What is life insurance and how does it work?

Buying life insurance is one way you can help protect your loved ones in case of the unexpected. For many, life insurance can provide peace of mind and a sense of financial security. 

Talking about life insurance can bring up difficult subjects, but choosing a policy doesn’t have to be a stressful process. Read on to learn how life insurance works and what factors to consider when you’re shopping for the right policy.

Key takeaways

• A life insurance policy provides funds for “beneficiaries” if the policyholder passes away.
• The two main types of life insurance plans are term life insurance and permanent life insurance.
• Term life insurance policies offer coverage for a set time period, while permanent life insurance policies offer lifelong coverage.
• Decisions about your life insurance policy—like the type, coverage and premium payment—can vary by individual and are based on different factors.

Life insurance is a type of insurance policy that financially protects and provides for chosen beneficiaries—typically immediate family members—in the event of the policyholder’s death. A life insurance policy can help cover anything from health care and funeral costs to housing payments, living expenses and debts.

Maybe most important of all, life insurance might help buy time for your loved ones and provide options if the unexpected happens suddenly. For instance, the recipients of your life insurance policy funds might be able to delay tough decisions like downsizing their home or finding a new job. And the funds could help eliminate your family’s financial worries while they’re grieving.

When your application for a life insurance policy is accepted and the terms of that policy are established with your insurer, you might pay a monthly or annual premium to receive your coverage. From there, your insurer shouldn’t typically withhold coverage once a policy has been issued, even if changes to your health occur gradually while you’re still alive.

There might be a few instances where claims made on your policy could be denied, like if you’ve failed to make your premium payments or your insurer discovers you’ve provided them with misleading information about your health. And some insurance providers might have other exceptions, like if your death is the result of a high-risk activity or homicide at the hands of a beneficiary.

There are two basic types of life insurance: term and permanent.

Both term and permanent life insurance policies help provide for your family if you’re no longer there to provide for them. These policies feature what’s called a “death benefit”—a guaranteed payout that goes to the beneficiary of the policy in the event of your death. Keep in mind that the death benefit could be subject to taxes.

While term and permanent policies both offer a death benefit, these policies differ in a few ways, especially when it comes to what they cover.

Term life insurance

Term life insurance policies are considered to be temporary life insurance solutions because they only last for a specific length of time. Term policies usually offer coverage terms of 10, 15, 20 or 30 years. But coverage terms vary from company to company. 

As long as premiums are paid on time, the death benefit payout is guaranteed for the entire length of the policy. But if the policyholder outlives the policy’s term, there’s no death benefit payout.

Because of their temporary nature, term policies typically have relatively low premiums and are less expensive than permanent policies.

Permanent life insurance

Like term life insurance, permanent life insurance is designed to provide your beneficiaries with a payment in the event of your death. However, permanent policies—as the name suggests—typically provide protection for the policyholder’s entire lifetime, not just a specific period. They’re typically more expensive than term policies and usually require higher premiums.

Permanent life insurance policies also include a savings or investment component known as the “cash value” of the account. As premiums are paid to the insurance carrier, a portion of the payment goes into savings or investments. Growth from those savings or investments is tax deferred and can sometimes even be used to increase the death benefit.

There are many types of permanent life insurance, but “whole,” “universal” and “variable” are three of the most common.

• Whole life insurance: Traditional whole life insurance includes a savings component that guarantees a minimum rate of return on the cash value of the policy. That means your cash value will earn interest at or above a rate predetermined by the insurance carrier.
• Universal life insurance: With universal life insurance, a portion of the premiums is invested in stocks, bonds or other available investment options. Growth from the investments can be used to pay the cost of the premiums. And whether universal life insurance includes a guaranteed death benefit depends on the policy. 
• Variable life insurance: Variable life insurance works a lot like universal life insurance. But variable policies could be considered riskier than universal policies. That’s because a bigger portion of the premiums is invested. And like universal life insurance, a variable life insurance policy may not have a guaranteed death benefit.

There are no set rules for determining how much life insurance coverage you need. Everyone’s situation is different. But there are numerous factors to consider as you figure out how much coverage is right for you. Factors may include things like future income, outstanding debts and whether you have people who depend on you. 

You may want to speak with a financial planner or advisor. They can help you figure out how much life insurance is right for you. Many of them may recommend coverage for five to 10 times the amount of your annual salary. Also keep in mind that the longer the length of the policy, the higher your quoted rates might be.

The average cost of a life insurance policy can vary significantly depending on a number of factors outside of the type of policy you’re pursuing and how much coverage you’re looking for. Your age, gender, quality of health and lifestyle at the time the policy is issued all play an important role in your insurance company’s decision to cover you. Each of those factors can also determine how high or low the premium you pay will be.

Find a reliable insurance carrier

Finding the right life insurance carrier can involve weighing price, customer service and the financial stability of the carrier, among other things.

J.D. Power®, an independent ratings firm, publishes customer satisfaction scores for the largest life insurers each year. The scores factor in everything from product offerings and policy prices to the ease and speed of the application process.

AM Best®, a credit rating agency with an emphasis on the insurance industry, is another source for comparing insurance carriers. Companies are rated on their ability to pay out as promised.

Shop around and ask for quotes

When shopping for life insurance, you may want to get quotes from multiple sources.

You could contact different carriers or go with an independent insurance broker. You might also want to contact your existing home and auto insurers. They can sometimes offer discounts for bundling life insurance with your other policies.

Prepare materials for your application

Once you identify a carrier or broker you like, it can be helpful to know what to expect in the application process. 

Before you apply for life insurance, make sure you know your medical history. In most cases, insurance companies will request some basic information about your and your family’s health. You may also have to undergo a medical examination. 

The healthier and younger you are, the lower your premiums will likely be. But remember that the criteria are subjective. And it’s up to the insurance company to make the final determination.

Buying life insurance can be both an emotional and a financial decision. But you can simplify the process—and eliminate some stress—by knowing what to expect before it’s time to buy. Consider speaking with a financial planner or adviser when you’re shopping for life insurance, as they can help you choose the policy that’s right for you.

If you’re looking to expand your coverage and financial protection in other areas of your life, check out Capital One’s article on health insurance shopping.