Insurance

What Is Life Insurance and How Does It Work

Life Insurance is a contract signed with an insurance company wherein the insured agrees to pay premiums (monthly, quarterly, annually or even a single premium) in exchange for the life insurance company paying out a death benefit to the beneficiaries selected by the insured.

Life insurance can serve many purposes, from replacing income and paying outstanding debt to covering college tuition or funeral expenses. Having a life insurance policy is a must for anyone who wants to ensure the financial security of family members and surviving loved ones.

This general guide will walk you through the process of understanding what is life insurance is and how it works. We’ve also put together a list of the best life insurance companies to help you select the best policy for your needs.

 

How Does Life Insurance Work?

In exchange for a premium, life insurance companies will grant a payment known as a death benefit to beneficiaries once the policyholder has passed away. A beneficiary can be one or more individuals, a trust, an estate or even an organization.

In some cases, such as after a terminal illness diagnosis, you may access a portion of your life insurance funds while you are still alive with an insurance rider known as an accelerated death benefit. You’ll need to have evidence of a qualifying condition or situation according to your life insurance contract.

What does life insurance cover?

Once disbursed, beneficiaries can use the money from the life insurance policy for whatever they want. Examples include:

  • Covering everyday expenses like groceries or household essentials
  • Paying off a mortgage or other outstanding debt
  • Covering burial costs or end-of-life medical care
  • Putting someone through college or any other major education expenses
  • Paying for child or dependent care or replacing care provided by a spouse

The payment from a life insurance policy may also function as a safety net by ensuring that a family can stay in their home and pay for the things that were planned before the policyholder’s death.

Life insurance companies must be contacted following the death of the insured individual to begin the claims and payout process. So long as your policy is still active at the time of your death, your provider is obligated to pay out — with a few notable exceptions. Providers will pay out death claims due to:

  • Natural causes, such as a heart attack, old age, or illnesses like cancer
  • Accidental death, including accidental drug overdose
  • Suicide, after the policy’s suicide clause period ends
  • Homicide, unless the beneficiary played a role in the murder

Specific exclusions are often written into life insurance contracts to limit the insurer’s liability. In cases of an expired policy, fraud, criminal activity or certain other exclusions, your beneficiaries may not receive your policy’s death benefit.

  • Expired policies: Policies only stay active as long as you keep up with premium payments.
  • Fraud: Your insurer can cancel your policy while you’re alive or deny or reduce the death benefit after your death if it found out you lied on your application.
  • Criminal activity: If you die while committing a crime (or your beneficiary committed a crime to access your insurance money), your insurer won’t pay out.
  • Other exclusions: Insurers typically exclude high-risk sports and hobbies from coverage. If you died while skydiving, for example, your insurer might not pay out.

Life insurance payout options

Common life insurance payout options include:

  • Lump-Sum Payout: A lump sum payout allows the beneficiary to receive the entire death benefit at once. This is the most common form of disbursement for life insurance products. It allows greater flexibility and is tax-free income.
  • Installments or Annuities: With this option, the beneficiary regularly receives proceeds and accumulated interest over a period of time. Since interest income is subject to taxation, you might be better off getting a lump sum of money rather than being paid in installments, depending on how large the policy’s death benefit is.
  • Retained Asset Account: These work similarly to a checking account held by the insurer, with the initial balance being the death benefit. The beneficiary can write checks against the balance in the account and accrue interest over time. Unlike checking accounts, retained asset accounts do not allow deposits.

How to choose a life insurance beneficiary

When taking out a life insurance policy, choosing a beneficiary is one of the most important choices the policyholder will be asked to make. A beneficiary can be a spouse, parent, sibling, children, trust, estate, business partner or charity organization.

In addition to naming multiple beneficiaries, policyholders can also name secondary beneficiaries. The policy’s death benefit will be passed on to them if your primary beneficiary cannot claim it. Make sure to update your beneficiaries as you undergo major life events to ensure that the payout doesn’t go to your estate or the wrong person.

Who Needs Life Insurance?

The quickest way to answer whether life insurance is a worthwhile investment is by asking yourself whether your death would financially impact the people in your life. If the answer is yes, consider including life insurance in your financial plan.

People who could benefit from having life insurance include:

  • Parents with young children or adult dependents – Life insurance can ensure that children who require lifelong care will have their needs met even after their parents die. The policy’s death benefit can also be used to fund a special needs trust managed by a fiduciary for the adult child’s benefit.
  • Older adults without savings – Older adults who want to provide financial coverage for their families or caretakers but lack substantial savings can leave them a death benefit.
  • Young adults who want to lock in low rates – Because age and health factor into life insurance premiums, younger adults are offered much more favorable rates.
  • Adults with private student loans – Private student loan debt is transferred to cosigners if the borrower dies. Life insurance can ensure your loved ones don’t get stuck paying off the rest of your debt.
  • Business owners – Firms, companies, and organizations can purchase a life insurance policy on employees whose passing would create severe financial hardship for the company.

When should you get life insurance?

Regardless of age, it’s never too early to start thinking about your life and long-term care insurance needs.

You should consider buying life insurance when:

  • You’re young and healthy
  • You reach certain life milestones, such as starting a family, planning your retirement, and buying a home or car (or otherwise accumulating debt)

If you’re in your 20s and are already looking into life insurance policies, take a look at the main steps to buying life insurance for young adults.

Life insurance for income replacement

Income replacement is one of the main reasons to get life insurance. Life insurance provides your loved ones with an additional source of income if you are no longer around to provide for them.

This is very important for people whose families depend on their income as part of their budget. Having life insurance means that you can make sure they have the financial support they need to maintain the lifestyle they’re used to, even after you die.

Life insurance for final expenses

Older adults without any dependents don’t need traditional life insurance coverage. However, they still have to plan for their funeral, which can cost anywhere from $8,000-$10,000 — not including other end-of-life expenses such as medical bills.

Your funeral costs may be covered entirely by taking out final expense (or burial) insurance. Take a look at our selection of the best life insurance for seniors for other alternatives.

Life insurance for covering debt

Individuals who are worried about passing on debt to their loved ones should consider credit life insurance. Unlike traditional life insurance, this type of insurance is uniquely designed to pay off a borrower’s debt after death.

You may receive an offer to take out a credit life policy after a major purchase, such as a home or expensive vehicle. The value of the policy will correspond to the value of the loan it’s intended to pay off. Credit life insurance is easier to qualify for than traditional life insurance but has limited use and loses value if the death benefit is larger than your outstanding debt.

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