life.
• Educational costs.
• Mortgage, car loan, credit cards, and other debts.
• Day-to-day expenses.
• Inheritance.

In fact, there really are no restrictions on how a life insurance death benefit can be used.

Some policies also include a cash value feature. This acts as a sort of investment account that grows over time. You (while living) can access this money through loans or withdrawals to pay for expenses.

Types of life insurance policies

There are two main types of life insurance policy: term life and permanent life.

Term life insurance

A term life insurance policy is intended to stay in force for a set number of years, typically 10, 20, or 30. You choose this term when you buy the policy, with a longer-term policy costing more than a shorter-term one. You also choose the amount of your death benefit. The higher your death benefit, the more you can expect to pay for the policy.

You pay an annual premium to keep the policy in force. This premium remains stable for the policy term, making it easy to account for in a family budget. You can choose to cancel the policy at any time. The insurer may cancel the policy if you fail to make timely premium payments. The policy is discontinued when the term ends, although some insurers offer an option to extend the term.

Term life typically costs much less than permanent life insurance. It's also considered a much simpler type of insurance to understand and own due to the absence of a cash value feature.

Permanent life insurance

A permanent life insurance policy has no set term. It stays in force until your death unless you cancel the policy or the insurer cancels it for nonpayment of your premium. As with a term life policy, you choose your death benefit amount and designate beneficiaries.

You pay an annual premium, but that premium may vary from year to year based on the specific type of permanent life policy and the business needs of the insurance company. Permanent life insurance tends to cost much more than term life.

Permanent life insurance policies also include a cash value feature. This means a portion of your premium payments earn interest. You can access this money either by taking out a loan against the policy or through a withdrawal. Note that the insurer may deduct any outstanding loan balance from the amount of death benefit your beneficiaries receive.

The specific type of permanent life insurance you buy will dictate how the cash value earns interest.

Common types of permanent life insurance include:

Whole life

A whole life policy has a fixed premium and fixed death benefit. The cash value accumulates at a guaranteed, though modest, rate. You must use the cash value during your lifetime, as it typically will not be paid to your beneficiaries upon your death.

Universal life

A universal life policy has an adjustable death benefit and premium. This means you can change your death benefit as your needs change—though this will change the amount of premium you pay as well. The insurance company can also charge fees or raise your premium depending on its business needs.

The cash value of a universal life policy grows based on the performance of the stock market. Your potential earnings may be capped or subject to a minimum. Caps and floors minimize your losses, but they also limit your earnings in years the market performs strongly.

Variable universal life

A variable universal life insurance policy offers even greater control: The insurer lets you choose where to invest your cash value from a list of up to perhaps 30 investment options. Your returns may be subject to caps and floors. These policies are typically considered riskier than indexed universal life policies.

A variable universal life insurance policy also offers the option to have the cash value paid out to your beneficiaries (along with the death benefit) upon your death. This option costs extra in premium, however.

How to choose a life insurance policy type

Choosing the right type of life insurance means reflecting on your and your family’s needs and budget. When considering your choices, ask yourself the following questions:

How much life insurance can I afford?

Term life insurance can be significantly cheaper than permanent life insurance. A recent review by USNews.com showed just how much cheaper: The average monthly premium for a 30-year-old male seeking 20-year term life insurance with a $1 million death benefit is $63. Meanwhile, the average monthly premium for the same 30-year-old male and the same death benefit amount with a whole life policy is $831 per month. That’s at least 13 times more.

If you’re on a tight budget but want the financial protection of life insurance, a term life policy may be the best choice.

Do I need life insurance for only a set amount of time?

Think about how long you really need to have a life insurance policy in force. Perhaps you’ve just had a child and want to be sure they can afford college if you pass away. Or maybe you and your spouse have just bought a home with a 30-year mortgage. In these cases, a term life policy with a 20- or 30-year term may be all you need to provide your family with financial security.

Do I need cash value?

The cash value feature of a permanent life insurance policy may be appealing as an investment tool. Bear in mind, however, that many financial experts recommend first exploring other investment options, including maxing out your 401(k). Some experts, such as Dave Ramsey, flat-out advise against buying permanent life insurance, arguing that it’s unlikely you’ll ever actually benefit from the cash value feature.

Do I have special circumstances?

Families with unique circumstances—such as children with special needs who will always require financial support—may want to consider paying extra for permanent insurance.

Can life insurance help protect my small business?

Besides providing financial security for your family, permanent life insurance can help protect the continuity of your small business in the event of your death. By naming business partners as policy beneficiaries, you can ensure those individuals have the cash available to buy out your equity and reorganize the business.

Should I talk to a financial advisor?

There’s much to consider when choosing between term life and permanent life insurance. These can be complex financial products that require not only some level of expertise but an understanding of your financial goals. This is why it may make sense to talk to an independent financial advisor or insurance agent specializing in life insurance.

Factors that affect the cost of life insurance

The average cost of life insurance is based on various factors:

Your age

You may hear others recommend buying life insurance when you’re young. This is because younger people typically pay less for life insurance than older people.

Your gender

Because women have longer life expectancies than men, they typically pay less for life insurance.

Your family health history

You may pay more if you have a family history of heart disease, diabetes, cancer, or other life-shortening diseases.

The amount of coverage

Choosing a higher death benefit—say, $1 million instead of $500,000—will cause you to have a higher life insurance premium.

The policy type

As we’ve seen, you’ll likely pay much more if you choose a permanent life insurance policy over a term life policy.

Term length (term life policies only)

The longer the term, the more you can expect to pay in premium.

Your occupation and hobbies

If your job has a high fatality rate—or you enjoy risky hobbies, such as skydiving or race-car driving—you may pay more for life insurance.

Your health

Unless you opt for a no-medical-exam policy, such as those offered by Fabric Life, expect to take a physical exam when you apply for a life insurance policy. Chronic conditions such as high blood pressure, high cholesterol, or obesity can lead to a higher life insurance premium.

Tobacco use

If you smoke, you can expect to pay more for life insurance.

The average cost of life insurance

According to a recent study by USNews.com, the average monthly cost of a policy with a $1 million death benefit for a non-smoking policyholder with average health is as follows (age showed is the age at policy inception).

How to choose a life insurance coverage amount

Deciding how much life insurance you need is often challenging. Ideally, you choose a death benefit amount that provides your beneficiaries with the financial security they need at a price that works for your budget. Nobody wants to overpay—especially for insurance.

Here are some methods you can use to come up with a suitable number.

10X income formula

The 10X income formula is a way to get a rough idea of your death benefit. It's simple:

• Multiply your income by 10.
• Add at least $100,000 per child to cover the cost of college.

So, if you earn $100,000 and have three children, you’ll need about $1.3 million in life insurance coverage.

DIME formula

The DIME (debt, income, mortgage, education) formula is a slightly more involved method to estimate your life insurance coverage needs. It requires you to carefully consider your debts, income, mortgage payments, and education costs for each child. You add these figures to arrive at an adequate death benefit amount.

Life insurance calculator

You can find various online tools, such as calculators from Ladder Life, to help you estimate your life insurance needs. These tools use information such as your age, health, income, and family makeup to estimate a suitable death benefit.

How to get life insurance quotes

The fastest and most convenient way to get a life insurance quote is directly from the insurer. Companies such as Ladder, Ethos, and Everyday Life offer quotes online, 24 hours a day.

If you need some guidance, contact an independent insurance agent specializing in life insurance, or an independent financial advisor. These types of professionals can take time to understand your needs and budget, and match you with a policy that ensures your family will be financially secure.

How to choose a beneficiary

Choosing the proper beneficiary (or beneficiaries) is crucial when buying life insurance. Insurer State Farm offers the following tips:

• The beneficiary should have a legitimate financial interest in the insured person. Your dependent children, for instance, have a financial interest in you because they rely on you as the family breadwinner.
• Create a trust if the beneficiary is a minor.
• Name a secondary beneficiary as a contingency in the event the primary beneficiary should die before the death benefit payout can happen.
• Consult an attorney to ensure that your choice of beneficiary follows state laws.
• Avoid naming your estate as the beneficiary; doing so means the death benefit may be subject to probate.

TIME Stamp: Life insurance is essential

Thinking about your death may not be a pleasant exercise. But planning for it is crucial, especially if others depend on you financially. Life insurance can help you provide security to the ones you love, even if you’re no longer with them.

Frequently asked questions (FAQs)

Is a life insurance death benefit taxable?

According to the U.S. Internal Revenue Service (IRS), life insurance death benefit proceeds generally do not need to be reported as income and thus are not taxable. To be sure, use this tool provided by the IRS. It may also be wise to consult with a certified tax preparer to fully understand your responsibilities related to your life insurance payout.

Is a life insurance death benefit payout subject to probate?

Typically, a death benefit paid to a beneficiary does not go through probate.

How do my beneficiaries file a life insurance claim?

Filing a life insurance claim is a fairly straightforward process. The beneficiary should procure a copy of the policyholder’s death certificate, a copy of the policy, and a copy of the insurer’s request for benefit form, then contact the insurance company and report the claim. The company’s claim representative should be able to answer any questions and guide the beneficiary through the process. Finally, the beneficiary can wait for the payout, which may take anywhere from a few days to several weeks.