How Does Life Insurance Work?

Life insurance works by paying a tax-free death benefit to your beneficiaries if you pass away while your policy is active. In exchange for regular premium payments, your insurance provider guarantees a lump-sum payout to the people you name in your policy.

Your beneficiaries must file a claim with the insurer to receive this benefit. The payout can be used for anything — from covering funeral expenses and medical bills to paying off debts or replacing lost income.

There are two main types of life insurance: 

• term life: this covers you for a set number of years
• permanent life: this lasts your entire life and may accumulate cash value. 

Understanding how each policy works helps ensure you choose the right plan for your family’s financial security.

Life insurance is a financial contract between you and an insurance company. In exchange for regular premium payments, the insurer promises to provide a tax-free lump sum — known as a death benefit — to your chosen beneficiaries when you pass away.

The primary goal of life insurance is to protect your loved ones financially after your death. This payout can help cover funeral expenses, pay off debts like a mortgage or credit cards, replace lost income, or fund future needs such as a child’s education. In some cases, policies also include living benefits, which allow you to access part of the death benefit while you’re still alive if you’re diagnosed with a serious illness.

Your life insurance premium is based on factors like your age, health, policy type, and coverage amount. Life insurance helps ensure your family or dependents aren’t left with financial hardship when you’re gone.

Life insurance policies come in two main types: term and permanent. Regardless of which you choose, your beneficiaries will receive death benefits if you die while the policy is active. Another similarity is the premium. Life insurance payments remain the same throughout.

What sets these two apart are cost and length. Term life insurance overs you for a specific amount of time for affordable rates. If you outlive your policy, your beneficiaries don’t receive a life insurance payout.

Permanent life insurance offers coverage that lasts your entire life. It also allows for a cash-value account, in which a portion of your premium is set aside and grows over time. Once you accumulate enough cash value, you can begin borrowing against it, offering a tangible life insurance policy benefit while you’re still alive. These characteristics make permanent life insurance more expensive, so understanding the details of your life insurance policy is important.

Term life insurance provides temporary coverage. You determine the length of the policy upon purchase. Temporary does not necessarily mean short. Term life insurance typically covers 10-, 20- or even 30-year periods. Its affordability compared with a permanent policy is one of the key benefits of a life insurance policy of this nature. Its lower premiums are a result of providing temporary coverage.

If you’re only looking for coverage for short-term needs, such as educational costs or your mortgage, term life insurance may be a logical choice. It is also a good option if you want affordable coverage. For young and healthy individuals, a term life policy could be the cheapest choice, highlighting its role in fulfilling the main purpose of life insurance.

Once your policy expires, you can choose to let it go if you feel you no longer need the coverage, renew it or convert the term plan to a permanent policy. This flexibility is vital to understanding life insurance and strategically planning for your financial future.

Permanent life insurance provides coverage for your entire lifetime, offering a guarantee that your beneficiaries will receive life insurance compensation no matter when you pass away. Because of this, it costs significantly more than term life insurance.

A distinctive aspect of permanent life insurance is its investment component, allowing the policy to serve as a safety net and a financial growth tool. This feature contributes to the benefits of a life insurance policy, as it accumulates cash value over time. Once the cash value reaches a sizable amount, you can borrow against the account.

You may find permanent life insurance a better option if you want your policy to double as an investment vehicle. It’s also a better choice if you have a lifelong dependent, like a child with disabilities. Make sure you’ll be able to afford the premium for the long term because these plans are more expensive. Your policy may lapse if you miss life insurance policy payments.

Many people can benefit from having a life insurance policy — it allows your loved ones to have financial support in the event of an unexpected passing. You can use death benefits to cover a wide array of expenses, including tuition fees, mortgages and regular costs associated with the household.

You typically need enough life insurance to cover your current debts, future expenses and income replacement — most experts recommend coverage equal to 10 to 15 times your annual income.

The right amount depends on your individual financial obligations. At a minimum, your policy should cover your mortgage balance, outstanding debts, college tuition for children, and provide enough income for your loved ones to maintain their lifestyle.

While coverage amounts can range from $100,000 to over $1 million, keep in mind that higher coverage comes with higher premiums. Aim for a balance that provides meaningful protection without straining your budget.

Life insurance generally covers death due to illness, accidents and natural causes. Here's a detailed look at what a typical life insurance policy might cover:

• Death by Illness or Accident: The policy pays out if you die due to an illness or accident.
• End-of-life Expenses: Funeral and burial costs can be covered, easing the financial burden on your family.
• Estate Planning Costs: If you have a large estate, life insurance can cover taxes and legal fees.
• Monthly Bills and Mortgage Payments: The death benefit can help your family maintain their standard of living by covering ongoing expenses.
• Income Replacement: The death benefit can serve as income replacement, ensuring your family can maintain their current lifestyle even in your absence.
• Educational Expenses: You can allocate the death benefit to cover tuition fees and other educational expenses, ensuring that your children's future remains secure.
• Debt Repayment: You can use the death benefit to settle debts, such as mortgage, car loan or credit card debt, preventing the financial burden from passing onto your family.

Specific life insurance policy information and the scope of your coverage will vary depending on the policy and provider.

While life insurance offers broad coverage, it's not a catch-all safety net. Here are some common exclusions:

• Pre-existing Conditions: Some policies may not cover deaths related to pre-existing medical conditions if the policyholder did not disclose them during the application process.
• War and Terrorism: Most life insurance policies do not cover deaths that occur due to acts of war or terrorism.
• Hazardous Occupations: Insurance companies consider some occupations hazardous, and deaths related to these occupations may either increase the premium or lead to certain exclusions. Examples include miners, loggers, fishermen, firefighters, police officers and construction workers.
• Death by Suicide within the First Two Years: Most policies won't pay out if the policyholder dies by suicide within the first two years. This exclusion, which is a part of the suicide clause, specifically prevents beneficiaries from claiming life insurance benefits under these circumstances.
• Insurance Fraud: Providing false information on your application can lead to a denial of the death benefit.
• Specific Exclusions: Some policies exclude deaths due to risky activities like skydiving or car racing.

Learning about these rules helps clarify what life insurance means in a tax context and ensures you can understand life insurance fully before making a decision. Remember to thoroughly check life insurance details and terms to familiarize yourself with its exclusions.

The primary benefit of life insurance is the financial support your family receives if you unexpectedly pass away while the policy is in effect. This life insurance compensation is referred to as a death benefit. Insurers will pay a tax-free lump sum to your beneficiaries.

Some policies allow you to take advantage of your coverage while you're still alive. These are called living benefits. They often have secondary benefits, some of which are:

Being informed about these benefits of a life insurance policy enhances your ability to make educated decisions about your policy.

Your policy’s coverage amount translates to how much your insurer pays out as a death benefit. There’s no standard coverage amount for life insurance, but the more common policy face values are $100,000, $250,000 and $500,000.

Your appropriate coverage amount depends on your financial situation. You can use the DIME method to estimate how much coverage you should purchase. It covers the following:

• Debt: How much debt would you be leaving for other people to pay? Include loans you’ve taken out.
• Income: Multiply your current income by the number of years you want to provide income replacement for your loved ones.
• Mortgage: How much is your current mortgage balance?
• Education: Consider how much college tuition, room and lodging costs.

Overall, a higher coverage amount provides more life insurance compensation, but it also means you pay higher premiums. We've provided the following guides for the four common life insurance policy values:

To receive the death benefit from a life insurance policy, beneficiaries must file a claim with the insurer. Payouts aren’t automatic — they require documentation and review. Most claims are paid within 14 to 60 days, but delays can occur based on the circumstances of the death or missing paperwork.

Before purchasing a life insurance policy, learning about its tax implications would allow you to make sure it aligns with your overall financial plan.

Understanding life insurance and its tax implications allows you to better align your policy with your financial goals. Make sure to review the life insurance rules and consider consulting a tax professional to avoid unexpected tax liabilities while maximizing the benefits of your policy.

Insurers use a variety of factors to determine the cost of life insurance. It results in premiums that vary because of an individual’s unique details, such as age or general health conditions. Learning more information about the different elements affecting your life insurance premium can help you make an educated purchase.

Gaining information about these life insurance factors provides a comprehensive view of life insurance basics and the purpose of life insurance, ensuring you select a policy that aligns with your budget and long-term needs.

Choosing the right life insurance policy depends on your financial goals, the length of coverage you need, and who relies on your income.

Start by Understanding the Two Main Types:

• Term Life Insurance: Offers affordable coverage for a specific period, such as 10, 20, or 30 years. It’s a smart choice if you need protection during high-expense years — like paying off a mortgage or raising children. Once the term ends, renewing the policy typically results in higher premiums.
• Permanent Life Insurance: Provides lifelong coverage and includes a cash value component. It’s more expensive than term life but may be better suited if you want a policy that doubles as a financial asset or if you have a lifelong dependent.

Match the Policy to Your Needs:

• If you have short-term financial responsibilities — like a loan or young children — term life insurance is often sufficient and more budget-friendly.
• If you have long-term obligations, such as caring for a child with special needs or planning for estate costs, a permanent policy may provide more lasting value.

By weighing your current financial responsibilities and future goals, you can choose a policy that offers the right level of protection for your loved ones — both now and later.

Life insurance can benefit most people, but knowing what term and permanent life insurance offers can help you decide which type best suits you. The table below details the benefits and drawbacks of each. One may fit better than the other, depending on your situation.

When you’re choosing a beneficiary for your life insurance policy, spouses and children are obvious choices. After all, financial support for the family is the most common reason why people purchase life insurance in the first place. If you’re not married, you can name your siblings or your parents. Even a trusted friend can be a recipient of your death benefit.

There are two types of beneficiaries. A primary beneficiary is a person or entity you want to receive the payout first. If the insurer cannot find your primary beneficiary, the death benefit goes to the secondary or contingent beneficiary. Remember, a beneficiary doesn’t have to be a person — you can set up your policy so that a trust gets the payout.

If you don’t name any beneficiaries on your policy, your death benefit goes to your estate, which could result in a delayed payout or diminished amount.

Most people see the need for life insurance but don’t carry a policy, commonly because they aren’t aware of the steps involved in purchasing it. Understanding the process can clear up confusion and help you make an educated decision for your life insurance needs.

Life insurance offers peace of mind by providing financial protection to your loved ones after you’re gone. Whether you choose term or permanent coverage, the key is selecting a policy that matches your family’s needs, financial obligations, and long-term goals. By understanding how life insurance works — from paying premiums to how death benefits are claimed — you can make confident, informed decisions that safeguard your family’s future.

These answers to some of the most frequently asked questions can provide more information about how life insurance works.

Why Trust MoneyGeek? We analyzed 1,488 life insurance quotes alongside customer satisfaction, financial stability reports, product offerings and more to determine the best life insurance companies.

MoneyGeek created a scoring system to compare life insurance companies across five categories and ranked them based on their scores. We chose to review these companies based on their broad national coverage and ability to provide an online quote.

MoneyGeek’s Scoring System

MoneyGeek ranked the top life insurance companies for parents using the following weightings:

• Financial Stability: 35%
• Customer Satisfaction: 25%
• Buying Process: 20%
• Product Diversity: 20%

We did not include affordability in the calculation since we do not have quotes for whole life insurance policies. Of the companies that offer whole life insurance plans, we chose the one with the highest score.

Each company’s score incorporates the following:

• Cost data obtained through online quotes
• Financial strength ratings from AM Best and number of years in business
• Customer satisfaction data from the National Association of Insurance Commissioners (NAIC) customer complaint index (we reviewed annual complaint data from 2020 to 2022, the most recent year available)
• Availability of tools to aid in the buying process, such as online product materials and multiple payment options
• Diversity of life insurance products offered

Sample Customer Profile

MoneyGeek used a standard profile to obtain life insurance quotes:

• 40-year-old male
• Non-smoker
• 5 feet 11 inches tall and 175 pounds
• Excellent health rating

Premiums are based on the standard profile unless otherwise noted.

We modified the profile by age, gender, height, weight, tobacco use, health rating and geographic location to collect a variety of quotes and determine the best life insurance company for several types of customers. We collected quotes for term life insurance with varying term lengths and coverage amounts as well.

We identified trends in the data set and used those patterns to calculate projections and extend the data beyond what was originally collected.