How Does Life Insurance Work? (2024)

When It Comes to Life Insurance, There Are No Dumb Questions!

So, you have questions about life insurance.

Perhaps, someone recently told you that you should buy a life insurance policy.

Maybe you already have a policy (or several) but suddenly want to really understand the ins and outs of how life insurance works.

Or, you may be feeling as if paying life insurance premiums is throwing money away because you believe you'll never need it.

Although the general concept of life insurance is pretty simple, when you dive into the details, things start to get complicated. Life insurance is a legal contract, and, as such, there are many small details that can make a big difference.

Often, when we think we “should” understand something, we avoid asking questions that we think someone might perceive as “dumb.” Instead, we nod our heads in agreement and assume everything will work out fine. Unfortunately, when it comes to finances, a lack of knowledge can lead to big problems.

Whether you think you’re already a life insurance pro or you aren’t sure you understand it at all, you’re in the right place. Stick with us as we examine the basics of life insurance and give you answers to questions you might not have even thought to ask.

Table of Contents

1. Why Life Insurance Exists
2. How Life Insurance Works
3. Types of Life Insurance
4. Frequently Asked Questions
5. Rules, Restrictions, and Conditions
6. Where To Buy Life Insurance

Why Life Insurance Exists

Before we get into the nitty-gritty of how life insurance works, we want to make sure to clarify how life insurance should be used, and how it should not be used.

You should use life insurance as a tool to manage the financial risk of dying prematurely.

As we'll explain below, life insurance pays out benefits when an insured individual dies while the life insurance policy is in force (i.e., active).

Most frequently, life insurance is used to provide financial stability to dependents in the event a family breadwinner dies.

It's important to recognize that life insurance is a negative expectancy bet.

Hopefully, you'll live to a rip old age and will end up paying all your life insurance premiums for nothing. However, losing those premiums is a better result than living with the risk that you could die and leave your family in a financial predicament.

Related: How to be a pro at growing your wealth

It's important to understand that life insurance is a negative expectancy bet because some life insurance and commissioned financial advisors may try to tell you otherwise. If that's the case, be sure to read our comprehensive explanation of whole life insurance. Either way, remember that if a financial company is aggressively selling you something, they're the one that's making out, not you.

How Life Insurance Works: The Basics

In the simplest terms: Life insurance is a contract, written by an insurance company, in which the company agrees to pay a sum of money to designated beneficiaries upon the death of a covered individual as long as the required premiums are paid up until that time.

Parties in a Life Insurance Contract

When trying to understand a contract, it’s always a good idea to start with each of the parties involved. The primary parties in a life insurance contract are the insurance company, the contract owner, the insured, and the beneficiary.

1. The Insurance Company

The insurance company is the financial institution that issues the contract. This is the company that agrees to pay a death benefit to a beneficiary upon the death of the insured in exchange for receiving premium payments from the contract owner.

2. The Contract Owner

The contact owner, also called the “policyholder” is the person who owns the policy. Life insurance is ultimately a contract between the policyholder and the insurance company. The policy owner is sometimes the insured, but not always.

For example, a father may purchase a policy on his own life and designate his children as beneficiaries. In this case, he is both the policyholder and the insured. The father could also purchase a policy on his spouse’s life and designate himself as the beneficiary so he would have money available to take care of his children upon his wife’s passing. In this case, the father would be the policyholder and the beneficiary while his wife would be the insured.

The policy owner is the person who controls the policy and makes all of the decisions. This includes designating and/or changing beneficiaries and accessing the cash value of the policy. The policy owner is also the person who is responsible for paying the premiums.

3. The Insured

The insured is the person whose life is covered by the policy. The death benefit will only pay out when this person passes away. This is also the person who has to go through the underwriting process and the physical examinations. The insured has no rights under a life insurance contract.

4. The Beneficiary

The “designated beneficiary” is the person (or people) who will receive the payout when the insured person dies. This payout is called a “death benefit,” and it’s almost always a tax-free payment that the beneficiary is free to spend as he or she sees fit. Only the designated beneficiary can collect the death benefit.

Related: Why you need a wealth plan, not a financial plan.

Many people designate their spouse or children as beneficiaries, but you can name whomever you wish. Note, however, that designating minors can create some serious problems (more on that later). There are many options when naming a beneficiary, including naming multiple beneficiaries and naming both primary and contingent beneficiaries. Depending on the purpose of a life insurance policy, the beneficiary may also be a charitable organization, business, or other institution.

Beware of the “Goodman Triangle”

When choosing the parties in a life insurance contract, it’s important to watch out for a tax trap called the “Goodman Triangle,” or the “Unholy Trinity.” This is a phenomenon that occurs when three different people are named as the policyholder, insured, and beneficiary. When this happens, the IRS could consider the death benefit payout to be a taxable gift to the beneficiary.

To avoid this, it’s important that the same person or entity takes on at least two of the three roles. Although this might seem confusing, taking a look at an example will help clarify things.

Consider the case of a policy purchased by Joe (the policy owner) on his wife, Mary (the insured). This policy named his son John as the beneficiary. When Mary dies, the insurance company will pay the death benefit to John. However, since Joe owned the policy, the IRS may deem the death benefit a taxable gift to John from Joe. In this case, the person who gave the gift (Joe, the policyholder) would be liable for the gift taxes, not John (the beneficiary).

This could have been avoided by having Mary purchase the policy, so she was both the policyholder and the insured. Upon Mary’s passing, John would receive the death benefit tax-free and no one would owe any gift taxes.

The current lifetime gift tax exclusion is $11.4 million for individuals and $22.8 million for couples. You may assume this means you don’t really have to worry about gift taxes. However, this huge tax break is set to lapse in the year 2025. If you’re planning for the long term, it’s best to assume that gift taxes are a concern and choose the parties for your insurance contracts carefully.

Considerations for Older Policy Holders

Sometimes, parties to an insurance contract may find themselves feeling frustrated when they learn about their limited rights.

Consider, for example, a contract that’s owned by Jane, an elderly woman with limited mental faculties. If her daughter, Julie, who is the beneficiary on a life insurance contract, wants to make a change to the underlying investments of a variable policy or needs to access the cash value to help pay for her mother’s care, she doesn't have the right to do this unless there is a durable power of attorney in place.

This legal document gives Julie the right to make financial decisions on her mother’s behalf. If Julie was named as the durable power of attorney, she could submit the document to the insurance company and take care of the necessary decisions. Having these legal documents drawn up before they’re needed can save everyone a lot of headaches.

Types of Life Insurance Contracts

Now that we’re clear on the parties involved in a life insurance contract, it’s time to examine the types of contracts that are available for purchase.

There are two primary types of life insurance contracts: term and permanent. There are also several different kinds of permanent contracts. The most common are whole life, universal life, variable life, and variable universal life. Although many are similar, there are some important differences. Following are the basics of how each one works.

Term Life Insurance

Term life is the simplest form of life insurance. It’s almost always the least expensive and it's almost always the only type of life insurance most people should buy.

Term life insurance coverage only lasts for a specified period, usually 10 to 30 years. As long as the premiums are paid, if the covered person dies during the contract period, the policy will pay a death benefit to the beneficiary.

Related: Here’s a scientific system to build your wealth now

Once the term period is over, no more payments are due, and the policy ceases to exist. Much like auto insurance, this is a type of policy that we hope we never need to use. However, it also gives us the peace of mind in knowing we’re protected if the unthinkable happens.

Term life is a “bare-bones” type of policy, although additional benefits are sometimes added by purchasing “riders” on the contract.

At the end of the term, some policies give you the option to renew or convert to a permanent policy. In many cases, however, these options are cost-prohibitive. Most people plan ahead to ensure that the term they choose will cover them for what they need. Once the term is over, they are able to comfortably lapse the policy.

Whole Life Insurance

Whole life is a “permanent” insurance. Instead of being in place for a specified term, it’s held for your entire life. This means that as long as the premiums are paid, the beneficiary will receive a death benefit whether the insured person dies at age 25 or 105.

Because coverage continues for the insured’s entire life, premium payments are also required for that entire time. The premium for a traditional whole life insurance policy stays level for the entire time the policy is in force. Those who don’t want to worry about paying premiums for the rest of their lives may wish to consider “paid-up whole life.” This type of policy allows you to make larger payments for a certain number of years and still keep the policy in force for your entire lifetime. “Single-Premium Whole Life” is another type of whole life policy that allows owners to pay the entire premium upfront with no additional payment.

Unlike term policies, whole life insurance has a savings component known as a “cash value” in addition to the death benefit. Each time the policy owner makes a premium payment, a portion goes towards the life insurance death benefit, and the rest goes towards the cash value.

Policy owners can access this cash value during their lifetime by taking a withdrawal or taking a loan against it. If the cash value is not withdrawn, it may be used to increase the death benefit or to pay part of the premium. Some policies also pay out a dividend based on the cash value, but this is less common now than it was in the past.

Withdrawals taken from the cash value and loans against it which have not been repaid will reduce the death benefit that the beneficiaries will receive. Before withdrawing or borrowing from a life insurance contract, it’s important to understand exactly how it will impact your payouts.

It’s also important to understand that whole life insurance policies are more expensive than term policies. There are several reasons for this. First, you’re contributing part of your premiums to savings, so it makes sense that you will have to pay more than if you were just paying for life insurance protection.

Related: Why you need a wealth plan, not an investment plan.

Second, when you buy term life insurance, if you don’t die during that time period, the insurance company keeps the premiums with no obligation to pay out anything. When you buy a whole life policy, as long as the premiums are paid, the company will definitely have to pay out a death benefit. When they determine how much to charge you, they’re essentially calculating how much they need to take in so they can cover that obligation without suffering a loss.

Universal Life Insurance

Universal life is another type of permanent life insurance coverage. It’s similar to whole life but works a little bit differently. This type of policy provides owners with more flexibility as they have the ability to adjust both the premium payment and the death benefit at any point throughout the life of the policy.

As with whole life, each premium made goes partly to cover the cost of insurance (COI) and the rest goes towards the cash value. The cash value portion is invested by the insurance company and pays out either a minimum rate or the market performance, whichever is greater. As the cash value grows, the policyholder can access a portion of this cash without affecting the guaranteed death benefit.

A universal life policy will usually have a required minimum and maximum premium amount. The policyholder can choose to pay any amount between these brackets. You can choose to pay a higher premium, which will allow your cash value to build up over time. Once you have enough cash value built up, you can skip premium payments or pay lower amounts without worrying about lapsing your policy.

It’s important, however, to keep an eye on the cash value of the policy and be aware of rising insurance costs. Otherwise, you might end up without enough cash value to keep your policy in force. If this happens, you could be faced with much higher than expected premium payments. If you don’t have enough cash flow to cover this, you could risk inadvertently lapsing the policy.

Variable Life Insurance

Variable life is similar to Universal Life. However, the policy owner can choose the underlying investments. These policies have multiple “sub-accounts” which are similar to mutual funds. There are often multiple investment choices which include stocks, equity funds, bonds, bond funds, and money market funds.

This investment aspect gives the cash value more potential to grow. However, the life insurance company offers no guarantees regarding the performance of the investments. If the investments underperform, the cash value will fall.

Variable life policies also give the owners more flexibility. Although the required minimum premium is usually fixed, the policy owner can choose how he or she wants to pay it. For example, if the owner wants to pay a lower premium, the insurance company will pull the remaining required amount out of the cash value. The owner could also pay more than the minimum required premium, thereby increasing the cash value and the policy’s investment holdings.

Although it might sound like this type of policy has a lot of benefits, there are some significant drawbacks. First, since there are no guarantees, it’s entirely possible that your cash value could fall so low that you have to pay significantly higher premiums to keep your policy in force. If you don’t have enough cash flow to do this, you could lose the entire policy. To make matters worse, if there are outstanding loans on the policy when it lapses, this could also cause you some significant tax headaches.

Secondly, these types of insurance policies are quite expensive. There are many fees and administrative costs baked into the premium. In most cases, it makes more sense to purchase a term insurance policy and then put your extra money into a less expensive type of investment.

Variable Universal Life Insurance

Variable Universal Life (VUL) combines the features of a variable life policy and a universal life policy. They work just like a universal life policy but give owners the advantages of flexible premiums and the option to invest in multiple sub-accounts. VUL policies usually have a maximum cap and a minimum floor on the investment portion of the policy.

When the policy owner pays the premium, the entire amount goes into the savings portion of the policy. Each year, the insurance company will deduct what’s needed to cover the cost of insurance (mortality and administrative costs), leaving anything that’s left in the investment portion to continue growing.

In this type of policy, the policy owner takes all responsibility for the performance in the sub-accounts. When returns are negative, it will impact the cash value. If losses are continual or drastic, then the policy owner may need to pay much higher premiums to cover the cost of insurance and build the cash value back up. VUL policies are also usually much more expensive than a traditional whole life policy.

Life Insurance FAQs

Now that we know the basics, it’s time to dive into some of the most commonly asked questions about life insurance.

1. How Do You Buy a Life Insurance Policy?

Life insurance contracts are typically sold through licensed life insurance agents who receive a commission for each policy they sell. While there are many reputable life insurance agents out there, when taking advice from an agent, it’s smart to keep in mind that the more money you spend on premiums, the more they get paid. This is why it’s a good idea to do your own preliminary research first and don’t hesitate to get more than one opinion before purchasing a policy.

You can also easily compare policies online. There are many great options like Policy Genius, Bestow, or Haven Life that allow you to purchase life insurance directly from the comfort of your home.

Many employers also offer group life insurance policies as part of their employee benefits package. To purchase these policies, you would need to talk to your employer and/or human resources department. The employer often covers all or part of the premium, and your employer will deduct your portion of the premiums (if any) directly from your paycheck.

2. How Do Life Insurance Companies Make Money?

There are two basic ways that life insurance companies make their money. The first is that they invest the premiums they’re paid, hoping to earn more over the lifetime of each contract than they have to pay out upon the insured’s death. The second is that when a contract owner lets a contract lapse, the insurance company gets to keep all premiums paid without having to pay out anything.

Insurance companies employ teams of people and use advanced calculation methods to determine exactly how much they need to charge for each person’s policy to offset the risks they take on.

3. How is Life Insurance Priced?

Almost every person who buys a life insurance policy will pay a slightly different premium. This is because a large number of factors go into determining how much a particular policy will cost. This includes (but isn’t limited to):

• Your age
• Your gender
• The type of policy you’re purchasing (term, whole life, universal, etc.)
• The death benefit amount
• Your medical history
• Whether you use nicotine
• Your family’s medical history (ex. cancer or heart disease in your immediate family)
• Your driving record
• Other risk factors (ex. whether you fly a private plane, scuba drive, have a history of drug abuse, or are planning to travel to dangerous locations)

To verify all of these factors, the insurance company does a great deal of research. They will review your medical records, credit history, driving record, and check the prescription drug database to determine what medications you are taking or have taken in the past. They'll also often check the MIB Group for past life and health insurance applications, run a criminal background check, and, if applicable, check your business credit reports.

Finally, in almost all cases, applicants will need to go through a thorough medical exam. This will usually include blood work, a urinalysis, and, possibly, and electrocardiogram (EKG). This entire process is called “underwriting,” and it typically takes several weeks.

Only once the underwriting process is complete will the insurance company issue the policy. The good news is after the policy is issued, you don’t have to inform the insurance company if there is a change in your health. So, if you develop cancer or start skydiving after you have a policy in place, your coverage and premiums won’t change.

There are some insurance companies that offer policies without the need for a medical exam. People who need term insurance quickly and don’t want to deal with the hassle of going through an exam may prefer an instant-approval life insurance policy like Haven Life’s InstantTerm or the policies offered by Bestow.

4. What Happens if I Die While Going Through Underwriting?

Many life insurance companies offer temporary insurance that will cover you while you’re going through the underwriting process. Since this can sometimes take several weeks or even months, this temporary coverage can give you some peace of mind while you wait.

Your temporary coverage amount is usually close or equal to the amount of coverage you’ve applied for, but you’ll want to check with the insurer to confirm this. To get temporary insurance, you’ll usually need to pay your first month’s premium at the time you submit your application. The company will issue a temporary insurance receipt, which indicates that you’re covered. This coverage will stay in force from the moment the receipt is issued until underwriting is complete and your actual policy is issued, or your application is declined.

If you die while you’re covered under temporary insurance, your beneficiary will receive the face amount.

Common Life Insurance Rules, Restrictions, and Clauses

It might seem like we’ve covered everything you need to know about life insurance, but there are still some important rules, restrictions, and clauses that you need to be aware of. Here are some of the most important.

1. You Need Insurable Interest and Consent

Many people don’t realize that you can’t buy a life insurance policy on just anyone. Before you can insure someone’s life, you must have:

1. an insurable interest, and
2. the person's consent.

To have an insurable interest in someone, that person’s death must cause you emotional, financial, or another type of loss. If the beneficiary of the policy is someone other than the owner, then the beneficiary must also have an insurable interest in the insured person. This is usually obvious in the case of immediate family members but can get more complicated when insuring others. For example, you would have to prove insurable interest to insure aunts and uncles, cousins, nieces and nephews, stepchildren, and stepparents.

Sometimes, an insurable interest exists in business relationships and in creditor-debtor relationships. Again, the insurance company may request proof before moving forward with the underwriting process.

The insured must also give their consent for you to take a policy out on them. In most cases, he or she will need to undergo a medical exam as part of underwriting. Even if the policy doesn’t require a medical exam, the insured will still need to sign the application. It’s not legal to purchase a life insurance policy on someone without their knowledge.

2. Your Premium Payment Frequency Matters

For the contract to remain in force, all required premiums must be paid on time. Policy owners can usually choose the frequency of their payments and many companies offer monthly, quarterly, semi-annual, and annual payment options.

If you choose to pay any more frequently than annually, the insurance company will usually add a small extra fee to each payment. It’s common for annual premiums to be 3 to 5 percent lower than payments made more frequently. Although in some cases this is only a couple of extra dollars each month, it can add up over the course of your lifetime.

You’ll want to take a look at your cash flow and decide which payment frequency is best for you. Many companies allow you to switch your payment mode, so, in many cases, you can make adjustments in the future. Many younger purchasers begin with more frequent payments, then switch to annual when they’ve built up enough extra cash flow.

3. You May Be Able to Change Your Mind

Most life insurance policies offer a “free look” period that ranges from 10 to 30 days from the date of issue. In fact, in all 50 states, there are laws requiring free look periods. This allows you to change your mind and surrender the policy without any penalties or surrender charges during the designated time period. If you’re not satisfied with the policy for any reason, you can simply contact the insurer and let them know you’ve changed your mind and you would like a full refund.

When you receive the final copy of your insurance policy, read the entire contract from cover to cover. Make sure you don’t see any red flags and that you’re comfortable with both the coverage and the final premium amount. Once the free look period has passed, things will get more complicated and changing your mind will likely cost you some money.

4. Beneficiary Designations Supersede Your Will

Many people don’t realize that your beneficiary designations supersede your will. This means that whoever is listed as the beneficiary on your policy will receive the death benefit regardless of any other legal documents you might have in place. That’s why it’s critical to review and update your beneficiaries regularly, particularly if you have gone through any major life changes.

Imagine you went through a bitter divorce, then several years later you got remarried, had children, and lived happily ever after. Even if you updated all of your legal documents and most of your insurance policies, if you forgot to change one of your policies and your ex-spouse is still listed as the beneficiary, then he or she will receive the death benefit.

Changing or updating your beneficiaries is very easy. All you need to do is call the insurance company and tell them you want to make a change. They will send you a simple form to complete and return to them.

What happens if you fail to designate a beneficiary or your beneficiaries predecease you and you didn’t update your designation? In this case, the company will pay the death benefit to your estate and it will be distributed as outlined in your will.

5. Naming Minors as Beneficiaries Can Create Problems

Designating minors as life insurance beneficiaries can create many complicationsbecause insurance companies won’t pay a benefit directly to a child. Unless you have set up a trust or made other legal arrangements, the courts will need to appoint a guardian. This is a complex and expensive process. It’s almost always a better idea to name a responsible adult, set up a trust, or make other legal arrangements. A reputable estate attorney can help with this.

6. Your Beneficiaries Must File a Claim

When the insured person dies, the beneficiary of the life insurance policy must file a claim with the insurance company so they can receive the death benefit. The beneficiary doesn’t need to have possession of the actual policy, but they will need to contact the insurance company and let them know that they’re a beneficiary.

The insurance company will then send them paperwork to complete and return along with proof of identification and a copy of the death certificate. Once everything is received in good order, the beneficiary will typically receive the death benefit within a few weeks. Once the beneficiary receives the death benefit payout, that money is 100 percent theirs and they can do whatever they want with it.

It's important to let designated beneficiaries and/or the person who will handle your estate know that you have life insurance and where to find the policies. If no one files a claim, the insurance may never pay out and all of your premium payments will be wasted.

5. There Are Times When Life Insurance Won’t Pay Out

In general, as long as life insurance premiums are paid up until the covered person dies, the life insurance company will pay the death benefit to the beneficiary. This is true whether the death is caused by an illness, accident, or old age. However, there are some situations when the company won’t pay. In most of these cases, beneficiaries will receive a return of the premiums you paid, but nothing more.

When purchasing a policy, it’s important to read the contract thoroughly and understand what is and isn’t covered. Below are a few exclusion clauses that are sometimes found in life insurance policies.

• Suicide Clause – the death benefit often isn’t paid if the insured commits suicide during the designated period (usually the first two years).
• Fraud – if the contract is obtained using fraudulent methods, the insurance company isn’t obligated to pay the death benefit.
• Murder – no death benefit is paid if it’s proven that the beneficiary murdered the insured.
• Alcohol and Drug Use – some policies will also refuse to pay out if the insured is under the influence of alcohol or illegal drugs at the time of death, even if this didn’t contribute to the cause of death. This can vary from policy to policy and is something purchasers will want to look out for.
• Illegal Activity – if the insured dies while participating in an illegal activity or committing a crime, the policy usually won’t pay out. This could be anything from participating in a bank robbery to driving while intoxicated or even having a heart attack while trespassing on someone’s property.
• Dangerous Activity – if this clause is included, it will usually list out the dangerous activities that are excluded. Examples may include skydiving, scuba diving, flying in a private plane, and car racing. It’s usually possible to purchase additional insurance so you are covered while doing certain activities. For example, if you’re an avid scuba or skydiver, you can pay an extra premium so your beneficiaries will receive a death benefit if you die while participating in that activity.
• Act of War – this clause is intended to exclude coverage for civilians who are killed during acts of war and isn’t intended to exclude benefits for active military. It’s also not as common in policies today as it was previously. However, people like journalists or those who intend to travel to unstable countries should check to ensure their policies don’t have this exclusion.

Most life insurance policies also have a contestability period which is typically within the first two years after a policy is issued. During this time, if the insurance company finds out you lied about your health when you completed your application, it’s within their rights to lower the death benefit payout amount or completely cancel the insurance policy. However, once the contestability period has passed, the policy becomes incontestable and the company must pay out unless they can prove fraud.

Now You’re Ready to Start Shopping for Coverage!

There you have it! You now know everything you need to know about how life insurance works.

If you’re considering purchasing coverage, the next step is to learn more about how to buy life insurance the smart way,how to calculate how much life insurance you need.

Finally, check out 3 of the best websites for buying term life insurance online here.

Armed with this knowledge, you’ll have everything you need to protect your loved ones and ensure their financial future.