What Is Life Insurance and How Does It Work?

Understanding what life insurance is and how it works is the first step toward determining if a person needs coverage. Upon the insured party's death, money is disbursed to a beneficiary. You can opt for a few different types of policies, including term, permanent, whole and universal. The policy you decide on depends on factors like family size, amount of debt, income and more.

The 2022 Insurance Barometer Survey finds that 106 million adults in the U.S. either don't have life insurance or lack sufficient coverage. Confusion over what life insurance is and how it works may lead some people to put off buying coverage.?

This guide demystifies life insurance by answering common questions and providing tips on choosing a policy.

What Is Life Insurance?

Life insurance pays out money when a person dies. Its purpose is to provide funds to a person, group of people or an organization that the insured specifies.?

How Does Life Insurance Work?

Life insurance starts with an application. A person seeking coverage can apply online, by phone or through a licensed agent. Then, the policy goes through underwriting, the process of determining if a person is insurable. The insured may undergo a medical exam or fill out a medical questionnaire as part of the application process.

During underwriting, the insurance company uses information gathered to determine how likely the applicant is to die soon. The insurer may decline applications for people at a higher risk for death or instead charge them a higher rate.

If the insurance company approves the application, the applicant receives a life insurance policy, which promises to pay out a sum of money known as a death benefit when the insured dies.?

What Is a Premium?

A premium is what the insured pays for life insurance coverage. The size of the policy and type of insurance help determine the cost of the premiums. Healthier, younger people may pay lower premiums than older adults and those with medical conditions.

Premium payment schedules vary. Depending on the policy, the insured may make monthly, quarterly, semi-annual or annual payments.?

What Is a Beneficiary?

The beneficiary is the person who receives the death benefit when the insured person dies. A beneficiary can be:

• A person, such as a spouse or child
• A group of people, such as all the insured's children or nieces and nephews
• A business, which is common if the insured owns the company or is a key employee
• A charitable organization
• An estate or trust

What Is Cash Value?

Cash value is a feature of some life insurance policies. When the insured makes a premium payment, part of it funds the cash value. The insured can usually borrow against the cash value or withdraw the money to cover major expenses, such as long-term care or college.

What Are the Advantages of Life Insurance?

A life insurance policy:

• Provides income for loved ones after death.
• Can settle expenses and debts after death.
• Offers peace of mind for the insured.
• May provide a vehicle for saving money for retirement or major expenses.

What Are the Disadvantages of Life Insurance?

While employees usually see life insurance as a benefit, there are some potential drawbacks, including:

• Cost: Life insurance may be expensive depending on age and health.
• Low-interest rate: In most cases, life insurance doesn't offer a high rate of interest when used as a savings vehicle.
• Difficult to navigate: It can be difficult to choose a policy due to the wide range of options.

What Are the Main Types of Life Insurance?

Term life and permanent life are the two main types of life insurance.

Term Life Insurance

Term life insurance provides coverage for a set period known as the term. At the end of the term, the policy expires. However, some policies allow the insured to renew at a new premium rate. Typically, term life insurance is the least expensive option.

Permanent Life Insurance

Permanent life insurance does not expire and remains in place until the insured dies. Most permanent life insurance policies build a cash value. As a result, premiums for permanent life insurance are typically more expensive than for term life.

There are many types of permanent life insurance. Whole life and universal life are the most common.

Whole Life Insurance

A type of permanent life insurance, whole life features premiums that stay the same over the life of the policy. The death benefit also remains constant. Most whole life insurance grows cash value at a guaranteed rate but pays only a small amount of interest on the value.?

Universal Life Insurance

Universal life insurance is permanent life insurance that provides more flexibility for the insured. The premium and death benefit amounts of universal life are typically adjustable.

Policies usually build cash value. However, the rate of growth depends on what changes the insured makes to the policy. As a result, insurance companies don't guarantee cash value.

What Does Life Insurance Cover?

Life insurance covers most causes of death, including death due to:

• Accidents.
• Natural causes.
• Homicide.
• Suicide.

Some policies won't pay death benefits for homicides and suicides for the first two to five years. Insurance companies may also exclude certain causes of death, such as war, drug use or risky activities like skydiving. As a result, it is important to read policies carefully.

Who Needs Life Insurance?

Anyone can benefit from life insurance, but the following are most likely to need it:

• Primary earners in households to make up for lost income
• People with young children to help cover the cost of college
• People with mortgages and other debts
• Older adults who don't have money saved to pass onto heirs or cover long-term care
• Seniors who want small policies to cover the cost of burial or cremation
• Business owners who want to enable someone to buy their business or to keep it operating after their death

What Are the Top-Rated Life Insurance Companies Today?

Based on rankings provided by U.S. News and World Report, Bankrate and CNET, the following are among the top-rated insurers:

• Haven Life
• Mutual of Omaha
• Nationwide
• Northwestern Mutual
• Prudential
• State Farm

What Is the Best Life Insurance with Cashback?

In the U.S., return of premium (ROP) life is the type of life insurance that provides cashback if the insured does not die during the term of the policy. Not all companies offer it. Some that do include:

• AAA
• Cincinnati Life
• Illinois Life
• Progressive
• State Farm

How to Choose the Right Life Insurance Policy for You

To choose the right life insurance, consider:

• Monthly expenses
• Total amount of debts owed
• Monthly income
• Children's ages
• Balances in savings, checking, investment and retirement accounts
• Current health status and age

Insurance needs can change over time as children grow and people pay off debts. Carrie Schwab-Pomerantz, president of the Charles Schwab Foundation and a 2022 LinkedIn Top Voice in finance, writes that a good rule of thumb is to “revisit your insurance once a year or when there's a major change in your life, such as buying a home or having a baby.”

Top Takeaways

What Is Life Insurance and How Does It Work?

• Life insurance pays a sum of money called a death benefit to a person, group or organization called a beneficiary when the insured dies.
• In exchange for coverage, the insured pays a fee called a premium.
• The two main types of life insurance are term and permanent. Whole and universal life are two popular types of permanent life insurance.
• People who have debt, have children, are primary breadwinners or wish to ensure their final expenses aren't a burden to their family may benefit from life insurance.
• Age, debt, income, children's ages and what other savings a person has are key considerations when choosing life insurance policies.

(Reporting by NPD)