How does life insurance work?

Even if you know what it is, you might not understand exactly how life insurance works. In this easy-to-understand explainer, learn what term and whole life mean, how death benefit payouts work, how life insurance companies make money and more.

Life insurance is pretty simple: The policyholder pays a recurring amount of money – the premium – to an insurance company. If the policyholder dies while the policy is active, the insurer pays out a tax-free lump sum of money – the death benefit. The parties that receive the death benefit, typically family members, are called beneficiaries. The death benefit helps the beneficiaries achieve financial goals, like college and homeownership, even if the primary breadwinner is no longer around.

The pricing model is simple, too. Life insurance rates are set largely based on the risk of the policyholder dying while covered by the policy. That’s why age, health and health history, along with the duration and coverage amount, set the policy cost.

That’s basically it. In theory, you don’t need to know more than that to understand your life insurance policy. But even if you know what life insurance is, it’s helpful to know the more nuanced details to understand how life insurance fits into your overall financial safety net.

Knowing how life insurance works is important because your different policy options will help determine how long it’ll be in effect, how much you’ll pay for it, and how your beneficiaries will be taken care of in the event of your death.

In order to understand how life insurance works, you need to know:

How does term life insurance work?

Most life insurance shoppers choose between term and whole life insurance, and term life insurance is the best option for 80 to 90% of them. The primary difference between the two is how long they last and how the death benefit works.

Term life gets its name because it only lasts for a set period of time, called the term. Terms typically last between five and 30 years. A term life insurance policy covers a death that occurs during the term, (as long as no fraud has taken place).

What happens at the end of a term life insurance policy? Assuming it’s ending because the term is up and not because you died, the policy simply expires. You stop paying premiums, and you don’t have life insurance anymore. That expiration date is one of the reasons term is the most affordable type of life insurance: You’re more likely to die the older you get, so if an insurance company doesn’t have to cover you while you’re in your 70s and 80s – when you’re more likely to pass away – it can offer cheaper policies.

This is an ideal situation for most people. Life insurance is most beneficial when you have people who rely on you financially. You may have family members that need to pay for a home, college, retirement and more. By the time a term policy expires, there’s a good chance that:

  1. You don’t have these dependents any more (your mortgage is paid off, your children are done with school, etc), and/or
  2. You can self-insure. That means you have enough savings to cover debts and other financial needs.

Most people don’t need life insurance later in life, so there’s no need to pay for an unnecessary policy.

What happens if you outlive your term life insurance policy but you still need coverage? Age is a big factor in setting life insurance rates, so if you still need protection at the end of a 30-year term, a new policy might be prohibitively expensive. Luckily, most term life policies come with a standard conversion option that turns it into a whole life policy, which lasts as long as you need it.

How does whole life insurance work?

Whole life is a type of permanent life insurance. There are two main differences between term versus whole life insurance:

  1. Whole doesn’t expire.
  2. Whole has a cash value component in addition to the death benefit.

Whole life insurance lasts forever

As the name implies, permanent life insurance (including whole) doesn’t expire. As long as the policyholder pays the premiums, the policy stays in effect.

This takes some of the guesswork out of shopping for life insurance, because you don’t need to estimate how long it’ll last. If you’re at or nearing retirement and still have dependents, you know your coverage will last for as long as you need it.

How does the whole life insurance cash value work?

It’s easiest to explain whole life policy as two different parts: A term life-style death benefit paired with a savings account-style cash value component that provides a guaranteed, but minimal, growth rate.

Over time, as you make more premium payments, a whole life policy becomes comprised entirely of the cash value. What happens to cash value when you die? It becomes the death benefit, and is what is paid out to your beneficiaries. There’s no practical difference here – if you die your beneficiaries get paid a certain amount of money, regardless of where it comes from – but if the policy fully matures (which can take several decades) there are some small interest gains.

You can also access the cash value component while you’re alive. This allows you to do things like take out a loan or increase the death benefit using dividends.

For people who have complex financial situations – for instance, those who are subject to the estate tax – the cash value component is a valuable tool. However it comes at a literal cost, as whole life can be up to four times as expensive as term life. That’s why it’s important to speak to an insurance agent or financial adviser to determine if a whole life policy is the right financial tool for you.

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Most shoppers choose between term and whole life insurance. A licensed expert can help you decide which is best for you.

How long does it take to get life insurance?

The process flow for getting life insurance is largely the same no matter what type of policy you get, but the exact time frame each step takes depends on a number of factors.

Here’s the average time to complete each step in the life insurance application process:

  1. Get life insurance quotes (30 minutes). If you’ve done your research beforehand and know what type of policy you’re looking for and how much coverage you need ( in terms of duration and benefit amount), and you know what your budget is, this step is quick. Using an independent broker like Policygenius allows you to compare rates from dozens of companies right away.
  2. Fill out an application (30 minutes). Whether you’re filling it out online yourself or talking to an agent over the phone, it should only take around half an hour to complete. Having documents related to your finances and health history handy is useful in speeding up the process and cutting down on any back-and-forth.
  3. Complete the underwriting process (three to four weeks). Insurance carriers use underwriting to determine how risky you are to insure. How long does underwriting take? It depends on if there are any complications. The medical exam, where a technician comes to your home or place of work for a short physical, only takes around half an hour but you need a few days to coordinate. If the underwriter needs to request an Attending Physician Statement (APS) from your doctor to get a better sense of your health history, that can add several more weeks. Note: Some applicants may qualify for a no exam policy, where the insurer uses existing third-party information instead of a medical exam to assess your risk. This can help shave some time off of this step.
  4. Complete a phone interview (20 minutes). You may be asked some follow-up questions to clear up any lingering issues.
  5. Wait for approval (one to two weeks). The underwriter takes all the information gathered throughout the application process and uses it to determine your final rates. When that’s done, you’ll need to sign the policy and submit the first premium payment, after which the policy goes into effect.

On average, it takes four to six weeks to get life insurance. This can change on a case-by-case basis – complications make it take longer, and not needing an APS speeds up the process considerably – but most customers can expect it to take this long.

Learn more about the steps involved in buying life insurance.

How is life insurance paid out?

Arguably the most important part of a life insurance policy is the death benefit. After all, that protection is why you pay for a policy for decades. So you should know how life insurance works when you die.

When the policyholder dies, the beneficiary needs to contact the insurance company to alert them, using a death certificate, policy document, and claim form to get the money after the death.

How long does it take to receive life insurance death benefits? The carrier wants to pay out as soon as possible, but the payout timeline depends on if there are any complications; it can range from a few days to up to 60 days for the benefit to be distributed. The life insurance check is tax-free, which means beneficiaries get the full amount.

Life insurance policies have a two-year clause, or contestability period, during which companies can contest a payout. This primarily applies in two scenarios:

  • The death is a result of suicide
  • There’s evidence of fraud on an application

In these cases, the company has the right to dispute a benefit claim. Besides that, though, when it comes to how long you have to have life insurance for the benefit to pay out, there’s no minimum. Your policy is active as soon as you make the first premium payment, and the benefit is, too.

How do life insurance companies make money?

Insurance carriers use policyholder premium payments as their main source of income. This works in a few ways:

  • As you pay premiums, the carrier doesn’t just let that money sit there. They’re invested over the life of the policy. Where do life insurance companies invest their money? It depends on the company; low interest rates have forced companies to diversify and invest in areas like infrastructure and real estate.
  • Carriers use underwriting to determine how likely it is they’ll have to pay the death benefit for a policy. If someone has a term life policy and they outlive their coverage, the carrier doesn’t need to pay out at all and keeps the premiums.
  • The cash value of a whole life policy is enticing for many people. They may cancel their policy prematurely to access it, and may have put more in premium payments than they’re getting out of it.
  • Some policies, especially permanent ones, have additional fees on top of premium payments.
  • If a policyholder lets their policy lapse, they lose coverage and the carrier keeps the paid premiums.

Reinsurance (essentially insurance for insurance companies) and government-mandated minimum cash reserves guarantee that life insurance companies always have enough money on hand to meet their financial obligations (i.e., paying death benefits).

At the end of the day, the more you know about life insurance, the fewer surprises – and the last thing you want when it comes to life insurance is a surprise. A licensed agent or financial adviser can help you sort out specific details, but there’s no harm in starting the shopping process prepared.


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