How Does Life Insurance Work? Everything You Should Know

Catherine Collins
Catherine Collins

Catherine leverages her background in education and finance to write articles that help readers make informed decisions about their insurance and finances.

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Katie Powers
Edited byKatie Powers
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Katie PowersAuto and Life Insurance Editor
  • Licensed auto and home insurance agent

  • 3+ years experience in insurance and personal finance editing

Katie uses her knowledge and expertise as a licensed property and casualty agent in Massachusetts to help readers understand the complexities of insurance shopping.

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Updated February 7, 2023 | Reading time: 7 minutes

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Life insurance is an important part of any financial plan, providing a safety net for your family in the event of your death. A life insurance policy can help ensure your loved ones are taken care of financially if something were to happen to you. In this article, we’ll discuss how life insurance works, what types are available, and how to determine which is the right fit for you.

What is life insurance?

Life insurance is a contract between a person — also known as the policyholder — and an insurance company. The policyholder pays the insurer a premium — an agreed-upon sum. If the policyholder dies while the policy is in effect, the insurance company must pay an agreed-upon sum, called a death benefit, to the beneficiaries (usually family members) of the deceased person. This money can help alleviate some of their financial burdens and provide some much-needed security during a difficult time.

Types of life insurance policies

Various types of life insurance policies are available to suit different needs. Three main types are whole life insurance, term life insurance, and universal life insurance.

Whole life insurance

Whole life insurance is a type of permanent policy that provides coverage for your entire life with premium payments that typically remain level. It also typically builds “cash value” that accumulates over time.[1] 

Your premiums will stay the same for as long as you have the policy, and as your cash value accumulates, you can borrow against it to cover unexpected expenses. However, whole life is generally the most expensive type of life insurance. And you may have to pay fees or penalties to borrow against your cash value.

Learn More: How Much Life Insurance Do I Need?

Term life insurance

Term life insurance is a temporary form of coverage that provides death- or illness-related expenses for a predetermined period of time, such as 10 or 20 years. It has no cash value and expires at the end of the term. 

Term life insurance offers flexibility in coverage amounts and lengths of policy, and it’s generally more affordable than other types of life insurance, such as whole life. However, term life insurance doesn’t provide any cash value in the event of outliving the policy’s lifespan, and a lapse in payments can result in a cancellation of the policy.

See Also: Types of Term Life Insurance

Universal life insurance

Universal life insurance is a type of permanent life insurance. It has a cash value that accumulates over time, which can be used to pay premiums at a later date. Premiums can be lower than whole life insurance because the cash value of universal life insurance earns interest according to the market rate. So, if the market fluctuates, your premiums can fluctuate. Thus, universal policies offer more flexibility than either whole or term life policies. However, there’s no guarantee of returns, since the interest rate is based on the market rate, and it’s possible your policy will get more expensive as you age.

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How to pick the right life insurance policy

When it comes to picking the right life insurance policy, it’s important to consider all your options and decide which type best fits your needs.

  • Evaluate how much coverage you need. Take into account both current and future financial obligations as well as any major expenses that you or your family may face in the future.[2]

  • Consider your budget. Look at both short-term and long-term costs associated with each policy, taking into account premium payments.

  • Research providers. Shop around to find an insurer that offers competitive rates, reliable customer service, and a variety of products that meet your needs.

  • Read the fine print. Understand what each policy covers, as well as any riders or additional features.

  • Talk to an expert. Speak with a financial advisor or insurance broker who can help you understand the different types of life insurance policies available and choose one that fits your requirements.

Keep Reading: How Much Does Life Insurance Cost?

Deciding on your coverage amount

Here are factors a prospective policyholder should consider when deciding on their life insurance coverage amount.

  • The size of your family: The more dependents you have, the higher coverage amount you likely need.

  • Your income: If you’re the primary bread-winner, your family will need your death benefit to offset the loss of your income. Your coverage amount should at least replace your annual income.

  • Other sources of income: If your family has other sources of income, you may be able to reduce your coverage amount.

  • Debts and liabilities: Certain types of debt can pass on to your family after you die. If you have a large mortgage or other transferable debt, make sure to factor that into your coverage amount.

  • Your lifestyle: If you want your family to be able to maintain a certain lifestyle — such as your spouse staying home or keeping your kids in private school — factor that into the amount you think your family will need.

  • Funeral costs: Don’t forget to include the cost of a funeral and other related expenses in your coverage amount. The median cost for funerals was $7,848 in 2021, according to the National Funeral Directors Association.[3]

  • Inflation: Make sure to take into account inflation when calculating your coverage amount.

  • Current and future financial obligations: Consider any outstanding debts that need to be covered, as well as any educational or living expenses that may come up in the near future.

Read More: 10 Best Life Insurance Companies

How to file a life insurance claim

First, contact the insurer as soon as possible after a death has occurred and provide them with information about the deceased, such as their name and date of birth. You’ll also likely need to supply a death certificate or other documentation to prove that the death was covered by the policy. Your insurer will typically require additional evidence or documentation to verify your identity and the relationship between you and the deceased person, such as marriage certificates or legal documents.

Once these items are provided and everything is in order, then the claim is usually processed quickly.

How to find the right life insurance policy for yourself

Shopping around for different policies and comparing quotes can help consumers find the best policy for them at the most reasonable price. It’s also important to read through the fine print of each policy to understand what each covers and what it doesn’t.

Some key factors to consider when shopping for a life insurance policy are the type of policy needed, the amount of coverage desired, and payment terms.

In addition to understanding the various types of policies available, it’s important to know how much coverage you need. This will depend on your age, family size, lifestyle, income level, and other factors specific to you. As a rule of thumb, it’s a good idea to have a death benefit that’s at least five times your annual salary to help your survivors cover major expenses, such as a mortgage or student loans, in case of your death.

Life insurance FAQs

Life insurance can be confusing, as there are many different types, terms, premiums, and other aspects to consider before choosing a company or policy.

Here are answers to some of the most frequently asked questions about how life insurance works.

  • Can you get life insurance with a pre-existing condition?

  • What happens if you don’t pay your premium?

    If you fail to make payments on time or miss any scheduled payments, your policy will lapse and all coverage benefits will cease. If death occurs while the policy is inactive, no death benefit will be paid out, and beneficiaries won’t receive any funds from the policy. It’s important to stay up to date with premium payments so the policy remains active.

  • Does life insurance cover death by suicide?

    It depends on the policy. Most life insurance policies will not cover death by suicide if it occurs within two years of the policy’s start date.[4] After that, companies provide coverage for suicides; however, there may be limitations or exclusions depending on the insurer and type of policy. It’s best to speak with a licensed life insurance agent for more information regarding your particular policy.

  • Is life insurance taxable?

    In most cases, the death benefit from a life insurance policy is not taxable.[5] However, if funds from the cash value are withdrawn or borrowed against, then there may be tax implications depending on how the money is used. It’s important to speak with a qualified tax professional for more information about potential taxes owed on life insurance benefits.

  • How long do you have to have life insurance before it pays out?

    Some types of insurance policies will pay the death benefit even if you pass away soon after the policy takes effect — as long as your premium payments are current. However, other types — notably guaranteed life insurance — may have a waiting period before the death benefit becomes payable.[6][7]

    Check with your insurance provider prior to purchasing a policy, however, as it could vary depending on the company.

  • How does life insurance make you money?

    Life insurance generally doesn’t make money on its own but can be a tool for financial planning and estate planning. Some life insurance policies have a cash value component that allows policyholders to access funds while they’re alive. Some policies may also provide options to invest the cash value of the policy in order to gain additional income. However, it’s important to note that these features come with additional risks. You should discuss this with a qualified professional before making any decisions.

  • Can you cash out a life insurance policy before death?

    Depending on the type of policy you have and the terms agreed upon when taking out the policy, you may be able to cash out a life insurance policy before death. This typically applies to whole life insurance policies, not term life insurance policies.

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  1. FINRA. "Investment Products: Insurance." Accessed January 30, 2023
  2. National Association of Insurance Commissioners. "What Type of Life Insurance is Right for You?." Accessed February 1, 2023
  3. National Funeral Directors Association. "2021 NFDA General Price List Study Shows Funeral Costs Not Rising as Fast as Rate of Inflation." Accessed January 30, 2023
  4. Progressive. "Does life insurance pay for suicidal death?." Accessed January 30, 2023
  5. Internal Revenue Service. "Life Insurance & Disability Insurance Proceeds." Accessed January 30, 2023
  6. Fidelity Life. "Why are there waiting periods for life insurance?." Accessed January 30, 2023
  7. SoFi. "How Long Do You Have to Have Life Insurance Before You Die?." Accessed January 30, 2023
Catherine Collins
Catherine Collins

Catherine Collins is a freelance financial writer and author based in Detroit. She's the co-founder of and, and author of the book Mom’s Got Money: A millennial mom’s guide to managing money like a boss. She has written for US News, Huffington Post, Money, Business Insider, Investopedia, Entrepreneur, Go Banking Rates, and many other publications. She currently resides in Detroit, Michigan with her boy-girl twins and a rescue dog named Julep.

Katie Powers
Edited byKatie PowersAuto and Life Insurance Editor
Photo of an Insurify author
Katie PowersAuto and Life Insurance Editor
  • Licensed auto and home insurance agent

  • 3+ years experience in insurance and personal finance editing

Katie uses her knowledge and expertise as a licensed property and casualty agent in Massachusetts to help readers understand the complexities of insurance shopping.

Featured in

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