From Coverage to Claims: How Does Life Insurance Work?

Many people don’t fully understand what life insurance is or how it works. This guide provides more information about life insurance to help you find the best policy for you and your family.

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Last Updated: 9/20/2022
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According to the Insurance Information Institute (III), 54% of Americans had a life insurance policy as of 2020. Most purchase it because life insurance offers benefits that can support their families after death. Some policies, such as whole life insurance also provide living benefits, which can help you save for retirement or pay for medical care.

The III found that approximately 41 million consumers (or 16% of the American population) don't have coverage, despite saying they need life insurance.

The process of getting coverage can be confusing, leaving people feeling overwhelmed. However, it’s a crucial part of modern money management, so it’s best to know how life insurance works. MoneyGeek provides more information to help you have a better understanding of what life insurance is.

Table of Contents

Key Takeaways

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There are two kinds of life insurance policies — term and permanent. Both offer death benefits, but one may be better suited for you based on your circumstance.

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Life insurance isn't just for those who have children or spouses. If you're single or childless, you can name your siblings, parents, or a trusted friend as your beneficiary.

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A beneficiary doesn't need to be a person — it could be a trust. If you don't name a beneficiary, your death benefit goes to your estate.

The Life Insurance Basics

Life insurance is a broad topic and may leave people feeling confused. MoneyGeek provides information to help you understand what it is, who should purchase it and what factors affect life insurance policy premiums. We also offer practical tips on choosing the best type of life insurance coverage for your needs.

What Is Life Insurance?

Life insurance is a contract between you and your insurance company. Most people purchase life insurance because it assures them their families will have something to fall back on after they have passed.

As with all insurance policies, you need to pay premiums to maintain coverage. In exchange, insurers pay a tax-free lump sum to your chosen beneficiaries upon your passing, who then have the freedom to use the amount in several ways. Death benefits can help pay for funeral expenses and burial costs, as well as household bills or mortgage payments. Some policies offer living benefits, which means you can access a portion of your death benefit while you’re still alive.

Your premium depends on several factors such as coverage limits, policy length and your unique details.

Types of Life Insurance

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

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

In comparison, whole life insurance offers permanent coverage which lasts your entire life. It also allows for a cash-value account, wherein a portion of your premium is set aside and grows over time. Once you accumulate enough cash value, you can begin borrowing against it, allowing you to benefit from the policy while you’re still alive. These characteristics make whole life insurance more expensive. Its annual premium can cost 10 times more than term life insurance.

How Term Life Insurance Works

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. Compared to a permanent policy, term life insurance is more affordable. 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. If you’re young and healthy, term life insurance may be your cheapest option.

Once your policy expires, you can choose to let it go if you feel you no longer need the coverage, renew it or convert it to a permanent policy.

How Permanent Life Insurance Works

As the term implies, permanent life insurance provides coverage for your entire lifetime. It guarantees your beneficiaries will receive death benefits regardless of when you die. Because of this, it costs significantly more than term life insurance.

Permanent life insurance, however, includes an investment component. It means you don’t only get coverage, but you also get additional financial support through that component. This type of policy builds 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 since these are more expensive plans. Your policy may lapse if you miss payments.

Common Life Insurance Benefits

The primary benefit of life insurance is the financial support your family receives if you unexpectedly pass away while the policy is in effect. It’s referred to as 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. Hence, it’s called living benefits. These often have secondary benefits, some of which are:

  • Accelerated Death Benefits — Your insurer pays out a portion of your policy if you are diagnosed with a terminal illness.
  • Return of Premium — Your insurer returns all premiums you paid while your policy was in effect if you outlive it.
  • Cash Value Withdrawal — When you access a portion of the cash value of your permanent life insurance policy.
  • Long-Term Care Benefits — Access the death benefit to cover long-term care expenses your health insurance policy doesn’t cover.
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Term and permanent life insurance provide multiple benefits. Having a clear understanding of your coverage needs can help you decide which type is best for you.

Life Insurance Coverage Amounts

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. A higher amount means your loved ones receive more financial support, but it also means you pay higher premiums.

The 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: Take your current income and multiply it 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.

The Claims Process

Insurers don’t automatically pay out death benefits. Beneficiaries must trigger the process by filing a claim. They will need to complete forms and provide evidence about the cause of death.

Insurance companies typically require a copy of the policy and a filled-out claims form. Beneficiaries must also provide a copy of the death certificate, which must be certified through the county, municipality or hospital where the policyholder died.

Most insurers will pay out death benefits within 30–60 days from when beneficiaries file a claim. Payments are made either through a lump sum or an annuity, which pays monthly or annually.

Several situations cause delayed payouts, such as the insured dying within two years of the policy’s issuance or the cause of death being homicide. Other reasons include the omission of known health issues or engagement in risky activities.

Compare Life Insurance Rates

Ensure you’re getting the best rate for your life insurance. Compare quotes from top providers to find the most affordable life insurance coverage for your needs.

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Insurance Rates

Who Needs Life Insurance?

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

An example would be an entrepreneur who loaned money to start their own business. If they unexpectedly die while the policy is in effect, their beneficiaries can use the death benefits to pay off the remainder of the loan. Another instance is if you are the sole breadwinner of your family. In the unfortunate event of your passing, your family can use the payout to continue supporting themselves.

Many people don’t get life insurance because they think it’s too expensive, but policies may be more affordable than you think.

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The best time to purchase life insurance is when you’re young since premiums are cheaper. As you age, you may develop health problems that cause rates to increase or, worse, disqualify you from purchasing a policy.

How Much Life Insurance Do You Need?

You have the freedom to choose how much coverage your life insurance policy provides — it can range from $100,000 to $1 million or more. Remember, though, that the bigger the payout, the higher your premium becomes. You’ll need to weigh this against ensuring that your death benefit is enough to support your loved ones should you pass away unexpectedly.

To ensure you have enough life insurance, you can examine your current financial responsibilities and see if your policy can cover the total amount. These should include your mortgage balance, future expenses (such as college tuition) and any existing debt.

Another way to determine how much life insurance you need is to multiply your annual salary by 10 and use this as a baseline.

What Determines Life Insurance Costs?

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.

1

Term Length

Term length refers to the amount of time a life insurance policy stays in effect. The longer the term length, the higher the likelihood your insurer will have to pay out your death benefit, making your premium more expensive.

2

Coverage Amount

The coverage amount is how much your insurer pays out as a death benefit. The higher your coverage, the more your insurer will have to pay, leading them to charge a higher premium.

3

Age

How old you are when you purchase your life insurance policy can significantly affect your premium. People are encouraged to buy life insurance when they’re younger because rates tend to be lower.

For example, a 30-year-old female in excellent health who has never smoked can purchase a $500,000 policy with a 15-year term from Progressive for an average of $24.80 per month. In comparison, a 50-year-old woman with the same profile buying life insurance with the same terms and coverage will have to pay $114.41 monthly on average.

4

Gender

Generally, women have longer life expectancies, so insurers often offer them more affordable life insurance. On average, Mass Mutual offers a policy with a 20-year term and $500,000 in coverage to a 40-year-old female in excellent health for $31.33 per month. A 40-year-old male with a similar profile purchasing a policy with the same length and coverage pays an average of $36.55 a month. The rate gap between genders also becomes wider as they age.

5

Overall Health

You’ll need to complete a medical exam before most insurers agree to sell you a life insurance policy. If you are in good health, you’re less likely to die within your coverage period, which leads insurers to approve you for a lower premium. Health issues or pre-existing conditions such as a high BMI or a heart condition may result in more expensive rates.

6

Smoking Status

Insurers find smokers more of an insurance risk than non-smokers. They are more likely to develop health issues and have a shorter life expectancy.

Prudential offers a policy with a 20-year term and a $500,000 coverage to a 40-year-old non-smoker for an average of $45.65 per month. The rate for a smoker with the same profile and similar policy preferences increases by more than 400% — they’ll have to pay a monthly premium of $185.18 on average.

Compare Life Insurance Rates

Ensure you’re getting the best rate for your life insurance. Compare quotes from top providers to find the most affordable life insurance coverage for your needs.

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Insurance Rates

How to Choose the Best Life Insurance Policy

You must consider several factors when deciding which type of life insurance you’ll purchase. Both term and permanent life insurance policies have their own set of advantages and disadvantages. Permanent life insurance may cost you more, but you have coverage for your entire life. Term life insurance is an affordable way to get coverage. However, once it expires, your premium may increase if you want it renewed.

If you have a short-term loan or have young children, a term life policy may be enough. These involve expenses that may diminish over time — for instance, as your children grow older, they’ll be less dependent on your income. However, if you have a lifelong dependent, such as a child or sibling with disabilities, or if you require long-term care, you may be better off with a permanent life insurance policy.

Comparing Term and Permanent Life Insurance

Life insurance provides benefits to most people, but knowing what term and permanent life insurance have to offer can help you decide which insurance type is best suited for you. The table below details the benefits and drawbacks for each. One may fit better than the other based on your situation.

  • Type of Life Insurance
    Pros
    Cons
    Who It’s Best For
    Who It May Not Work For
  • Term

    • Offers multiple options
      for policy length
    • May cost more if you want to
      renew your policy after it expires
    • Those who want an
      affordable life insurance policy
    • Those who have life-long dependents, such
      as a child with disabilities
  • Permanent

    • Earns cash value
    • Provides lifelong coverage
    • Higher premiums
    • Those who want to use their life
      insurance as an investment vehicle
    • Those who aren’t comfortable
      with an expensive premium

How to Choose the Right Beneficiary

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.

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Make sure to review your beneficiaries regularly. Life events such as getting married, divorced or having a child may require you to update your policy.

How to Buy Life Insurance

Most people see the need to have life insurance but still don’t carry a policy. One of the most common reasons for this is that they aren’t aware of the steps involved in purchasing it. By understanding how the process works, you can clear up confusion and make an educated decision for your life insurance needs.

1

Calculate how much life insurance you need.

First, determine how much coverage you need. Consider all your financial obligations (present and future) and make sure your policy will cover the total amount. Your income is also a good benchmark — take your current annual salary and multiply it by 10.

2

Research life insurance companies and what policies are available to you.

Insurance companies offer a variety of life insurance policies. The company with the lowest rates isn’t always the best option. Make sure to check other aspects such as financial stability, user experience ratings and customer complaint ratios.

These will help you determine which company will give you the best deal and increase the likelihood that your beneficiaries can easily file the claim for your death benefit.

3

Determine the type of life insurance you want as well as the coverage amount.

Both of these factors affect the cost of life insurance. Consider your financial responsibilities and see whether a term or permanent life policy is more appropriate for your situation. Remember, either one has advantages and disadvantages.

Your coverage amount should be enough to help your beneficiaries pay for expenses if something happens to you.

4

Gather multiple life insurance quotes.

Explore what different insurers have to offer. You can usually get quotes online, so you don’t have to visit various agents. You can also use an online comparison tool to make your search more efficient.

5

Compare life insurance quotes and policy options.

Although insurers use the same factors, they compute rates differently. It’s not unusual to find varying rates from different life insurance companies. Comparing life insurance quotes from three or four insurers gives you more options and lets you choose the best one.

6

Decide on a policy and purchase it.

When you find a policy that you’re happy with, you can fill out an application form. Most insurers allow you to do this online. You may also need to submit an Attending Physician’s Statement from your doctor.

Insurers may have different processes, but typically you’ll go through a phone interview and a medical exam. Insurance companies use the results from these activities to determine whether you’re eligible or not. If you are, you’ll receive the policy documents to sign.

Compare Life Insurance Rates

Ensure you’re getting the best rate for your life insurance. Compare quotes from top providers to find the most affordable life insurance coverage for your needs.

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Insurance Rates

Life Insurance FAQs

Some people can be overwhelmed by the idea of getting life insurance. Learning the answers to some frequently asked questions can provide more information about how life insurance works.

About the Author


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Mark Fitzpatrick is a senior content manager with MoneyGeek specializing in insurance. Mark has years of experience analyzing the insurance market and creating original research and content. He graduated from Boston College with a Bachelor of Arts and Johns Hopkins University with a Master of Arts.


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