What Is Life Insurance And How Does It Work?

Life insurance is a way for you to avoid significant financial strain for yourself and your family. Most people underestimate the cost of funeral services or end-of-life care.

By not carefully choosing the right policy, your family might be forced to go into debt in order to cover remaining mortgage payments, credit card debt, or funeral expenses. This article will explain what life insurance is, which policies are available to you, and how it works.

Life insurance is a contract with an insurance provider that promises to pay your beneficiary a sum of money when you die. Depending on the contract you have, you can also trigger benefits if you are diagnosed with a terminal illness or disability or need long-term care.

What Is Life Insurance Used For?

Life insurance covers different expenses, replaces lost income, or supports your family members after you pass away. People use different policies for several reasons, such as:

1. Paying off a mortgage
2. Covering college tuition for children
3. Building retirement savings
4. Paying off student loans or credit card debt
5. Covering the end of life expenses
6. Leaving an inheritance to children
7. Providing financial security for the family while they grieve

Life insurance policies can provide financial security to your loved ones in the event that you pass away. You can choose a policy that offers enough coverage for funeral expenses, to replace your lost income for a few years, or to pay off a specific debt. There’s a great deal of flexibility which means you can find a policy that fits your needs.

The premium functions the same as any other insurance premium: there is a specific amount that you have to pay every month.

If you fail to pay your premium, it could result in your policy being canceled, in which case you might have to apply for a new policy all over again.

Some policies provide cash value, where some of your money is put into an account that you can take out before you die or use as collateral for a loan. If you use your cash value, that comes out of the total death benefit amount.

For example: If Terry has a policy for $250,000 with a cash value account, and she uses $50,000 total before she dies, her beneficiaries will only receive $200,000.

What Does Life Insurance Cover?

It will cover several situations that may cause your death, including:

1. Death by natural causes
2. Death because of an accident
3. Suicide after the first two years of your policy
4. Illnesses
5. Homicide (without beneficiary involvement)
6. Injuries

What Does Life Insurance Not Cover?

Less than 1% of life insurance claims are denied, according to the Insurance Information Institute.

Still, knowing what circumstances will void your death benefit is important.

1. If you lie on your application and the company finds out, your death benefit will be voided.
2. If you engage in risky activities (including a risky job), that might not be covered.
3. If you are murdered, but your beneficiary was involved, say goodbye to coverage.
4. Your beneficiaries won’t get anything if you engage in illegal activities that cause your death.
5. You are also not covered in the event of suicide within the first two years of your policy.
6. You won’t receive a death benefit if your policy expires and you do not renew or take out a new one.

Types Of Life Insurance

There are several types of life insurance policies. All policies fall under one of two categories: Term or Permanent.

Term Life

Term life is a policy that applies to a specific term or length of time. It is one of the least expensive forms of coverage and the easiest to get, especially if you have pre-existing medical conditions.

Within this category, there are several variants. For example:

• Decreasing Term Life: With this policy type, you have a decreasing death benefit. This is best for people who want coverage for specific debts like a mortgage but want the death benefit to decrease as they continue to pay off that mortgage.
• Convertible Term Life Insurance: This is a policy that lets you convert your term policy into a permanent life insurance policy at the end of the term.
• Return of Premium Term Life: This type of policy refunds any payments you have made if you outlive your policy term. Note that because you are refunded all your premiums, your premiums will be much more expensive than regular term policies.

How Term Life Insurance Works

When you take out a term life insurance policy, it has a set number of years before it expires. Every month you pay premiums toward that policy, and if you pass away during the “term,” the company will pay your death benefit to your beneficiaries.

What Does Term Life Insurance Cover?

Term life insurance doesn’t have as many riders as a permanent policy, so it will cover a lump sum or annuity paid to your beneficiaries.

When To Get Term Life Insurance?

Term life insurance is best for people who want cheaper premiums but are young enough that they still have expenses beyond burial expenses that they want to cover with their death benefit.

What Are The Pros And Cons Of Term Life Insurance?

Term policies are typically much less expensive. However, they also have an expiration date, so once they expire, if you need additional coverage, you will be at a disadvantage because of your age and possible health problems.

Permanent Life Insurance

As the name suggests, permanent life insurance is a policy that lasts your entire life. It is a permanent policy so long as you continue paying your premiums. There are several variations, each of which comes with things like cash value accounts or the opportunity to add riders.

Whole Life Insurance

Whole life insurance is the most common permanent life insurance. It has a cash value account that earns a fixed-rate interest. It’s best for people who want to prepare for the cost of long-term care.

Universal Life Insurance

Universal life insurance gives you more flexibility because you can increase or decrease the amount of money you put toward your premiums. You also get to choose a monthly or annual premium.

People who might have reduced expenses over time and be able to put more money toward their premiums can choose to do so with this type of policy. It also has a cash value account, but it comes with an investment risk because that interest is earned based on the market.

Variable Life Insurance

Variable policies let you invest the cash value, which means there’s a much higher potential for losing money if your Investments don’t perform well, but you also have the potential gain of Investments performing very well.

Final Expense (Or Burial) Life Insurance

Final expense policies are the least expensive out of the permanent life insurance plans, and they are designed simply to cover the cost of your burial. They’re great for people with serious health conditions who might not qualify for other policies, they don’t require a medical exam, and they have much lower premiums.

Comparing The Major Types Of Life Insurance

There are several factors you need to consider when comparing the major types of life insurance.

Which Life Insurance Policy Is Right For Me?

Picking the right life insurance policy is completely contingent upon your circumstances. You need to consider your family’s needs right now and in the future, what costs they might incur when you pass away, and what you want to leave behind.

Term

Term life insurance is best for people who only want to provide financial coverage for a specific length of time. The most common examples include setting up enough money to cover a mortgage or pay for kids to go to college. These are things that only last a specific length of time and once the house is paid off or the kids have gone to school, that financial need no longer exists.

Permanent

Permanent life is better suited for people who want to have coverage for the rest of their lives and not worry about unexpected health changes or increases in premiums. People who have a genetic history of debilitating diseases might be better off choosing a permanent plan while they are still healthy as this can guarantee coverage but after a serious disease manifests coverage may not be possible.

Permanent plans are better for people who want to add riders too, like disability protection in the event that they become disabled at any point or long-term care. This is a great plan for people who want to add child riders and keep their children protected.

Burial

Burial insurance is best for people who are on a significant budget or just need to have enough coverage to cover final expenses. for some individuals burial insurance might be the only option because of age or health but it’s still better than no coverage.

What Affects Your Costs And Premiums?

Life insurance is priced based on when you are expected to die. Insurance companies use actuarial life tables to set prices on policies. These consider occupation risks, smoking, socioeconomic status, debt load, health, and age.

There is a lot of math that goes into predicting when you will pass away, and it’s based on things like:

Your Current Age

Insurance companies are, at their core, businesses. So they have to budget how much they expect to pay out every year and the older you are the more likely you are to pass away sooner rather than later.

Your Health

Those same actuarial life tables calculate how soon an insurance company can expect to pay out a death benefit based on health. This is a very detailed analysis. When you apply for a life insurance policy and admit that you are a smoker, for example, you will be asked exactly what types of tobacco products you smoke, how often you smoke, the last time you smoked, how many of each item you smoke, and so forth.

They ask for similarly detailed information about any health issue you might have even if it was something as small as asthma with which you were diagnosed in childhood. Each of these questions helps them determine when you are likely to pass away and when they are likely to have to pay your death benefit.

Your Lifestyle Choices

Lifestyle choices contribute to your risk as well. If you have a job like pilot where there is a high risk of accidents, that influences when you are likely to pass away.

Your Finances

Financial strain or gambling can affect your likelihood of things like paying premiums on time, needing to change your policy, and dealing with chronic stress.

Your Hobbies

If you like to participate in risky hobbies like sailing or rock climbing, that influences your risk of dying prematurely and, by extension, your premiums.

Who Needs Life Insurance?

Plenty of people might need life insurance. If you have a spouse or children who live off your income, they might not be able to sustain their lifestyle if you pass away.

If you or your family contribute to the costs of care for an aging relative, you might need a life insurance policy to continue providing that care in the event that you pass away. Life insurance can benefit anyone whose family may not be able to cover the cost of a funeral.  The median cost of a funeral in 2023 is $7,848, according to USA Today.

Do You Need Life Insurance After You Retire?

There are several situations where maintaining life insurance in retirement is a good idea. However, it is up to you to determine your current financial needs, what (if anything) you have to pass on to heirs, ongoing costs, and the premiums you pay in exchange for all that.

• If you want to leave an inheritance or have money to cover estate taxes, life insurance can help you achieve that even in retirement.
• If you are retired but still have debt like an existing mortgage or car payments, a life insurance policy can give your beneficiaries the money to cover any existing debt.
• If you already have a cash-value permanent life insurance policy, you might have to face tax consequences for canceling, in which case maintaining your existing policy could be the better option.

When Should You Get Life Insurance?

You should consider getting life insurance when you face certain life events like buying a new home, getting married, getting divorced, or having children. You need to consider that the type of insurance you get, or the amount of coverage you want, might change throughout several stages in life, which you can accommodate with certain riders.

• Several pre-existing health conditions or career fields are designated as substandard risk. If you are listed as a substandard risk during your initial application, that does not mean you can’t get life insurance. It does mean that your options are more limited. For people with severe health issues or high-risk jobs who are a substandard risk, the only available option might be final expense insurance.

• If you have a pre-existing condition or history of legal issues, you can speak with several companies to see which companies offer the best policies. Some examples include:
  • Bad driving record
  • Felonies or misdemeanors
  • Depression/anxiety
  • Diabetes
  • Cancer
  • Dementia
  • Asthma
  • Sleep Apnea
  • Pulmonary heart disease
  • Weight issues

Note: If you have a pre-existing health condition, your biggest challenge will be with the premiums you are given. Your condition’s severity, current health history, and family history will influence the rates you receive.

• Approval can take anywhere between a few days and a few months. If you don’t have pre-existing conditions, approval is generally much faster.

• When you apply, you’ll submit basic information like your name, your address, and where you work as part of your application. You will also be asked about your height, weight, lifestyle habits, health history, medications, annual income, risk-related hobbies, and any history of criminal convictions.
• You won’t have to pay anything when you apply, but you will have to start paying your premiums once your policy goes into effect.

How Much Life Insurance Do You Need?

You can figure out how much insurance you need in several ways. In general, you just want to write down how much of your income you want to replace for your beneficiaries and for how long. You can figure this out by adding up your current and future expenses.

You’ll want to throw the balance of your mortgage on top of that so that you know your family will be able to continue living in your home after you pass away.

If there are any other debts you want to cover, add those into the calculation, and if you decide you want to pay for college or other education costs for your children, throw those in for good measure.

Let’s look at a few examples:

Matt

Matt is 38 years old with a wife and no children. He recently bought a house for $230,000, putting $50,000 down in Louisiana. The couple owned the house for one year and paid off $18,000.

So the outstanding balance on the mortgage is $162,000. Their car is paid off. Their monthly bills come to an average of $350.

Matt wants to ensure that his wife can cover funeral costs (around $20,000), the remainder on the mortgage ($162,000), their credit card debt ($32,000), and the cost of living for 3 years while she grieves for which he has allotted $20,000 for bills and groceries.

In total, he needs a policy that offers a $234,000 minimum. He opts for $250,000 with a MassMutual life insurance agent in Louisiana to be on the safe side.

Trent

Trent is 42 years old with a wife and three kids (12, 15, and 17) living in L.A. He paid $470,000 for his home, put $20,000 down, and has been paying into it for years. He still owes $320,000. He owes $12,000 on the first car and $22,000 on the second car. His family has $27,000 in other debt. Monthly bills amount to $1,100.

Trent wants to ensure his family can pay off the home if he passes away, live for a few years without worrying about returning to work, and that his children will have some money for college. So Trent needs $450,000 in coverage plus $100,000 per child. In total, he takes out a life insurance policy with Nationwide agent in L.A for $750,000.

Tina

Tina is 70, divorced, with no children and no debt. She has owned her house in Dallas for decades. She only wants enough money to ensure her younger sister can cover the funeral service costs. So, for Tina, $20,000 for final expense life insurance with Transamerica in Dallas might be the best option.

What Is A Life Insurance Beneficiary?

A life insurance beneficiary is the person who receives the death benefit when you pass away. As the policyholder, you get to decide who the beneficiary is.

According to the Insurance Information Institute, there are two “levels” of beneficiaries: Primary (the one who gets the death benefit) and Contingent (the one who gets the death benefits if the primary isn’t found).

A beneficiary can be:

• A single person
• Multiple people
• A trustee who is responsible for a trust you create
• An estate
• A charity

Your death benefit goes to the estate if you don’t name a beneficiary.

While it’s not a requirement, it is important to name your beneficiary and identify them as clearly as possible. Before your death benefit is paid out to any beneficiary, the insurance company has to verify their identity. Providing information like their social security numbers can make it a lot easier for the insurance company to track them down and confirm who they are.

If you just write something like “my wife” and don’t use a name, getting the death benefit to the right party can be much more challenging, especially if you have exes.

Life Insurance Riders And Policy Changes

Riders are add-ons, things you can add to your existing policy. Think of them like the side dishes you can get to bolster your entrée. You start with the steak, then you pick from the broccoli, mashed potatoes, mac and cheese, or Brussels Sprouts.

Only, with life insurance, you start with your policy and pick things like coverage for your kids or your spouse, long-term care, or disability protection.

Life Insurance With A Long-Term Care Rider

Life insurance with a long-term care rider is designed for individuals who prioritize life insurance but also want to account for the potential cost of long-term care.

Let’s consider the example of Matt above. If Matt, in his older years, is no longer able to care for himself, a long-term care rider makes it possible for him to use some of his benefits to cover live-in nurses, the costs of a nursing home, or a long-term care facility.

Note: Most term life insurance policies do not provide long-term care riders.

Can You Increase Life Insurance Coverage Later On?

Consider the example of Trent above.

Trent recently had a birthday, and he is now 48. His oldest child graduated college, got married, and recently had their first child. His middle child graduated college but just started a master’s degree. The youngest is still in college.

Trent has paid off more toward his mortgage and paid off the cars but now has additional debt in the form of student loans to help his children. His oldest child is trying to buy their first house and wants help with that.

With a benefit increase rider on a permanent life insurance policy, Trent can make changes to his coverage at certain intervals, like the birth of his first grandchild, the marriage of his oldest child, and other major life events. He can update his policy to provide more accurate coverage based on the changing circumstances.

How To Choose The Right Policy Type

As you can see, there are several types of policies, and finding the right one takes time.

Research Policy Options And Company Reviews

Start by researching different policy options and figuring out which one you think will be a good fit for your circumstances. Research the policy options, including the riders from various companies. Not all companies have the same options.

While doing your research, check out company reviews and see what other people have said, especially about the claims process, adding or removing riders, and customer service.

Consider How Much Death Benefit You Need

Take the time to do the calculations for what you want your policy to cover. Be sure to account for anything you want to leave, not just to your spouse but to your children and potential grandchildren.

Know Why You Are Buying Life Insurance

If you only want to make sure that your family is covered in the event that you pass away unexpectedly while still paying off the house or while the kids are still living at home, a term policy might be the best option for you.

If, instead, you plan to leave your house to one of your children and your business to another, a robust life insurance policy might provide an inheritance for a third child.

Common Life Insurance Terminology

There are several terms you might encounter when reviewing a life insurance policy or looking at your benefits, and understanding each of them can make it easier to figure out what it is you’re actually paying for and what else you might need.

• Accelerated Death Benefit Rider: This is a rider you can add to a policy that pays out a portion of your death benefit if you are diagnosed with a terminal illness, and it pays it prior to death.
• Annuity: A contract that gives beneficiaries income on a regular basis, like monthly or annually.
• Beneficiary: The person who receives life insurance proceeds upon the death of the person who took out the policy.
• Burial Insurance: Sometimes referred to as final expense insurance, this is a policy used to cover end-of-life expenses, such as the cost of your funeral.
• Cash Surrender Value: This is the amount available in cash if a policy owner decides to voluntarily terminate the contract before they die.
• Cash Value Life Insurance: This is part of a permanent life insurance policy that functions similarly to a savings account. It accumulates money over the lifetime of your policy which you can withdraw at any time. You can also use it as collateral if you have to take out a loan. When the policyholder passes away, any money remaining gets paid out to beneficiaries.
• Contestability Period: If you take out a policy and die within the first few years, there is contestability. During which time the insurance provider can review the claim for fraud and deny the claim if they find any evidence.
• Critical Illness Rider: This is an add-on for a policy that provides a lump sum payment if you are diagnosed with a critical illness such as cancer, stroke, heart attack, or kidney failure.
• Death Benefit: This is the untaxed lump sum that is paid out to a beneficiary upon death.
• Disability Income Rider: This is a writer you can add to a policy that provides monthly stipends if you become disabled and cannot work.
• Effective Date: This is the date that your policy becomes effective. If you take out a policy and you pass away before that date, the benefits are not paid out.
• Exclusions: Exclusions are usually listed in your policy, and they cover any reasons why your benefits would not be paid to the beneficiary, such as suicide, death related to illegal activity, or omitting information.
• Lapsed: This is when a policy is terminated because you failed to pay your premiums.
• Long-Term Care Rider: This is an add-on to a policy that allows you to withdraw money from your total death benefits in order to cover the cost of long-term care.
• Permanent Life Insurance: This is a policy that remains active for your entire life with a cash value component. It is one of the most expensive forms of life insurance.
• Policyholder: This is the individual who owns the life insurance policy. Only policyholders are allowed to make changes to an existing contract.
• Premium: This is the amount of money paid every month toward the insurance.
• Rider: These are add-ons that you can apply to an existing life insurance policy at an extra fee to provide more comprehensive coverage.
• Standard Risk: If you apply for life insurance and you have an average life expectancy, you are considered a standard risk.
• Substandard Risk: If you apply for life insurance, but have a below-average expectancy because of health problems, habitual smoking, or other factors, you are considered a substandard risk. This rating will directly increase your premiums.
• Term Life Insurance: This is a policy that has a set term length, usually between 5 years and 30 years.
• Universal Life Insurance: This is a form of permanent life insurance that allows you to adjust your premiums based on your finances.
• Variable Life Insurance: This is a whole life insurance policy that has a cash value associated with investments. That cash value can diminish based on investment returns, so there are higher premiums because of the risk.
• Waiver of Premium Rider: This is an add-on that states you won’t be responsible for paying your premiums if you become disabled and are unable to return to work. However, if your disability comes to an end, you’ll be expected to resume premium payments.
• Whole Life Insurance: This is a form of permanent life insurance that usually comes with a tax-deferred savings account.