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:
Most life insurance shoppers choose between term and whole life insurance, and term life insurance is the best option for most 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:
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.
Whole life is a type of permanent life insurance. There are two main differences between term versus whole life insurance:
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.
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 six to 10 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.
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:
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.
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:
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.
Insurance carriers use policyholder premium payments as their main source of income. This works in a few ways:
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.
Disclaimer: Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.