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What Is Life Insurance & How Does it Work?

Life Insurance
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A family on a walk in nature discussing what life insurance is

An unexpected death is more than an emotional tragedy. It can also create financial issues for the deceased person's family. While nothing can replace you as a person, life insurance can help to protect your loved ones against the cost of a sudden death.

If you're wondering how life insurance works, this guide answers some common questions about these policies.

What Is Life Insurance?

Insurance is one way to help protect a valuable asset, such as a car or house. If the insured property is damaged or destroyed, the insurance company pays out to help cover the loss according to the policy terms. With a life insurance policy, the covered asset is a person's life.

When you purchase a life insurance policy, you pay a premium to the insurance company. As long as you continue to pay those life insurance premiums, your beneficiary will receive the death benefit payment when you die. A death benefit can help your beneficiary pay for your final expenses and help replace your income.

How Does Life Insurance Work?

When you first apply for life insurance, you choose how much coverage you would like. If you're approved, the life insurance policy will list out the total death benefit in your policy. Then, if you die while covered by the policy, the insurance company will pay your beneficiary the amount of the death benefit.

As the owner of the policy, you can buy coverage on yourself. It's also possible to buy life insurance for another person, such as your spouse, a relative or a business partner. However, you need to have insurable interest, meaning that the person's death would impact you financially. You cannot buy life insurance on a stranger.

To keep the coverage active, you must keep paying regular premiums to the insurance company. Depending on the insurer, you may be able to choose whether to pay the premiums in monthly, quarterly, semiannual or annual installments.

What Are the Different Types of Life Insurance?

There are a few different types of life insurance with different arrangements for how long they last, their cost and their benefits. Here are three of the most common types on the market.

Term Life Insurance

Term life insurance is temporary life insurance. When you sign up, it lists a set amount of time for how long the coverage will last, such as a five-year term or 20-year term. If you pass away during the term, your beneficiary will receive the death benefit. However, if you outlive the term, the coverage will expire.

In exchange for being temporary, term life insurance is typically less expensive than other types of coverage. It may be a good fit for needs that will not last your entire life, such as helping to cover your mortgage or protect your income while your children are young.

MORE: How Term Life Insurance Works

Whole Life Insurance

Whole life insurance is a type of permanent life insurance and does not have a set expiration date. As long as you keep paying your premiums, your coverage can continue for your entire life, hence the name whole life. The premiums on whole life insurance generally start out higher than on term life insurance, but they do not increase as you get older. These policies may be a good fit to help cover needs that never go away, such as paying for final expenses.

Some whole life insurance policies also include an additional benefit called cash value. Part of your premium payment goes toward cash value and the money has potential to grow over time. You can take out this money while you're still alive through a loan or withdrawal. However, loans or withdrawals may generate an income tax liability, reduce the cash value and death benefit and cause the policy to lapse. Loans will also accrue interest until you pay them back.

MORE: How Whole Life Insurance Works

Universal Life Insurance

Universal life insurance is another form of permanent coverage and can potentially last your entire life as long as premiums are paid. With these policies, you may have the flexibility to change your premium each year, paying less some years and more in others. There must be enough cash value in the policy to cover monthly charges if a lower premium is paid than the amount selected at issue or if a premium payment is skipped. Additional premium payments may need to be made to keep the policy in force. Universal life also has a cash value component.

MORE: How Universal Life Insurance Works

Who Should Consider Purchasing Life Insurance?

If you're wondering whether you need life insurance, here are some common situations in which you may want to consider purchasing a policy.

You Want to Help Cover Your Final Expenses

The average cost of a funeral and burial was $7,640 in 2019, according to the National Funeral Directors Association. You could also face other expenses, such as covering your medical bills or processing your will in probate court. Life insurance can help pay for these costs when you die.

You Have Young Children or Family Members Relying on Your Income

If you have young children, a spouse or others that rely on your income, they may face financial hardships if you passed away unexpectedly. Life insurance could help replace your lost income to help your loved ones pay bills and maintain their lifestyle.

You Have Outstanding Debts

Whether you have a mortgage, student loans or other outstanding debt, life insurance can help pay off these debts so your beneficiary won't have to. This can be especially beneficial if someone co-signed your bills, as they would legally be responsible for paying the debt after you pass away.

MORE: How Life Insurance Helps Protect a Mortgage

You Want to Leave an Inheritance

Life insurance can be a way to leave an inheritance to your family members, such as to help your grandchildren pay for college. It could also be a way to leave a donation for your favorite charity.

How Much Life Insurance Do You Need?

When you apply for life insurance, it's important to consider your coverage needs. If you purchase too large a death benefit, you'll be paying for more insurance than is necessary. On the other hand, if you buy too little, you could put your beneficiary in a tough situation and they may not have enough money to handle everything after you die.

If you'd like a more accurate target, you could run a financial-needs analysis using a life insurance calculator. These calculators ask you to list out some basic financial information, such as your current savings, debt, income and financial goals to help you figure out the right amount of coverage. For help with this decision, you could also meet with a financial representative.

How Much Does Life Insurance Cost?

The cost of life insurance depends on several different factors. First, it depends on how much coverage you buy. The larger the death benefit, the more expensive the policy will be because you're buying more coverage.

Insurers also look at how long the policy will last, since the longer the coverage lasts, the more likely you are to pass away, at which point they would be responsible to pay the death benefit. For example, permanent whole life insurance typically costs more than temporary term life insurance, while a 20-year term policy will cost more than one-year term.

The cost also depends on your age and health. The younger and healthier you are, the less expensive your coverage could be. On the other hand, someone who is older and has health issues may need to pay more for their coverage. Smokers typically pay more than nonsmokers while someone with risky hobbies — such as skydiving — may also need to pay a higher price.

While these factors can give you an idea of what goes into pricing, the only way to know for sure how much your insurance will cost is by applying for a quote. It's free to apply, and then you can decide whether you want to accept the policy at the quoted rate.

MORE: 9 Factors That Could Affect the Cost of Life Insurance

How Do You Apply for Life Insurance?

The life insurance application process depends on the insurance company. Some companies let you apply online while others may ask you to meet in person to make sure you fill out everything properly. The application will ask for some basic information, such as your age, weight, whether you use tobacco, whether you have any dangerous hobbies and the amount of insurance you'd like to buy.

As part of the process, you may need to go through medical underwriting. The insurer could check your medical records, ask you to meet with a medical professional for a physical, or submit your blood and urine for lab testing. They will also check whether you have any dangerous hobbies or habits.

With this information, the insurer could come back with an offer showing how much life insurance you qualified for and at what price. If you are happy with the offer, you can accept it.

Qualifying for life insurance is not guaranteed, though. If you have medical issues or other high-risk factors, the insurer could charge you a higher rate or even deny coverage altogether. That's why it can be a good idea to apply as soon as you can, when you are younger and healthier, to help increase your chances of qualifying.

MORE: How to Choose Life Insurance

How Does Life Insurance Pay Out Death Benefits?

When you purchase life insurance, you choose a beneficiary for the policy. This is the person or entity that would receive the death benefit if you passed away while the policy is in force. When you die, the beneficiary would then fill out a form for the insurer, listing their name, your policy number and your cause of death. They might also need to submit a copy of your death certificate.

The insurance company will review the information for the claim. The policy will likely lay out some exclusions where they would not provide the death benefit, such as if someone lied on their application about a preexisting medical condition. Provided that you didn't die of an excluded cause, the insurance company would pay the death benefit to your beneficiary.

For more information about what is life insurance and how it works, consider meeting with a financial representative. They can help you go over your finances, weigh your insurance options, and help you decide which type of life insurance is right for you and your loved ones.

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