How life insurance works

The bottom line:

When you buy life insurance, you can transfer the risk of financial loss.

Common reasons Americans buy life insurance are to pay for funeral expenses, replace lost income and transfer wealth.

Life insurance is a mid- to long-term commitment. It’s wise to choose a policy you plan to stick with.

Life insurance is meant to help your loved ones have enough money when you die. You pay premiums and, in return, your loved ones receive a benefit when your life ends. That death benefit can help replace your income, pay the mortgage or finance education. It can help make sure your family doesn’t lose the life you’ve built with them.

Life insurance fits alongside health, long-term care and disability insurance. Together, these protections help reduce the financial burden of injury, illness and death.

Per LIMRA, the most common reasons Americans buy life insurance are to pay for funeral expenses, replace lost income and transfer wealth. Maybe one of those categories fits why you’re looking to buy life insurance. No matter the reason, it’s good to start by understanding the fundamentals of how life insurance works and how it protects your family.

When you sign up for life insurance, you name a beneficiary. This person (or people) gets the death benefit (financial payout) from your policy if you die. This death benefit is usually received income tax-free. Most people choose a spouse, children, parents, or other people who are financially dependent on them as their beneficiaries. A person may also choose a charitable cause as their beneficiary. Alongside the death benefit, there can be other reasons to buy life insurance as part of your financial strategy.

It’s pretty common in the U.S. to have life insurance. About half of Americans reported having it in the 2021 Insurance Barometer study from LIMRA. Of the people who had life insurance, 39% say they wish they had purchased coverage when they were younger.

Like many financial products, life insurance is about helping hedge risk. There’s a risk that an accident, disease or injury could end your life unexpectedly. It’s important to consider who would suffer if that happens. What would replace your lost income? Would your family have enough money to thrive?

For some people, there would be enough money in the bank to provide for loved ones. For others, there wouldn’t be nearly enough cash to make up for years of lost income or other support. With life insurance, your insurer agrees to help your family support financial losses.

The main purpose of life insurance is to provide a death benefit to loved ones. When you die, your income goes away. But your family’s financial needs remain. Life insurance helps protect the people who depend on you financially by providing a death benefit. As long as you make premium payments and your contract retains value while you were alive, your beneficiaries will get a payout when you die.

Life insurance payouts can be used to help cover ongoing expenses such as:

• Mortgage payments
• Childcare
• Living expenses
• Credit card bills
• College

Another big reason Americans buy life insurance is to pay for a funeral. Funeral costs can add up quickly. The median cost of a traditional funeral was $7,848 in 2021, according to the National Funeral Directors Association.

A death benefit can be used to help cover after-death expenses such as:

• Funeral expenses
• Charitable contribution or memorial fund
• Time away from work to grieve

Look for a policy from a reputable organization that can help you reach your goals. Life insurance is a mid- to long-term commitment. So you'll want to consider an organization that should be steadfast through the life of your contract. If it’s important to you, you may also choose an organization that aligns with your values.

No matter who you buy life insurance from, you’ll want to make sure that you have the right amount of coverage for the right length of time. The death benefit you select should cover the needs of your dependents. Not sure how much they might need? We have you covered with a calculator below. You’ll also want to remember that life insurance is customized. So age, gender, profession, number of dependents, health, hobbies and more will influence what's available to you and how much it costs.

1. Calculate how much coverage you’ll need—get a picture of how much life insurance to consider buying with a life insurance calculator. Use the calculation as a starting point for how big of a death benefit you might want.

2. Evaluate your options—did you know there are multiple types of life insurance? Choose between term or permanent coverage.

3. Talk with your family or spouse—if you want tips for starting a protection conversation with your family, start here. Some people may want to take this step after purchasing a plan or talking with a financial advisor.

4. Comparison shop and pick a policy—it can sometimes be difficult to see differences in price, quality and reputation as you comparison shop. Enlist the help of a financial advisor if you could benefit from help understanding the options.

5. Put a yearly protection checkup on your calendar—make an audit of your insurance policies part of your year-end financial review. Add it to your calendar to help you remember.

There are two main types of life insurance: term and permanent. The main differences between them are cost, length of contract and extra features like cash value. A third type of life insurance called “blended” combines the two types of policies.

Term life insurance is also known as "pure life insurance" because its sole purpose is to provide a death benefit to your dependents when you die. Term life insurance is generally more affordable than permanent life insurance because it lasts for a set number of years. Contracts that last 10, 15, 20 or 30 years are the most common. If you die before that term is up, the death benefit is paid to your beneficiary. Term policies are often used by parents who want life insurance until their kids are grown and financially independent. Term policies are also popular with people taking care of aging parents.

As long as premiums are paid and the contract retains its value, permanent life insurance provides coverage throughout your life. Besides having a death benefit, it may build cash value. You can access the cash value of your policy during your life to pay for expenses. Though, before doing so, you should learn how cash value life insurance works to understand the consequences of using it.

High-income earners often use a permanent policy when putting together a complex end-of-life financial strategy. Adults with someone who will always be financially dependent on them, like a child with special needs, also find this policy useful. If you're worried about the ability to get insurance later on, permanent coverage may be a good option.

Whole life insurance is the most common type of permanent life insurance, according to the Life Insurance Information Institute. It provides a death benefit and cash value. The features most talked about with whole life policies are consistent premiums, consistent cash value growth and a death benefit for as long as premiums are paid. Read about the differences between term and whole life insurance.

Universal life insurance provides a death benefit and the potential to build cash value. The policy lasts throughout your life, as long as premiums are paid and the contract retains its value. Universal life policies usually offer more payment flexibility than whole life insurance. So, as time passes, you can change how much and how often you make payments. That means having the ability to build up cash value quicker. Or slow down contributions if you experience an income change.

Note that reducing your contributions can decrease the cash value of your life insurance. It can also reduce the death benefit available to your beneficiaries. It may also make it take longer to meet your life insurance contract goals. So be mindful when slowing down contributions. And talk with a financial professional before altering planned contributions.

Furthermore, your life insurance contract can become a modified endowment contract (MEC) if you make large, additional premium payments. Having a MEC affects how you are taxed. Note that there are limits to how much you can pay into your life insurance contract.

Variable universal life insurance provides a death benefit and cash value. The policy lasts throughout your life, as long as you continue to make payments and the contract retains its value. Like universal life insurance, it offers more flexibility on payment timing and dollar amount. What sets this policy apart is that it puts you in a higher-risk environment with the potential for gains or losses. Variable universal life policies have subaccounts where you can invest the cash value of your policy. If the market performs poorly, there’s a chance that a variable policy could lose all its value and terminate.

Note that using premium payment flexibility to reduce your contributions can decrease the cash value of your life insurance (like with universal life insurance). It can also reduce the death benefit available to your beneficiaries. Reducing premium payments may also make it take longer to meet your life insurance contract goals. So be mindful when slowing down contributions. And talk with a financial advisor before altering planned contributions.

Furthermore, your life insurance contract can become a modified endowment contract (MEC) if you make large, additional premium payments. Having a MEC affects how you are taxed. Note that there are limits to how much you can pay into your life insurance contract.

This type of policy combines the benefits of term and permanent life insurance. At the start of the coverage period, it provides benefits similar to term coverage. It can help cover things like college, a mortgage and funeral expenses if you pass away. Then, later on, this type of policy starts to act more like whole life insurance. Cash value that you can access while you’re alive becomes available.

If you have life insurance through work, it may not be enough, depending on your life stage. Your employer may not provide enough coverage to replace your lost income over a multi-year period, in addition to other family needs. Use this life insurance calculator to determine how much life insurance you might need. Then, check if your group life insurance policy through work provides enough coverage to meet that need.

Unfortunately, there isn’t a one-size-fits-all answer to the question of what life insurance costs. A process called underwriting will determine your insurability. Your age, sex, profession, number of dependents, health, hobbies and more can all influence how much you pay.

The good news is that life insurance may cost less than you think. According to the 2021 Insurance Barometer Study by LIMRA, more than half of consumers tend to overestimate the cost of life insurance. And, it’s no wonder. It can be difficult to find cost information online.

Life insurance prices are determined by factors such as:

• Type of coverage—term life insurance is generally more affordable than permanent coverage. That’s because it’s for a set period of time versus your whole life. It also lacks cash value.

• Size of death benefit—large death benefits typically cost more than small death benefits. If you want a bigger payout when you die, then you’ll probably have to pay more.

• Your gender—men may pay slightly more than women for a similar life insurance policy. That’s because the average life expectancy of a man is shorter than that of a woman. (According to a 2021 report from the U.S. Centers, men live to age 77.8 on average and women live to age 80.5 on average.)

• Age, health and hobbies—the younger and healthier you are, the less you can usually expect to pay. While the more dangerous your job or hobbies are, the more you can expect to pay.

When buying a permanent policy for a young child, you might see rates as low as $12 per month. However, most of us can expect to pay more than that for permanent coverage. It’s good to remember that permanent life insurance will usually cost you more than term life insurance. You’re paying for cash value and lifelong (as opposed to limited-time) coverage.

Connect with a financial advisor to get a cost estimate for life insurance, after finishing your initial research online. They can assist with comparing costs and value across insurers. You also have the option to use an online cost comparison tool. In the end, you're looking for a quality policy at an affordable rate.

The time to think about getting an affordable rate on life insurance is before signing up. Prices are customized by many factors including age, gender, profession, number of dependents, health, hobbies and whether your parents or siblings have a history of serious medical conditions. You can’t influence all of these, but there are a few things you can pay attention to. If you already bought a policy, it may still be possible to reduce premiums by reducing your death benefit.

Generally, the younger and healthier you are, the less money you pay for life insurance. As you grow older, the potential risk your life insurance provider takes on can grow in size. So you might see costs go up with age and worsening health. For many policies, you can "lock-in" a rate when you buy. So buying young for a policy that lasts 30 years, for example, may add up to a lot of savings long term.

Your current income and lifestyle impact your estimated life insurance needs. If you have a mortgage and pay for childcare—you may need more life insurance than someone with grown children who has paid off their home. The more bills you have each month, the more coverage you typically need to help your family maintain their current lifestyle when you are gone.

If your policy requires a medical exam, be sure to get a good night of sleep before your appointment. Take your medicines as prescribed and follow your doctor’s instructions about fasting before bloodwork, caffeine intake and foods or activities that might cause inaccurate lab results.

And quit using tobacco. Tobacco users generally pay more.

The type of policy you choose and the organization you choose to buy it from will have can have a big impact on how much you pay. There are hundreds of organizations in the U.S. that offer life insurance. By comparing differences in price, quality and reputation—you're more likely to save in the long term. Instead, buy a quality policy at an affordable price.

If you’re struggling to pay the premiums on a policy you already have, consider reducing your death benefit. It's important to choose a premium (and its corresponding death benefit) that’s affordable from the start. But if life changes and you need to pay less, ask your insurer if they’ll let you reduce the death benefit.

If you have people who depend on you, then life insurance is worth considering. Here are some common times and life events to buy life insurance:

• Early in life—lock in potentially lower premiums while you’re young.

• Getting married or having a child—these milestones often mean your financial responsibilities have grown to include others. If you support a child or partner, then life insurance can help protect your family’s future income.

• Change in employment—many people have life insurance through their employer. So if you lose a job, you may lose your life insurance as well. Coverage levels can vary from job to job. As you start a new one, it’s important to make sure you have enough protection.

• Supporting a parent—if you already have life insurance, check your coverage level. You may need more to match your shifting responsibilities.

• Divorce or single parenting—money can be tight when supporting a family alone. If any room can be made in the monthly budget for the basic protections of a term life policy, it’s a worthwhile safety net to consider having for your family.

• Later in life—leave a planned gift to support a cause that matters to you.

• Annual financial review—if you haven’t already, add life insurance to your list of policies to reexamine yearly—alongside your car and health insurance. You can meet with a financial professional to audit your life insurance policy. Ask questions like: Is my coverage level still appropriate? What does my current policy allow?

When life insurance pays out, the death benefit is sent to the beneficiary named in your contract documents. Your insurer will look at the death benefit amount you selected while you were still alive. The insurer will also look at whether your death met the criteria outlined in your contract. For example, a death by suicide or from a dangerous activity like skydiving may invalidate the policy. If your cause of death is covered, you died while the policy was active, and you paid your insurance premiums on time, then your beneficiary will get a death benefit.

If you had permanent life insurance, the size of the death benefit could be reduced by any loans or withdrawals that were made while the policy was active. The death benefit is calculated after those are subtracted.

It's also good to remember that death benefits are usually received income tax-free. The U.S. tax code is nuanced, so double-check what's true in your case. But, generally speaking, the income-tax-free nature of death benefits can be a big plus of having life insurance.

Ready to learn more about your coverage needs? Connect with a financial advisor. They can walk through the options and help you determine what's best suited for you.