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How Does Life Insurance Work?

How Does Life Insurance Work?
Chris Muller
Updated September 23, 2021
13 Min Read

Life insurance may be one of those things you always hear about but rarely spend time thinking too much about, especially if you have coverage through work.

But according to the Insurance Information Institute, about 20% of Americans don't feel like they have enough.

And I think that by understanding it more, that number would be even higher. Especially since the risk posed with NOT having it can be devastating to your loved ones.

So how does life insurance work? Let's find out below.

How Does Life Insurance Work?

Life insurance provides important protection when a policyholder dies, and a beneficiary will receive the death benefit (upon proof of a death certificate). You sign up for a plan with a provider and make some regular payments for the plan. Typically, this is a monthly premium.

If and when the insured dies, assuming you've continued to make payments on time, the insurance provider will pay out a lump sum of cash - called the death benefit - to your beneficiaries. Beneficiaries are those you designate to receive the money (in most cases, this is a spouse, kids, or other family members).

It is a legally binding contract between the policyholder and the insurer. So as long as all pieces of that contract are met (i.e., you're making your monthly payments), the insurer is legally required to make a payment if you die.

When you sign up for a plan, you'll either do a health assessment or a physical exam - sometimes both. This allows the insurer to determine a) if they'll insure you and b) at what rate. Your health and many other factors determine your eligibility and risk level to the insurer.

Because of that, you must be honest on all health assessments. For a policy to be legally enforceable, your application must disclose your current and past health conditions. In many cases, it must also disclose any high-risk activity you're involved in (i.e., if you regularly go skydiving).

Who Should Get Life Insurance?

There are several circumstances where you should probably consider getting life insurance. Let's unpack those below.

  • If a person would inherit your debt. Believe it or not, when a policyholder dies, their debts don't disappear - the beneficiaries tend to inherit them. So if you have a cosigner on a loan or another person like a family member is a joint account holder (who might be a beneficiary), they might be on the hook to cover your debts if and when you “kick the bucket.” In this case, it would make sense to get a plan that would cover the cost of your debts.
  • Your partner or your spouse needs your income. If your partner, spouse, or other similar beneficiary counts on things like your paycheck to cover everyday living expenses, losing your salary could be financially devastating. In this circumstance, it would make sense to get a plan to replace that salary if and when you die so your spouse is taken care of.
  • Your kids depend on your income. If your kids need your financial assistance - to raise them or to go to college, for example - they would be at a significant disadvantage if your salary went away. Particularly if your kids are minors or if they rely on your support for any kind of health conditions or disabilities. Again, it would make sense to have coverage so you may be able to ensure your kids are taken care of in these cases.
  • Your funeral would be a financial burden on your loved ones. Currently, the median cost of a funeral is $7,640. If this will put a beneficiary at a financial disadvantage, you can ensure your family isn't taxed when trying to pay for your funeral while they're grieving. It would also cover most of your funeral costs, if not all of them.
  • If you're a small business owner. If you're a small business owner, your employees, company, and business partners all depend on you. So having a plan in place may be able to provide support to these people after you're gone. Note that there are some other considerations that you may need if you own a business.

How Much Life Insurance Do You Need?

How much life insurance you need depends on a variety of factors. The most common (and basic) equation to determine the amount of coverage you need is this:

(Financial Obligations You Want to Cover) - (Existing Assets That Can Be Used Toward Bills) = How Much Life Insurance You Need

Now that's SUPER basic, but it's a good baseline understanding to determine what you'll need.

What to Include in Your Financial Obligations

When you're looking at your financial obligations, make sure to include things such as:

  • The cost to replace your income. If you pass away, most likely, your dependents will need to replace your salary. A simple equation for how much you'll need is to multiply your salary by the number of years you'll need it to replace. Don't forget to consider both current and future expenses (i.e., a wedding).
  • Your home loan. One of the most important things to make sure is accounted for is your home loan, if you have one. The last thing you'd want is for the home to be foreclosed on if payments couldn't be made. So make sure to include the balance of your mortgage in your financial obligations, as well as any other related housing expenses.
  • Large debts. If you have other large debts, like a student loan, car loan, or something else, be sure to account for that in your financial obligation number so a beneficiary doesn’t have to worry about this.
  • College tuition. This is a big one, especially if you have children. I strongly recommend including the estimated cost of education in your needs. This removes any worry that your children can attend college if they want to and allows them not to rely on debt to do so.

What to Include in Your Assets

Here are some things you should include in your existing assets when using the above calculation:

  • Existing plans. You may already have an existing policy (i.e., through work) in some cases. Make sure to subtract whatever that is. And remember that if you leave a job, your supplemental life insurance doesn't go with you - so it's important to find additional coverage outside of your job.
  • Savings. You can lump things like emergency funds, a 401(k), CDs, or other investments together as "savings" to keep this part simple. Just be aware that if you're including your retirement savings, you're assuming your beneficiaries can access that amount today. So if that needs to be preserved for the long-haul, I'd recommend leaving retirement accounts out.
  • 529 Savings. Suppose you've already established a 529 savings account for your children's college tuition. In that case, you can subtract the value of this account from what you need in coverage (knowing that they'll have this for when they go to college).

Other Methods to Calculate What You Need

The simplistic formula above isn't the only way to determine how much you need, it's just probably the easiest. There are two other methods to consider when looking at how much you need:

The 10X Rule

Using this rule, you would estimate how much you needed by multiplying your income by 10. So, if you made $75,000 per year, you'd need about $750,000 in life insurance. Other, similar rules I've seen use the same calculation with 5X your income or 17X your income.

DIME Method

The DIME Method accounts for Debt, Income, Mortgage, and Education (DIME). To get the number you need, add up your debt, mortgage balance, and education costs you anticipate. Then multiply it by however many years you need it.

Say, for example, you had the following:

  • $50,000 in debt
  • $150,000 in annual income, needed for 15 years
  • $400,000 mortgage balance
  • $300,000 needed for college tuition for three kids

Here’s how you’d determine your needs:

  1. You’d add the debt, mortgage, and college tuition: (50,000 + 400,000 + 300,000 = $750,000) first.
  2. Then, you’d multiply your income by how long you needed it (150,000 x 15 = $2,250,000)
  3. Finally, add the two together (750,000 + 2,250,000 = $3,000,000)

$3 million in coverage seems high. But maybe for this individual, it's not. The DIME Method is a good estimator, but sometimes it over-estimates what you'd need.

Main Types of Life Insurance

All types of life insurance policies fall under two categories: term and permanent.

How Term Life Insurance Works

Term life insurance policies last for a specified number of years and are best for most people. If your term expires and you haven't died (good news) you'll need to sign up for another term policy (bad news).

Term policies are typically sold in lengths of 1, 5, 10, 15, 20, 25, or 30 years. The maximum death benefit you can get depends on the life insurance company and other factors. Still, many offer term policies into the millions.

A level premium policy locks in a single price for the entire duration of the plan. An annual renewable term policy is a one-year plan that just renews every single year (and your rate may need to change). More than likely, this is the least expensive option since it adjusts to your current health and life situation.

Just remember, if you outlive your policy and don't renew it, your beneficiaries will receive nothing in the event you die.

How Permanent Life Insurance Works

Permanent life insurance policies last for your entire life. They typically include a cash value component like I mentioned above in the terminology. With this cash value component, you can borrow against it or withdraw it while you're still living. The two primary types of permanent policies are whole and universal, which I'll cover below.

Whole Life Insurance

Whole life insurance usually lasts until you die as long as you've paid your premiums on time. In most cases, your rate is going to stay the same for the duration of the plan. You'll also receive a guaranteed rate of return on the cash value of the policy, and your total death benefit does not change.

Whole life policies will cover a person for their entire life, and they build cash value - that's the positive aspect. However, whole life policies aren't offered everywhere. They have more nuances than a term life policy. They tend to be a lot more expensive than term life policies (which is why most people pick term life insurance).

Universal Life Insurance

Universal is permanent life insurance that has an investment savings element to it. It also offers lower rates, much like a term policy. People tend to opt for universal life insurance policies because the rates are flexible. Some do require a single lump-sum payment or even scheduled fixed-dollar amount premiums.

Variable Life Insurance

Variable life insurance is another type of permanent policy. It contains a separate account that holds various investments - like stocks, bonds, ETFs, and money market funds. It is more flexible than most permanent policy types - especially with rates and cash accumulation - but it's often one of the most expensive types.

How to Choose a Policy Type

So now you have a general understanding of the types of life insurance available. Now let's look at which type would benefit you most, based on your circumstance.

When to Choose Term Life Insurance

Here are some scenarios where term life insurance would be best:

  1. You need coverage for a finite period. One of the great things about term policies is that you can match the term's length with how long you need it. So if you want to make sure you account for your mortgage being paid off or want to be sure to see your kids through college (financially), you can get a term policy to match that length of time.
  2. Your budget is limited. This type tends to be a lot cheaper than other types of policies. This is because it only pays out if you die. And even then, you have to meet specific guidelines. And if you outlive your policy, coverage stops, and you'll need to buy a new one. There's generally less risk for the insurance provider, so it's a lower cost to you.
  3. You're young and/or healthy. Your term life insurance premiums are going to be the lowest when you're young and/or healthy. You can sign up for some policies without a medical exam. Still, you'll often get the lowest rates when you do a medical exam - this essentially proves how healthy you are.

When to Choose Permanent Life Insurance

Now that you better understand term life, here are some scenarios where a permanent policy will benefit you more:

  1. You need coverage for as long as you live. Remember that a permanent policy will pay the death benefit regardless of whether you live to be 120 or pass away tomorrow. If you want a plan that protects those you care for for life, this is the best option.
  2. You want the savings or interest benefits. Permanent policies feature a savings account where interest grows tax-deferred. You can leverage these funds for loans or a cash withdrawal. The death benefits become collateral for any loan you take out, however. This savings benefit can also be used to cover premiums if you want to keep them lower or can't afford them.
  3. You're older and/or less healthy and/or have poor credit. This isn't always true, but permanent policies are more expensive than term policies in most cases. If you're unhealthy, you're older, or you have shaky credit, you might be better off getting a permanent policy since it'll last forever. And if you need funds, you can borrow against your plan.

How a Life Insurance Policy is Priced

Life insurance is priced based on several factors. The main factors, however, are:

Death Benefit

How much coverage you need will directly correlate to the cost of your premium. The more you require, the higher the rate. Remember that the death benefits are your beneficiaries' amount if you pass away. And this money is tax-free.

Type of Policy

As I noted above, a term policy will be less expensive and cover a finite period. Whereas a permanent policy, such as a whole life insurance policy, tends to be costlier and lasts for the entirety of your life.

Age

Statistically speaking, the younger you are, the lower the overall risk of death. So, there's a lower chance you'd receive the death benefit on the plan. Your rate reflects this if you're young. If you're older, you'll tend to pay more.

Gender

Depending on your gender, you might pay higher or lower premiums. The current life expectancy for women, for example, is higher than men. According to Scientific American, "in the U.S. male life expectancy was 73.4 years for males and 80.1 years for females, a difference of 6.7 years." And because women live longer, the probability of dying is lower, so their life insurance policy rates tend to be lower.

Smoking History

It's proven that people who smoke have a much higher risk of health-related issues and, thus, a higher risk of dying younger. Because of this increased risk, insurance companies will charge a higher rate to smokers or may not insure them at all.

Overall Health

Probably the most significant factor is your overall health. Insurance companies are businesses, so their job is to assess the risk of you dying and price a plan accordingly. The insurance company is going to evaluate any pre-existing health conditions you have. They'll also look at the other factors I've listed above to determine your overall health. Alternatively, they'll ask for a full health exam to help determine that. From there, they'll price your plan based on your overall health.

How Do Life Insurance Payouts Work?

If and when the insured dies, beneficiaries will need to file a claim to receive a payout. From there, the insurance company will do its due diligence to ensure the death benefit met the terms of the policy (and things like the death certificate have been provided) before paying out that claim.

In fact, in the first two years of your life insurance policy, called the contestability period, your life insurer can review your application and refuse a payout if they find evidence of fraud. Once the claim is verified, they'll provide the death benefit to the designated beneficiaries.

There are a few options for beneficiaries to receive a payout from a claim. A lump-sum, cash payment is often the most popular since you get all the money at once, and it's tax-free. There are several other options to receive a payout, though:

  • Lifetime installments - have the benefit paid out in equal installments for the rest of your life. This will help be determined by the insurance company based on your age and life expectancy.
  • Fixed amount - go with a fixed payout amount to be delivered each month, quarter, or year. Payments will stop after the death benefit has been used up, however.
  • Interest installments - you can keep the death benefit in the insurance company’s hands, and they'll cover you interest installments. Think of this as an investment that pays dividends.
  • Life with period certain - this is similar to lifetime installments. Still, you get to designate the number of years you want the benefit for. With lifetime, the payments end if you die. With this option, though, you can designate your beneficiaries (such as other family members) to receive the rest of the installments if you die.

Which Option is Best?

I hope you never have to make this decision, but that's what insurance is for. So if you do, I recommend talking to an insurance professional first (or a family estate planner). That said, most people will opt for the lump sum of cash because they can do whatever they want with it - whether that's stick it into an investment account or cover your debts.

Tips Before You Apply

By now, you should know almost everything you need to know about life insurance. So the next step is to apply for coverage. But, there are some things you should know first. Here are some tips to help you before you apply:

  1. Shop around. It's easy to get quotes online from most life insurance providers now. Take the time to check rates with at least three to four providers before making a decision. Also, you can use a service like Policygenius that aggregates policies from different providers together and lets you compare them all at once.
  2. Focus on more than the premium. The rate you pay is significant, but you also need to understand the plan's details and the company you're working with. So read the details of what you're signing up for (in addition to what you’ll have to pay), and make sure to do some research on the company you're buying from (Trustpilot is a great resource).
  3. You'll have to answer a lot of questions. While the process is typically quick to get a quote when you apply for life insurance, it can take a bit longer, and you'll have to answer a TON of questions. This helps the insurance company determine your risk level and if they can ensure you.
  4. You may have to do a health exam. While many companies offer no-exam life insurance, many still require a medical exam. This is so they can determine how healthy you are and what risk level you're at before they insure you.
  5. You can get temporary coverage. In many cases, the underwriting process can take a few weeks before your policy is official. Check with your life insurance company to see if you can get temporary coverage during that period by paying your first premium - that way, you don't have to worry about a lapse.

Final Thoughts

According to Policygenius, only 54% of Americans have a life insurance policy. Only 27% of those people are insured only by group insurance, which often isn't sufficient. Now that you have a better understanding of life insurance, evaluate which option is best for you. And then make sure you're insured - even if you go for a low death benefit, short-term policy. It's still better than not being insured at all.

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