Life Insurance Basics: What is Life Insurance & How Does it Work?

Term life insurance

This option offers coverage for a specific period between 10 to 30 years. It is the most straightforward and affordable life insurance option and provides a death benefit if the policyholder dies within the set term. 

Permanent life insurance

The second category of life policies is permanent life insurance, which lasts a lifetime, ensuring that beneficiaries receive a payout upon the policyholder’s passing. What sets permanent life insurance apart is its dual-purpose nature. It is a financial safety net for loved ones and provides an investment vehicle, with a portion of each premium payment accruing as cash value. Some types of permanent life insurance include: 

• Whole life insurance: Offers lifetime coverage at a fixed premium. Your premium is split between the cost of the policy and a cash value component that grows at a guaranteed rate. Therefore, whole life insurance offers a death benefit and a savings element. Moreover, as your cash value grows, you can borrow against it or withdraw funds. 
• Universal life insurance: This option is a more flexible permanent life insurance that allows you to change your premiums and death benefits within certain limits. Like whole life insurance, the policy also includes a cash value component that earns interest. 
• Variable life insurance: This is a riskier kind of permanent insurance with two components: a face-value death benefit and a variable cash value. It allows policyholders to invest the policy’s cash value in various investment options, offering the potential for higher returns but with greater risk. 
• Variable universal life insurance: Combines the investment options of a variable life policy and the flexibility of universal life insurance in terms of premium and death benefit adjustments. 
• Final expense life insurance: This is a type of whole life insurance that covers end-of-life costs, such as funeral expenses, outstanding debts, and other final bills. These policies typically have lower coverage amounts, usually from a few thousand to about $25,000. They are easier to qualify for seniors, often requiring no medical exam. 

1. Choosing a policy

The first step is selecting the type of life insurance policy that best suits your needs, whether term life, whole life, universal life or a different kind of policy. Consider your financial goals, coverage needs, budget and how long you want the coverage to last. 

2. Application and underwriting

Once you’ve chosen a policy, you must apply, providing the insurer with information about your health, lifestyle, and any risky activities you participate in. The insurer may require a medical examination to assess your health status. This process includes underwriting, where the insurer evaluates the risk of insuring you and determines your premium rates based on your risk factors. Age and sex are the primary factors when considering premiums, but factors such as your lifestyle, weight, health and tobacco usage also matter. 

3. Paying premiums

After the policy is issued, you are required to pay premiums to keep the coverage active. They can be paid monthly, quarterly, semi-annually, or annually, depending on the policy terms. One of the common misconceptions about life insurance is that premiums are expensive. According to LIMRA, 46% of individuals admit they haven’t purchased life policies because they are costly. However, the reality is that insurance protection has never been cheaper. The average premium for a healthy 40-year-old adult is less than $30 per month. 

4. Death benefit

The key reason to buy life insurance is the death benefit, a tax-free sum paid to the beneficiaries upon the insured’s death. When you purchase the policy, you choose the death benefit amount, which can be influenced by your coverage needs and the premiums you’re willing to pay. 

5. Cash value

Some permanent life policies, like whole life and universal life, have a cash value component in addition to the death benefit. A portion of the premium goes into a cash value account, which grows over time based on the policy’s terms. You can borrow against the cash account or withdraw the amount during your lifetime. However, doing so may reduce the death benefit or have tax implications. 

6. Claim process

Beneficiaries must file a claim to receive the death benefit upon the insured’s death. They must submit a completed claim form, the death certificate and possibly additional documentation as required by the insurer. Once the claim is verified, the insurer pays out the death benefit to the beneficiaries. 

7. Policy maturity

For term life insurance, the policy expires at the end of the term if the insured is still alive, with no benefit paid. Policyholders can renew the policy, convert it to a permanent policy, or let the coverage lapse. For permanent life insurance, the policy remains in effect for the insured’s lifetime, provided premiums are paid, with the death benefit paid out upon their death.