What Is Life Insurance, and How Does It Work?

Life insurance offers a way to support your loved ones if you happen to suffer a fatal accident. Obviously, when dealing with important matters like this, you should get a good understanding of the topic before financially committing to a policy.

How does life insurance work? What does life insurance cover? |And, most importantly, is life insurance worth it? Read on to find out!

What Is Life Insurance?

At its core, life insurance is a financial product designed to protect the policyholder’s beneficiaries in case of the insured person’s death. When purchasing a policy, a buyer chooses beneficiaries who will receive a so-called death benefit upon their passing. The money can then be used to cover various expenses, including but not limited to funeral costs, mortgage payments, debt repayment, and more. Life insurance is also frequently chosen as a way to leave an inheritance.

It should be noted that, depending on the selected insurance type, a policyholder may also access the funds during their life. This reduces the future death benefit if the sum is not repaid later, but it can still be a lifesaver in case of large, unexpected expenses.

Finally, how does life insurance work as an investment? It’s complicated. Life insurance can’t be considered an investment in a traditional sense (i.e., funds spent to get a return at a later date), but some policies can generate cash that the insured person can access. However, it’s unwise to think about life insurance policies in investment terms, as they serve a wholly different purpose.

Types of Life Insurance Riders

Depending on your needs, you can choose a term or a permanent life insurance policy. They differ in cost, terms, and death benefit amount.

What is term life insurance, what is whole life insurance, and what’s the difference between the two? Let’s review it in more detail.

Term Life Insurance

So, what is term life insurance? As the name suggests, this type of policy offers coverage for a specific length of time. For example, you can choose 10, 15, or more years, depending on your financial capabilities and needs. If a policyholder dies during the insurance period, the beneficiaries will get the death benefit. If an insured individual is alive as the term comes to an end, the insurance amount is not paid. However, there is an option to choose a return premium rider to get a refund on the previously paid premiums.

Term life insurance is a good choice if you want a cheaper option or only require coverage during a specific high-risk period.

Permanent Life Insurance

Once again, there are two policy types to choose from here — universal and whole life insurance. As opposed to term life insurance, both permanent options feature a cash value account in addition to the standard death benefit. This means that you can theoretically withdraw funds from the insurance amount. You should keep in mind that not returning the borrowed sum will reduce the final payout.

Next, there are some notable differences between universal and whole-life policies. The former has flexible conditions for premiums, while the latter is fixed. Universal life insurance is more complex, as market interest rates affect the cash value growth, making this policy less reliable.

Cost of Life Insurance

At this point, you likely wonder — how much is life insurance? The exact cost depends on a range of factors, notably:

• Your age;
• Current state of health;
• Whether you have a high-risk occupation;
• Lifestyle, unhealthy habits (smoking, etc.);
• Family’s medical history.

The general rule is that the younger and healthier you are, the less expensive your policy will be. For instance, if you are a low-risk adult applying for term life coverage, you’ll likely have to pay no more than $25 a month for a death benefit of up to $500,000. The monthly payment also depends on the insurance company you choose.

The insurance cost can also vary depending on the policy’s length and its type. Permanent insurance costs significantly more compared to term one. For example, a 30-year-old who chooses permanent life insurance with a $250,000 coverage will have to pay around $245 a month on average.

Choosing a Beneficiary

When applying for life insurance, you can choose a single or multiple beneficiaries:

• Parent or guardian;
• Husband or wife;
• Sibling;
• Grown child;
• Minor;
• Trust;
• Business partner;
• Nonprofit organization.

As a policyholder, you can choose a primary beneficiary and one or multiple contingent beneficiaries. The way it works is that contingent beneficiaries will obtain death benefits only if the primary beneficiary dies before receiving the payment.

Another consideration to mention here is that minors can access death benefits only after they become legal adults. For this reason, an underage person cannot be named a beneficiary without a guardian.

Filing a Life Insurance Claim

When a policy owner passes away, the chosen beneficiaries do not obtain the funds automatically. To access a death benefit, a beneficiary has to reach out to the respective insurance company. In some cases, the application can be filled out online, while in others, a beneficiary is required to submit a paper claim.

A beneficiary will also need to provide documents proving their identity, a copy of their insurance policy, and a copy of the insured individual’s death certificate.

Some situations may cause delays in the payout process:

• A beneficiary doesn’t provide all the necessary documents. You should double-check whether you have attached all the documents to your claim.
• A policy owner dies or commits suicide within two years of the insurance’s start. If this is the case, all you can do is wait 6 to 12 months as the investigation is taking place.
• An insured person dies engaging in illegal or dangerous activity. An insurance company may deny payouts or delay them while the cause of death is being investigated.

Payout Options: Lump Sum vs. Installments

When customizing an insurance policy, the policyholder must choose between a lump sum payment and payment in several installments. Here are the differences to consider.

Lump Sum

A lump-sum payment means that a beneficiary will receive the entire death benefit at once after the insured person’s passing. This is the most widely used payout variant. The advantage of this option is that it allows a beneficiary to immediately use the money to cover any immediate expenses. Note that in most cases, death benefits are not subject to income tax.

Installments

As for installment or annuity payouts, the interest and proceeds are paid to a beneficiary at certain intervals. For example, the payouts may be provided every month, quarter, or year. A policy owner can choose a period over which such payouts will be made, typically ranging from 5 to 40 years.

Is life insurance taxable if you choose payment in installments? The way it works is that the tax will apply to your interest income, so while the initial sum remains nontaxable, your later earnings do not. This is another reason why a lump sum payment may be a better option overall.

Who Needs Life Insurance?

Life insurance is a universal asset from which a large percentage of the population can benefit. It is particularly suitable for individuals who have:

• A partner who depends on them for income;
• Any dependents (minors, etc.), especially as a single parent;
• A house currently in a mortgage;
• Cosigned debt with someone.

If you don’t currently have children or a mortgage but have such plans, getting life insurance in your younger years can be a good idea to get lower payments for the future.