How Does Life Insurance Work?
Life insurance provides financial protection for your loved ones by paying a death benefit when you pass away.
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Written byBen Luthi
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Ben Luthi
Ben Luthi has been writing about personal finance for over a decade with the intent to help people improve their finances and lifestyle. He’s covered just about every personal finance topic under the sun for a variety of publications, including the Wall Street Journal, Fortune Recommends, Yahoo Finance, Experian, Credit Karma, NerdWallet, and many more. Ben lives near Salt Lake City with his two kids and two cats.
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Edited bySara Getman
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Sara Getman is an Associate Editor at Insurify and has been with the company since 2022. Prior to joining Insurify, Sara completed her undergraduate degree in English Literature at Simmons University in Boston. At Simmons, she was the Editor-in-Chief for Sidelines Magazine (a literary and art publication), and wrote creative non-fiction.
Outside of work, Sara is an avid reader, and loves rock climbing, yoga, and crocheting.
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Table of contents
Life insurance is a policy between you and an insurance company that gives financial protection to your beneficiaries when you die. New parents and anyone with financial dependents might need life insurance to replace lost income, pay off debts, and cover burial expenses in the case of their death.
In this guide, you’ll learn how life insurance policies work, explore different policy types, break down costs and premium payments, identify factors affecting rates, and get step-by-step guidance on choosing the best policy for your family’s needs.
Here’s what you need to know about life insurance.
How life insurance works
Life insurance generally follows a straightforward process:
You apply for coverage.
The insurance company evaluates your risk factors.
Upon approval, you pay regular premiums to keep your policy active.
Your beneficiaries receive a payout if you pass away within the policy’s term.
Upon your death, your designated beneficiary (the person or people you list to receive the insurance payout after you pass away) will file a claim with the insurance company, typically providing a death certificate and a completed claim form. The claims process usually takes 30–60 days, after which the beneficiary or beneficiaries receive the claim payout, known as a death benefit.[1]
Standard policies cover most causes of death. But exclusions may apply for self-harm resulting in death within a set period after the purchase of a policy. Exclusions can also apply for deaths resulting from military service or illegal activities.
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The basics of life insurance
Life insurance serves as a financial safety net, replacing your income and protecting your family’s financial future when you’re no longer there to provide for them. Like all other types of insurance, it’s a legal contract. To uphold this contract, you pay premiums in exchange for a specific amount of coverage.
In the case of your death, the insurance company will pay your beneficiaries based on the amount of coverage your insurance provides.
This coverage primarily serves the purpose of income replacement and debt protection, ensuring your family can maintain their lifestyle and pay off mortgages, loans, and other obligations.[2]
Key life insurance terms include:
Policyholder: The person who owns the policy and pays premium payments
Insured: The person whose life the policy covers
Beneficiary: The person or entity who receives the death benefit payout
Death benefit: Also called the face amount, it’s what the insurer pays to beneficiaries upon the insured’s death
Premiums: Regular payments required to keep the policy active and in force
Types of life insurance to consider
Two types of life insurance are generally available: term coverage and permanent coverage. Term policies provide life insurance for a specific term length, while permanent policies offer lifelong coverage plus an investment component.
Both policy types pay death benefits to beneficiaries, but permanent life insurance also accumulates cash value that policyholders can access through loans or withdrawals.
Permanent life insurance includes several subcategories, including:[3]
Whole life insurance: Features fixed premiums, guaranteed cash value growth, and lifetime coverage
Universal life insurance: Offers flexible premiums and death benefits with market-based cash value growth
Variable life insurance: Allows policyholders to direct cash value investments into various subaccounts
Variable universal life: Combines universal life flexibility with variable life investment options
Here’s a look at more ways these types of coverage can differ:
Types  | Term | Whole | Universal | Variable |
|---|---|---|---|---|
| Duration | 10–40 years; some are annually renewable | Lifetime | Lifetime | Lifetime |
| Premiums | Usually level during the term; annually renewable policies may have increasing premiums | Fixed for life | Flexible | Fixed or flexible |
| Cash value | None | Yes; guaranteed growth | Yes; interest-sensitive | Yes; investment-based |
| Best for | Temporary needs and budget-conscious people | Stable, lifelong protection | Flexible coverage needs | Investment-focused people |
Term life insurance offers affordable protection but expires after the term length, while permanent policies provide lifelong protection with additional benefits through cash value accumulation. Many policies include optional riders that enhance coverage for additional costs, such as a disability premium waiver or accelerated death benefits for terminal illnesses.[4]
Term life insurance provides death benefit protection for a set period, typically ranging from 10 to 40 years. This temporary protection makes it the most affordable option for substantial coverage amounts.
Term policies typically feature level premiums during the initial term, meaning your monthly payments remain consistent throughout the coverage period. But some are annually renewable, and premiums may increase.
Many term policies include conversion options that allow you to convert some or all of your term coverage to permanent life insurance without undergoing an additional medical exam. But conversion typically needs to happen before age 65–75 or by a certain point in your policy’s term.[5]
Whole life insurance combines a lifelong death benefit protection with a savings component that builds guaranteed cash value over time. These policies have fixed premiums that never increase, providing predictable costs throughout your life.
The cash value grows at a guaranteed rate set by the insurance company, offering stable but typically lower returns than stock market-based investments. Whole life insurance costs significantly more than term coverage because premiums fund both the death benefit and the cash value accumulation. This makes it suitable for long-term estate planning and wealth transfer strategies.
Universal life insurance offers flexible premium payments and adjustable death benefits, allowing you to modify coverage and cost as your needs change throughout your life. The cash value earns interest based on current stock market rates. This potentially provides higher returns than whole life policies but is less predictable.
Variable life insurance lets you direct cash-value investments into various subaccounts so you have the potential for higher returns. But this does come as a bigger investment risk that could reduce your cash value. Both policy types provide more flexibility than whole life insurance but require more active management and understanding of the investment components and tax implications.
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How much does life insurance cost?
On average, a healthy 35-year-old man pays approximately $33 monthly for $1 million in 20-year term life insurance coverage. The same coverage amount in whole life insurance costs around $324 per month.
Term life policies consistently cost less than permanent policies because they provide only insurance protection and don’t have an investment component that builds cash value. Here’s a look at some average costs of coverage for both term and whole life.
Age and Gender | Term | Coverage Amount | Monthly Premium |
|---|---|---|---|
| 25-year-old woman | 10 years | $250,000 | $8 |
| 25-year-old man | 10 years | $250,000 | $10 |
| 25-year-old woman | 20 years | $500,000 | $15 |
| 25-year-old man | 20 years | $500,000 | $18 |
| 35-year-old woman | 10 years | $250,000 | $9 |
| 35-year-old man | 10 years | $250,000 | $10 |
| 35-year-old woman | 20 years | $500,000 | $17 |
| 35-year-old man | 20 years | $500,000 | $20 |
| 45-year-old woman | 10 years | $250,000 | $15 |
| 45-year-old man | 10 years | $250,000 | $17 |
| 45-year-old woman | 20 years | $500,000 | $36 |
| 45-year-old man | 20 years | $500,000 | $45 |
| 55-year-old woman | 10 years | $250,000 | $28 |
| 55-year-old man | 10 years | $250,000 | $37 |
| 55-year-old woman | 20 years | $500,000 | $83 |
| 55-year-old man | 20 years | $500,000 | $113 |
Source: Insurify partner SelectQuote provided these averages based on term policies and whole life policies from one or more of the companies SelectQuote represents. Rates are for men and women in excellent health. Premiums may vary depending on individual health, issuing company, and other factors.
Age and Gender | Coverage Amount | Monthly Premium |
|---|---|---|
| 25-year-old woman | $250,000 | $64 |
| 25-year-old man | $250,000 | $69 |
| 25-year-old woman | $500,000 | $113 |
| 25-year-old man | $500,000 | $130 |
| 35-year-old woman | $250,000 | $91 |
| 35-year-old man | $250,000 | $103 |
| 35-year-old woman | $500,000 | $152 |
| 35-year-old man | $500,000 | $181 |
| 45-year-old woman | $250,000 | $123 |
| 45-year-old man | $250,000 | $145 |
| 45-year-old woman | $500,000 | $219 |
| 45-year-old man | $500,000 | $265 |
| 55-year-old woman | $250,000 | $170 |
| 55-year-old man | $250,000 | $209 |
| 55-year-old woman | $500,000 | $328 |
| 55-year-old man | $500,000 | $390 |
Source: Insurify partner SelectQuote provided these averages based on term policies and whole life policies from one or more of the companies SelectQuote represents. Rates are for men and women in excellent health. Premiums may vary depending on individual health, issuing company, and other factors.
Factors that affect life insurance costs
Similar to other types of insurance, life insurance companies use various rating factors to assess risk and determine premium costs. The application process includes detailed health questions, a medical history review, and possibly a physical exam.
Key factors affecting life insurance costs include:
Age
Older applicants pay higher premiums due to an increase in mortality risk.
Health
Current medical conditions and family history significantly affect rates.
Nicotine use
Smokers typically pay two to three times more than non-smokers.
Policy duration
Longer term lengths generally cost more due to extended risk exposure.
Type of policy
Permanent policies cost more than term policies due to cash value components.
Gender
Women typically pay slightly less due to longer life expectancy statistics.
Lifestyle
Dangerous hobbies or occupations may result in higher premiums or more exclusions.
Medical history
Past health issues or treatments affect risk assessment and pricing.
Younger, healthier people generally secure the lowest premiums, making it advantageous to purchase coverage early in life to lock in affordable rates before health issues develop.
How much life insurance coverage do you need?
Two popular methods can help you determine how much coverage you need: the DIME formula and the 10x income rule.
The DIME formula calculates coverage needs by adding up your debts, income replacement, mortgage, and education costs. For example, if you have $50,000 in debts, need $500,000 for income replacement, owe $200,000 on your mortgage, and want $100,000 for your children’s education, your total coverage would need to be at least $850,000.
The 10x income formula simply multiplies your annual income by 10 to estimate coverage needs. Using this method, someone earning $75,000 annually would need approximately $750,000 in life insurance coverage. This approach provides a quick estimate but may not account for specific family circumstances.
When calculating coverage needs, consider additional costs, such as childcare expenses, future college tuition, stay-at-home spouse contributions, and burial expenses. These factors can significantly affect your family’s financial situation and should influence your coverage decision.
How to choose and buy the right life insurance policy for you
Finding the right life insurance policy requires balancing enough coverage with affordable premiums that fit your budget. The decision process involves several key steps to ensure you select appropriate protection for your specific needs and circumstances.
Follow these steps to choose your ideal policy:
Assess needs. Calculate your coverage needs using the DIME formula or the 10x income rule.
Estimate your budget. Determine the monthly premium amounts you can comfortably afford long-term.
Decide on coverage duration. Consider whether you need coverage for a certain amount of time, such as 10 or 20 years, or if you prefer lifelong protection with a permanent policy.
Compare riders. Evaluate optional benefits like disability waivers, conversion options, or living benefits.
Vet company ratings. Research the financial strength and customer service ratings of insurers before you buy coverage from them.
The buying process is pretty straightforward once you’ve made these decisions:
Gather the necessary information. Compile your medical history documents, financial documents, and beneficiary details so you can fly through the application process.
Get and compare multiple quotes. Request quotes from several highly rated insurance companies to compare coverages and rates.
Complete an application. Provide detailed information about your health, finances, and lifestyle factors.
Schedule a medical exam. Most policies require a basic health screening by a medical examiner. Some may include a blood test and a urine sample.
Review the policy. Carefully examine all terms, exclusions, and riders before accepting your coverage.
Pay the first premium. Submit the initial payment to activate your policy and begin your coverage.
Safely store policy documents. Keep your original policy and related paperwork in a secure, accessible location.
Tips to help save on life insurance premiums
You can reduce your life insurance costs in several ways while maintaining adequate coverage for your family’s needs. Here are just a handful of money-saving tips:
Buy while you’re young. Premiums increase significantly with age, so purchasing coverage early locks in lower rates.
Work to stay healthy. Maintain a healthy weight, avoid tobacco use, and exercise regularly.
Pay your premium annually. Most insurance companies offer discounts for making annual payments instead of monthly installments.
Skip unnecessary riders. Purchase additional benefits only if they provide meaningful value for your specific situation.
Compare quotes every three to five years. Shop around periodically to ensure you’re getting competitive rates as market conditions change.
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How to file a life insurance claim
Beneficiaries handle the claims process after the policyholder’s death in order to receive the death benefit payout. Essential documents typically include a certified death certificate and a completed claim form, which you can get from your insurer.
The claims process usually takes 30–60 days from the time the insurance company receives all the documentation. Beneficiaries can typically choose between a lump sum payment or payments spread over time.
Also, life insurance death benefits are generally tax-free to beneficiaries. But if you choose to receive payments over time and the money continues to gain interest, you may have to pay taxes on the interest.[6]
How life insurance works FAQs
Life insurance is an important and, at times, confusing coverage. The answers to these frequently asked questions address common concerns about life insurance and its benefits.
How do life insurance companies make a profit?
Insurance companies profit by collecting more in premiums and investment returns than they pay out in claims and operating expenses.
How do life insurance policies pay out?
Policies pay death benefits to designated beneficiaries after the insurer processes a claim and verifies the policyholder’s death. Depending on the beneficiary’s preference, they may receive a lump sum or periodic payments.
How does the death benefit of a life insurance policy work?
The death benefit is a tax-free payout to beneficiaries equal to the policy’s coverage amount, assuming premiums are current and no exclusions apply to the cause of death.
Can you cash out your life insurance policy?
Yes, if you have a permanent life insurance policy. Permanent life insurance policies can be surrendered for their current cash surrender value, but this terminates coverage and may have tax consequences.
Which life insurance is better, term or whole?
Term life insurance works better for temporary coverage needs and budget-conscious buyers, while whole life insurance suits long-term estate planning and wealth-accumulation goals.
Sources
- III. "How do I file a life insurance claim?."
- III. "What are the principal types of life insurance?."
- III. "What are the different types of permanent life insurance policies?."
- Naic.org. "Life Insurance."
- III. "How to choose the right type of life insurance."
- IRS. "Life insurance & disability insurance proceeds."
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Ben Luthi
Ben Luthi has been writing about personal finance for over a decade with the intent to help people improve their finances and lifestyle. He’s covered just about every personal finance topic under the sun for a variety of publications, including the Wall Street Journal, Fortune Recommends, Yahoo Finance, Experian, Credit Karma, NerdWallet, and many more. Ben lives near Salt Lake City with his two kids and two cats.
Sara Getman is an Associate Editor at Insurify and has been with the company since 2022. Prior to joining Insurify, Sara completed her undergraduate degree in English Literature at Simmons University in Boston. At Simmons, she was the Editor-in-Chief for Sidelines Magazine (a literary and art publication), and wrote creative non-fiction.
Outside of work, Sara is an avid reader, and loves rock climbing, yoga, and crocheting.
