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What Is Life Insurance and How Does It Work?


Understanding how life insurance works is important for almost any stage you’re in as an adult. Having this type of insurance brings peace of mind that any financial hardship for your family will be minimized if you should pass away. So what is life insurance? Keep reading to find out how it works, what’s typically covered (and not covered), and the types of life insurance you can choose from.

Life Insurance Explained

Life insurance is a financial planning tool that can leave a lump sum of cash to your beneficiaries after you pass away. Having a life insurance policy in place can help your surviving family members in a number of ways, such as paying final expenses like your funeral costs or federal and state estate taxes.

A life insurance death benefit may also help replace your lost income for your family or pay off debts like a mortgage or auto loan. It could also be used as a cost-effective way to leave an inheritance to your chosen beneficiaries.

How Life Insurance Works

Like any insurance policy, you’ll pay a premium in exchange for a payment disbursed to your heirs after you pass away (also known as a death benefit). In other words, you’ll pay a set amount either every year or every month. If you pass away while your life insurance policy is active, your beneficiaries will receive a death benefit. The higher the death benefit, the more you’ll pay for the policy. 

Other factors influencing the cost of your life insurance policy include whether it’s a term or permanent policy (more on that soon), your age, and your health. Some insurers may require a health exam as part of the application process to set your premium rate.

 How does life insurance pay out once you have a policy in place? You’ll list one or more beneficiaries — those are the people who receive the pay out if you pass away. If and when that happens, your beneficiary needs to file a claim with the life insurance company. After the claim review process, the insurer issues the death benefit payout. 

What Life Insurance Covers

Almost all types of deaths are covered by your life insurance policy. In addition to natural causes, most life insurance policies also cover accidental deaths, suicide (unless the death occurs during an exclusionary window, which is an introductory time period), and murder.

However, most insurers do include a list of exclusions. If the cause of death is due to one of those reasons, your beneficiary won’t receive the death benefit or any type of reimbursement for the premiums you paid over the years.

Your beneficiary could lose out on your death benefit if you allow your policy to lapse by not paying the premiums. Fraud and criminal activity can also nullify your policy, as can death caused by certain high-risk activities, like skydiving, flying private airplanes, scuba diving, and mountain climbing. You may need to purchase an additional policy if you partake in these types of activities. 

Types of Life Insurance

There are several types of life insurance to choose from, which impacts the details of your policy. Here’s a brief overview of the two primary types of life insurance.

Term life insurance: Term life insurance gives you coverage for a set period of time, usually up to 30 years. It’s a straightforward policy that offers a death benefit in exchange for your premium payment. It’s usually less expensive than permanent life insurance since it only lasts for a certain length of time.

Permanent life insurance: Also called whole life insurance, permanent life provides you with coverage for your entire life. That means you enjoy a fixed premium amount no matter how old you get. There are many subsets of permanent life insurance that offer different types of policy structures. Universal life, for instance, includes a cash value account that earns interest. You can later use that money to lower your premium payments. Another option is variable life, which includes an investable savings component. The value may grow more aggressively, but is also subject to riskier market fluctuations. 

Final Thoughts

Life insurance can be a useful financial tool for almost anyone. Wondering if you need a life insurance policy? Find out why purchasing a policy could be worth it.

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