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How Life Insurance Works

A Guide for First-Time Policyholders


Life insurance is a financial contract that provides a death benefit to the designated beneficiaries upon the policyholder’s passing. Its purpose is to offer financial protection and support to the insured’s loved ones in the event of their death. It is essential because it helps ensure that dependents and beneficiaries can cover expenses such as funeral costs, debts, mortgages, and future financial needs.

Understanding how life insurance works might seem tricky, but it’s a crucial tool for many families. This guide explains how it all works so you can pick the right coverage for you.

Overview on How Life Insurance Works

In its broadest sense, life insurance acts as a safety net for families when someone passes away. It gives a certain amount of money — the death benefit — to the individual, people, or entities the policyholder named as the beneficiary.

Some life insurance lasts for a specific number of years, while others last for a person’s whole life. Some types of life insurance also let you invest your money, and a few even allow you to use the money before you pass away.

Common Terms to Know

Before diving into the nuances of different life insurance types, it can be a big help to first gain familiarity with these key terms. These are important to helping you better understand how life insurance works and make informed decisions when choosing a policy that aligns with your needs and financial goals.

  • Policyholder: The policyholder is the individual who owns the life insurance policy, and they are responsible for keeping the policy active. The policyholder can make decisions such as designating beneficiaries and making changes to the coverage.
  • Beneficiary: A beneficiary is the person or entity chosen by the policyholder to receive the death benefit when the policyholder passes away. This can be a family member, a loved one, multiple people, or an organization.
  • Death benefit: The death benefit is the specific amount of money that is paid out to the designated beneficiaries when the policyholder dies. This can help them cover expenses and maintain their financial stability when the policyholder passes.
  • Premium: The premium is the recurring payment made by the policyholder to the insurance company to keep the life insurance policy active. It is typically paid on a regular basis, such as monthly or annually.
  • Cash value: The cash value is a feature of some permanent life insurance policies. It represents a savings or investment aspect of the policy, allowing the policyholder to build a cash reserve that can be accessed or borrowed against while the policy is active.
  • Convertibility: A policy’s convertibility refers to the option to convert a term life insurance policy into a permanent one without the need for a new medical exam or underwriting.
  • Riders: A rider is an optional add-on that policyholders can include with their life insurance policies to provide additional benefits or coverage. Policyholders can have multiple riders on their policy.
  • Underwriting: The underwriting process is used to evaluate an applicant’s risk factors, such as their age, health, and lifestyle, to determine their eligibility for a life insurance policy and to set the appropriate premiums. It helps the insurance company assess the level of risk associated with insuring the individual.
  • Surrender value: The surrender value is the cash value that becomes available to the policyholder if they decide to cancel or surrender their life insurance policy before the end of its term. It provides a way for the policyholder to access some of the accumulated value in the policy.
  • Dividend: Policy dividends are non-guaranteed payments from the insurance company to participating policyholders. These payments are based on the company’s financial performance.

Do You Need Life Insurance?

Determining whether you need life insurance depends on your individual circumstances and financial goals. Common reasons why many choose to take out a life insurance policy include:

  • Financial protection for beneficiaries in the event of the policyholder’s death. Life insurance can provide a lump sum payment of the death benefit, or deliver it as periodic income to designated beneficiaries.
  • Support for beneficiaries’ long-term financial needs. For those with dependents, the death benefit can help cover future expenses should the policyholder pass away, such as having the policy pay for a child’s school tuition.
  • Coverage for funeral expenses and outstanding debts. Life insurance payouts can be used to settle the policyholder’s affairs, including mortgages and loans. It can also help pay for funeral and burial expenses.

Life insurance can be a valuable financial tool to ensure your loved ones are protected and supported in the event of your passing. When deciding whether or not you need life insurance, consider the following factors:

  • Dependents: Do you have dependents, such as a spouse, children, or elderly parents, who rely on your financial support? If your family relies on your income, life insurance can replace lost income and ensure their financial stability.
  • Debts and financial obligations: Do you have significant debts, like mortgages, loans, or outstanding bills? Life insurance can help cover these expenses if you’re no longer there to pay them.
  • Estate planning: Does a life insurance policy fit in with your overall financial plan? Life insurance can be part of your estate planning strategy to cover estate taxes and facilitate the transfer of assets to beneficiaries.
  • Final expenses: Do you have enough saved to help pay for funeral costs? Life insurance can cover these costs, which can also help protect your beneficiaries against the sudden expense of burial.
  • Business ownership: Do you have something in place for your business when you pass? If you’re a business owner, life insurance can protect your business partners or provide funds for a buyout.
  • Age and health: Are you ready to begin planning? Younger and healthier individuals often get lower premiums, making it an advantageous time to secure life insurance.
  • Long-term financial goals: Could you benefit from supplemental income? Life insurance with cash value growth can serve as a savings component and supplement retirement income.


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Types of Life Insurance

There are mainly two kinds of life insurance: term life insurance and permanent life insurance. At a high level, term life insurance gives you coverage for a certain number of years, whereas permanent life insurance lasts your whole life as long as you keep up with premium payments. There are also numerous types of permanent life insurance, the most common being whole, universal, and variable life insurance.

These types of life insurance are each tailored to meet different financial and family needs. In addition, term life insurance can be used to supplement permanent life insurance coverage.


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Term Life Insurance

Term life insurance provides coverage for set terms, typically 10, 20, or 30 years. If the policyholder dies within the active term, the death benefit will be paid out. Advantages of term life insurance include lower premiums and simplicity in coverage. It offers temporary financial protection, making it suitable for covering specific needs like mortgage payments or children’s education expenses.

However, term life insurance has limitations. It does not accumulate cash value like whole life insurance, and if the policyholder outlives the policy, there is no payout or refund on premiums paid.


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Whole Life Insurance

Whole life insurance is a type of permanent life insurance with fixed premiums. As a permanent policy, the death benefit is guaranteed. Advantages of whole life insurance include the ability to conservatively build cash value that can be borrowed against or withdrawn, and potential tax benefits for the cash value growth.

Drawbacks of whole life insurance include higher premiums compared to term life insurance, limited investment options for cash value, and the potential for lower returns compared to other investment options.


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Universal Life Insurance

Universal life insurance is a type of permanent life insurance that offers some flexibility in premium payments and death benefit coverage, allowing both to change over time as needed. The investment component in universal life insurance is typically tied to a cash value account, which earns interest at a variable or fixed rate. Policyholders can use the accumulated cash value to cover premiums or borrow against it.

The downsides of universal life insurance are the complexity of the policy structure, the potential for the cash value to underperform, and the risk of policy lapsing if the cash value is insufficient to cover premiums.


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Variable Life Insurance

Variable life insurance is a form of permanent life insurance that allows policyholders to invest their premiums in vehicles like stocks and bonds. The cash value of the policy fluctuates based on the performance of these investments. As such, potential rewards are higher compared to other types of life insurance.

However, variable life insurance also carries risks because of the fact that the cash value is subject to market fluctuations. If the underlying investments perform poorly, the policy’s cash value may decrease, leading to higher premiums or potential policy lapses.

How Much Does Life Insurance Cost?

The cost of life insurance varies based on several factors, including:

  • Policy type: Different types have varying cost structures. Term life usually has lower initial premiums.
  • Coverage amount: Higher death benefit leads to higher premiums.
  • Policy duration: Longer terms may result in higher premiums for term life insurance.
  • Age: Younger individuals pay lower premiums due to lower risk.
  • Health status: Better health usually means lower premiums.
  • Lifestyle habits: Risky behaviors increase insurance costs.
  • Gender: Women may have slightly lower premiums due to longer life expectancy.
  • Underwriting: Risk assessment, medical exams, and health history affect premiums.

This means specific costs vary from person to person. However, here is a comparison for three basic types of life insurance based on a 30-year-old in excellent health taking out a $500,000 policy:

Policy Type
Average Monthly Premium (Male)
Average Monthly Premium (Female)
Term, 20 year
Whole Life
Universal Life

Note that these are rough estimates. Get accurate cost estimates by obtaining quotes from multiple insurance providers. Utilize an agent or online tools to compare rates and find suitable coverage within your budget.


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How Much Life Insurance Do You Need?

Determining the right amount of life insurance is a personal decision, but you can use tools like the DIME (debt, income, mortgage, education) method or the 10X income replacement rule to get started. When figuring out your death benefit, keep these factors in mind:

  1. Income Replacement: Think about how much your life insurance can replace your beneficiaries’ monthly income. The 10X income replacement rule (multiply your yearly salary by 10) offers a useful starting point.
  2. Outstanding Debts: Consider that creditors may come after your debts if they don’t get immediate payment from your life insurance.
  3. Burial Costs: Factor in the financial relief your insurance can provide for costly burial, cremation, and funeral expenses.
  4. Financial Needs of Your Beneficiaries: Your beneficiaries’ financial needs vary based on their age, job, and health. The DIME method can assist in assessing their future requirements for significant expenses.
  5. Liquid Assets: Keep in mind that you might need a higher level of liquidity for your survivor benefits, whether for a loan or collateral purposes.

These considerations can guide you in determining the right coverage to ensure your loved ones are financially secure in the future.


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How Life Insurance Pays Out

Life insurance pays out the death benefit to the designated beneficiaries upon the policyholder’s death, provided that the policy is in force and all policy requirements are met. The payout process typically follows these steps:

  1. Death of the policyholder: When the insured person passes away, the beneficiaries or their representatives must notify the insurance company. The insurance company will not automatically know that the policyholder has died.
  2. Claim submission: The beneficiaries submit a death claim to the insurance company, which includes necessary documentation such as the death certificate, policy information, and any other required forms.
  3. Claim review: The insurance company reviews the claim to ensure it meets all the policy requirements and that the death is within the coverage period and not excluded by any policy provisions.
  4. Verification and investigation: In some cases, the insurer may conduct an investigation to validate the claim and gather additional information, especially for larger death benefits.
  5. Claim approval: Once the claim is approved, the insurance company calculates the death benefit amount based on the policy’s terms and conditions.
  6. Payment options: The beneficiaries can typically choose how they want to receive the death benefit. Options may include a lump sum, periodic installments, or an annuity.
  7. Payment processing: The insurance company processes the payment and disburses the death benefit to the beneficiaries or their chosen payment method. Depending on the policy and local tax laws, the death benefit may or may not be subject to income tax. Generally, life insurance proceeds are income tax-free for the beneficiaries.

The payout process aims to provide financial support to the beneficiaries in a timely and efficient manner. Beneficiaries should be proactive in notifying the insurance company of the policyholder’s death and promptly submit the necessary documentation to expedite the claim settlement.


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What Are Living Benefits of Life Insurance?

Living benefits of life insurance refer to the features or riders that offer financial support to the policyholder during their lifetime, beyond the death benefit for beneficiaries. Common living benefits include:

  • Cash value: Those with permanent policies may have cash value built in. This accumulates savings over time, accessible through withdrawals or loans.
  • Accelerated Death Benefit: Policyholders who add the accelerated death benefit to their policy receive an early death benefit if they are diagnosed with a terminal or critical condition. This early death benefit is paid to the policyholder generally to help cover medical expenses.
  • Long-Term Care Rider: A long-term care rider provides financial assistance for long-term care expenses, such as nursing home or in-home care, if the policyholder becomes unable to perform daily living activities due to illness or disability.
  • Disability Income Rider: A disability income rider in a life insurance policy is an additional feature that offers income replacement if the policyholder becomes disabled and is unable to work.

Living benefits enhance life insurance, offering policyholders financial security beyond the death benefit. However, it is important to review and understand rider terms before adding them to your policy.


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Applying for Life Insurance

The application process for buying life insurance varies by insurer, but it generally follows these steps:

  1. Initial inquiry: Contact a broker, agent, or insurance company representative for policy information and answer initial questions about the type of policy you want, what you would like to protect against, and your income.
  2. Application form and documents: Complete personal details and beneficiary information. Submit identification, income proof, and additional requested information.
  3. Medical history questionnaire: Provide health, family history, and lifestyle information. Depending on the type of policy, you may be required to undergo a medical examination for medical underwriting.
  4. Policy offer: Insurers review your application and medical data to assess your insurability and premium. If approved, you will receive policy details, coverage, premium, and riders.
  5. Premium payment: Activate the policy by paying the first premium.
Application process varies between companies and policies. An experienced agent can guide you and ensure proper information submission for suitable coverage.


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Putting It All Together

Life insurance offers crucial financial protection for families, yet finding the right policy can seem overwhelming. There are numerous term and permanent life insurance options, each tailored to diverse needs. To simplify your decision-making, take into account your age, health, family circumstances, and financial responsibilities. For more help, work with a broker, agent, or financial advisor to select the ideal policy for your specific needs.


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