How Does Life Insurance Work?
Updated: Jul 7
Your life insurance policy should be tailored to your needs. If you are considering enrolling, read this guide first to understand how life insurance works.
When you are shopping around for life insurance, the last thing you want is to be left asking more questions than when you first started.
That is why it’s important to do cursory research ahead of time to understand the terms and how insurance companies work first, so you can make a more informed decision without the confusing run-around many agents will lead you on.
If you find yourself asking an agent “how does life insurance work?” you should be able to receive a succinct answer. Individual policies often have intricacies and fine print to wade through, but the basic principle of how it works remains the same.
In this in-depth guide, you will learn everything you need to help you through the process of finding the right life insurance policy for your needs. Quote comparison will become easy, and you’ll become a pro at making snap policy decisions.
You might just find yourself opting into the more affordable, basic policies offered by Life Assurance Company of America because you don’t need anything more to help provide the peace of mind you are looking for.
What Is Life Insurance?
In the most simplistic form, life insurance is a contract between an insurance company and a policyholder ensuring that their income or financial support will be paid to their beneficiaries, most often family members, in the event of the policyholder’s death.
This type of insurance ensures that any debts that would normally fall to the family are paid, and any medical or funeral expenses are taken care of, allowing the family to grieve properly. This is especially important in any case where the dependents rely on the policyholder’s income to pay bills, purchase food, and pay for housing.
How Does Life Insurance Work?
Life insurance policies have many individual footnotes and clauses and, therefore, it can be confusing to wade through the sea of details. Fortunately, no matter what policy or coverage amount you choose, life insurance still works in the same basic way.
An insurance company promises to provide your named beneficiaries or estate with a tax-free payout in the event of your death so long as the policy is still active.
In exchange, you pay a smaller, recurring premium – typically either monthly or annually – which goes towards that final payout. The policy remains active either for a full contractual term or for the lifetime of the policyholder so long as payments are made.
This payout acts as a replacement to your income and financial support, allowing beneficiaries to continue paying bills and any outstanding debts which would default to them.
The cost of the recurring premium depends on your age, health, policy length, the overall payout risk you pose to the company, and many other factors. Policies may also include clauses that stipulate certain actions or timeframes in which events must occur in different circumstances to maintain the validity of the policy.
What Does Life Insurance Cover?
Life insurance is typically meant to cover lost financial support from the policyholder, along with outstanding debts and funeral costs. It may also provide enough to cover certain education costs or other types of support that the policyholder specified.
Once the benefits are paid out, it is within the hands of the beneficiary and there are – in most cases – no contracts in place requiring the money to be spent on certain services, debts, or items.
Depending on the policy you choose, life insurance policies may pay out in the event the policyholder dies from natural causes, by accident, or through acts of suicide or homicide. The policy must still be active at the time of death, however, for a claim to be considered valid.
If the circumstances around the death are suspicious, the insurance company may delay payment to launch an investigation for more details.
Fraudulent or criminal activity – such as omitting information or providing false information on an application or death caused by engagement in illegal activities – will result in the death benefit being withheld from beneficiaries, as it is a breach of contract on the policyholder’s behalf.
Life Insurance Terminology
Below is a short list of common terms you might come across while shopping for your life insurance policy:
Annuity: Also known as a monthly or yearly premium, this is a contract that describes a fixed premium that the policyholder will pay out at regular intervals. This either lasts for the duration of the policy in term insurance, or the policyholder’s life for permanent insurance.
Death Benefit: Also known as a coverage amount, this is the dollar amount that the insurance company will be paying out in the event the policyholder passes away. In term life insurance, this stays static throughout the policy. In whole life policies, this might decrease if a loan is taken out on the benefit or could increase if certain individual policy conditions are met.
Beneficiary: This is the individual who receives the death benefit, and who must submit a claim at the time of death. Beneficiaries are often the direct family or dependents of the policyholder.
Cash Surrender Value: Some plans provide a surrender value, which is the amount that is paid out on the plan if it is willingly terminated before the policyholder dies or becomes severely disabled.
Do I Need Life Insurance?
Many people only begin thinking about life insurance when they receive devastating medical news or begin working towards starting a family.
You are never too young to have life insurance. Even in your early 20s, accidents can happen that leave your dependents or close family members liable for your financial burdens. (1)
Singles with no dependents often need little or no coverage. But it can be an important purchase for people whose families depend on their income to cover daily living costs, mortgage repayment, college, retirement, or other major expenses.
Premiums are often more affordable and flexible if you enroll when you are young, allowing you to start your policy at a fixed rate with the right plan.
Still, life insurance policies are valuable for almost any individual between the ages of 18 and 65, especially for those who enroll while they are still considered in good health. A policy is good to hold at any age where you have close relatives or dependents to whom your financial burdens might fall to in the event of your death.
Term policies are a great way to maintain maximum flexibility in payments and coverage amounts without locking yourself in for a lifetime.
How Much Life Insurance Do I Need?
When you are looking at different coverage amounts, it is easy to get overwhelmed with the options available. There are two options for calculating your coverage needs quickly and easily:
Evaluate Your Financials
In this method, you should look at all your assets and debts. Calculate any source of debt that you have or expect to have in the future. This might be credit card bills, mortgage payments, dependent income, or college tuition for your children.
Subtract any assets you currently have, such as an estate or investment that your beneficiaries will have access to; the leftover amount is your minimum coverage recommendation.
Estimate Your Salary
For less extensive calculations, you can take your annual salary and multiply it by 10. The resulting number will provide you with a recommended minimum coverage amount. If you have significant debts on top of that number, this can be added to the amount to come up with a final dollar amount.
What Type of Life Insurance is Right for Me?
Most often, the type of life insurance policy you choose is based on your current health and the coverage amount you estimate will be necessary in the event of your death. (2)
Monthly premiums and flexibility of payments play a significant role as well, especially for individuals who are concerned about their current financial situation.
There are two primary types of life insurance: term and permanent life. Permanent life insurance such as whole life insurance or universal life insurance can provide lifetime coverage, while term life insurance provides protection for a certain period.
The type of policy you choose may also reflect how involved you want to be in the process.
Term insurance is best for financial and personal flexibility, as it allows you to renew the policy every term and does not require a lot of paperwork and action on your behalf beyond the initial qualifying application and monthly payments.
Whole insurance is often best for those who are more versed in investing and wish to optimize their benefits, but they must continue paying into the policy for it to remain active.
How Do Life Insurance Payouts Work?
Death benefits are typically paid to the listed beneficiaries on the plan at the time of death. The beneficiaries must file a claim with the company by submitting a certified death certificate.
From the time that adequate proof is provided, most companies are allowed 60 days to review the claim. Though there is no guaranteed timeframe, companies may be subject to interest on the payments if the claims are not paid on time.
Claims must first be accepted by the insurance company before it is paid out. If inadequate proof of death is provided or more details are needed, the company may ask beneficiaries for additional information.
Insurance payout claims may also be denied for a variety of reasons, in which case they must supply adequate reason as to why the claim is unable to be paid to the beneficiaries. The most common causes of payout denial are if the policyholder died during illegal activities, if they lied on the application, or omitted risky hobbies or significant health issues.
Depending on the clauses outlined in the insurance policy, payouts may also be delayed. The insurance company must ensure the claim is not fraudulent, so many permanent policies contain a clause that allows them to delay payout for investigation if the policyholder passes away within two years of obtaining the policy.
Can I Get Life Insurance with a Pre-Existing Condition?
Yes, you can still qualify for a life insurance policy with a pre-existing health condition whether you are applying for term or whole life insurance.
Depending on the severity of the medical condition, you might not qualify for some plans or coverage amounts, however, which will be determined at the time of application.
Some insurance companies may deny your application for all of their available plans if you are not in good health as it is beyond their risk tolerance, which is why it is important to apply for multiple policies that you believe you can qualify for.
It is important to understand that, since insurance policies take your overall health and measure it against age and current mortality estimates, your premium may increase or be higher than expected for someone who is in better health.
The reason for this is because insurance companies must weigh their payout risk. By weighing this, they can ensure there is enough money to go around when it comes time to pay out their promised policies for individuals that might pass away that year.
If you have a pre-existing medical condition that is not terminal or serious to your overall health, it will not affect your rates as much in term policies, particularly in shorter-term ones compared to longer-term or permanent insurance.
On the other hand, life-threatening or serious medical conditions may dramatically affect your rate, as the insurance company must consider these health concerns, even for short-term policies.
How Does Life Insurance Work If I Don’t Die?
Term life insurance is only valid for the selected period in which it is active; in other words, it doesn’t cover you for life, but it also doesn’t lock you into a larger obligation or payment plan than you need at the time. This is ideal for individuals who are looking for flexibility in payments and don’t want the commitment of a permanent policy.
If you do not pass away within the term that is specified by the insurance policy, you do not get a return on the unused premiums. Any money that you have paid into the policy to date goes to payouts claimed by families who weren’t so lucky in that regard. You may have the opportunity to renew into a new term policy depending on your health and age.
This type of policy is beneficial if you are worried about leaving a large debt as a family burden if you were to pass away unexpectedly, such as credit card bills, school loans, or a mortgage.
At the end of the term, your debt might be lowered, and you could always re-insure yourself for a lower coverage amount which would be reflected in your monthly premium. Term policies are often much simpler than whole life and can have less expensive premiums, as the insurance company is taking less of a risk in your case.
If you do pass away during the active term, your beneficiaries may make a claim on the policy to receive their payout, relieving the financial burden of the event.
Jason Alderman, Life Insurance 101, https://www.huffpost.com/entry/life-insurance-101_b_1133878
Ashley Kilroy, How Does Life Insurance work?, https://www.forbes.com/advisor/life-insurance/how-it-works/