How Does Life Insurance Work?

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Quick answer:

A life insurance policy is a contract between you and an insurance company. You agree to pay a regular premium. In return, the insurance company agrees to pay out a sum of money to your designated beneficiaries if you die before the policy’s term is up.

A life insurance policy is a unilateral contract, meaning you can stop paying your premiums or cancel your policy at any time without any legal ramifications.

Depending on the type of life insurance you want, your policy may work differently. The main types include:

  • Term life: Your policy is for a specific term only, say 10 to 30 years, and your beneficiaries don’t receive any benefit if you outlive the set term. Your premiums can be level, increasing or decreasing throughout the life of the policy.
  • Whole life: Your term is for life, and there’s a cash value component from which you may borrow or withdraw in the future. You pay level premiums throughout the life of the policy.
  • Universal life: Similar to whole life, this type of life insurance is for life and includes a cash value account. However, some universal life policies offer more flexibility. For example, you can use your cash value account to help pay your premiums.

Those are the basics, but let’s dig a little deeper and then address each type of life insurance more fully.

Understanding the how life insurance works is essential to getting the right policy for you and your loved ones. You’ll learn how your premium is determined and what to expect from each type of life insurance.

How life insurance premiums work

When you apply for life insurance, the insurance company looks at several factors to determine your premium, including:

  • Age
  • Gender
  • Medical history
  • Family health history
  • Nicotine use
  • Hobbies
  • Occupation
  • Type of policy

You’ll typically pay your premiums monthly, quarterly, semi-annually or annually. Keep in mind that you’ll typically get a discount if you pay less frequently.

Because age and health are major factors, the sooner you buy life insurance, the better. That’s because you can lock in a low premium for the duration of your term. Then, if your health deteriorates or you take up a dangerous hobby like skydiving or rock climbing, you don’t have to let the insurance company know.

On the flip side, if your health improves or you stop smoking, you can apply to have the insurance company reconsider your policy and potentially lower your premium.

If you’re concerned about how your health will affect your premium, you can opt for no exam insurance, which skips the medical exam portion of the application. If you’re healthy, though, and just want to avoid getting poked with a needle, note that a no exam policy can be more expensive.

How the different types of life insurance work

The right life insurance policy for you depends on a few factors. For example, how much the policy costs, how long it lasts and whether you want a savings feature.

Here’s a deeper dive into each of the major types of life insurance and their pros and cons.

Term life insurance

The simplest type of life insurance, term life is also the cheapest. You’ll choose how much coverage you want and for how long. Term lengths typically include five, 10, 15, 20, 25 or 30 years.

Types of term insurance

Level term: Your premiums and death benefit stay the same throughout the life of the policy. Choose this type if you want a cheap policy with no caveats.

Increasing term: Both your premiums and your death benefit increase over time. This can be a good option if your budget is tight now, but you expect to have more money later.

Decreasing term: Your death benefit decreases over time, but your premiums stay the same. People often buy this type to pay off a debt with a decreasing balance, such as a mortgage.

Annually renewable: Your premiums start off low — usually lower than a level policy — and increase each year throughout the life of the policy. Young people can benefit from this type by getting lower premiums for five to 10 years, then replacing it with a level term policy when it starts to get expensive.

Pros

  • Term is more budget-friendly than whole and universal life.
  • Policies are easy to understand.
  • You can cancel your policy without any tax implications.

Cons

  • You may outlive your policy.
  • If your health changes and you can’t re-qualify when your term expires, you may be out of luck.
  • There’s no cash value component.

Whole life insurance

With whole life insurance, you usually don’t have to worry about outliving your coverage — most policies are valid to age 100 or later. Your premiums stay the same throughout the life of the policy, a portion of which pay for the death benefit and the rest goes into a cash value account that grows over time.

Cash value growth rates are guaranteed but typically lower than what you’d earn by investing your money in the stock market. That said, whole life can be a good way to save for retirement if you’re already maxing out your 401(k) and IRA contributions.

You don’t have to wait for retirement to access your cash value funds, however. You can choose instead to borrow from your policy or simply withdraw cash.

If you choose to withdraw, any cash you take out of the account up to what you’ve put into the policy is tax-free. But the earnings portion may be taxable. What’s more, the amount you withdrew will be deducted from the death benefit amount when you die, unless you pay it back.

If you cancel the policy, you’ll receive the cash value balance, and the same tax rules apply.

Pros

  • Coverage is guaranteed for life as long as you pay your premiums.
  • You’ll get a guaranteed rate of return.
  • You can access your cash value funds at any time.

Cons

  • Premiums are expensive compared with term life insurance.
  • Policies are more complex and difficult to understand.
  • Rates of return are modest compared with other investment opportunities.

Universal life insurance

Universal life insurance is another form of permanent life insurance that covers you for life. Premiums are typically expensive and fixed, but depending on which type you choose, you may be able to use your cash value to cover part or all of your payments.

Like whole life, universal life allows you to access your cash value funds through tax-free loans or cash withdrawals, for which the same tax rules apply.

Types of universal life insurance

Guaranteed universal life: This term-permanent hybrid offers lower premiums than you’d get with a typical permanent life insurance policy, but also offers lifetime coverage that you can’t get with a term policy.

It offers little to no cash value, so you don’t really have the flexibility to use the cash value to cover your payments.

Indexed universal life: With this policy, you have the option to allocate some or all of your cash value funds in an account that tracks a stock market index, such as the S&P 500.

While this gives you the opportunity for a higher rate of return than a whole life policy, your gains are capped at a predetermined rate. Also, your cash value account may not grow at all if the index goes down.

You can use your cash value to help cover your premiums, but this can be a poor choice if the index your cash value account is tracking isn’t doing well.

Variable universal life: Instead of tracking a stock market index, variable universal life allows you to invest your cash value funds in various investments, such as stocks, bonds and money market accounts. But again, your gains may be capped at a certain rate.

This comes with a higher risk-return ratio than you’d get with other forms of permanent insurance and requires you to be a little more hands-on. And while you can use your cash value funds to help pay your premiums, doing so can come back to bite you if your investments perform poorly.

Pros

  • Coverage is guaranteed for life as long as you pay your premiums.
  • Flexibility with premiums can help if your budget is tight.
  • Some policies offer the opportunity for higher returns.

Cons

  • Premiums are expensive compared with term life insurance.
  • Returns can be limited by caps and fees.
  • You’ll forfeit the policy if you can’t pay your premiums out of pocket or with your cash value funds.

The bottom line

In its basic form, life insurance is simple. You pay your premium, and you’re covered if you die prematurely. But some life insurance policies can get complicated, making it harder to know whether they’re right for you.

Now that you understand the basics of how life insurance works, get a free consultation with one of our licensed life insurance coaches. They can offer answers to your questions and a quote so you can get the right policy for your budget.

Peace of mind starts at $14/month*

See Your Rate
*Sample quote is based on 35-year-old healthy male in California receiving a $250,000 10-year Term Life policy (Policy Form # I L1702) underwritten by Assurity Life Insurance Company.
ABOUT THE AUTHOR
Ben Luthi is a freelance writer who covers insurance, credit cards, student loans, and other personal finance topics. His work has appeared in publications like USA Today, The Christian Science Monitor, Credit Karma, NerdWallet, Money, and more.

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