How Does Life Insurance Work?

Posted February 10th, 2017 by Ashley Kane

So maybe you already have auto and home insurance and understand how those coverages operate. They protect your car and home. Yet what about life insurance? How does it protect your life? Here’s all you need to know about how life insurance works.

What Is Life Insurance?

People purchase insurance for peace of mind. If you’re involved in a car crash, you want to know you’re covered. The same goes for home damage or health issues. Similarly, people purchase life insurance to protect themselves and their families.

A life insurance policy can help secure income for your family or other beneficiaries in the event of the policyholder’s death. Essentially, life insurance helps take care of them if you aren’t able to. The death benefit can cover funeral costs, bills, mortgage payments, college tuition and more.

Types of Life Insurance:

There are two main types of life insurance.

Whole Life Insurance

Also called permanent life insurance, whole life provides lifelong coverage. The life insurance payout amount is guaranteed, and it does not end after a specific term, as long as premium payments are made. Whole life encompasses many subcategories—traditional whole life, variable life, universal life, variable universal and survivorship life insurance. You can read more about these forms here.

Price: Whole life insurance is very expensive. The premium is often paid on a yearly basis and the rate generally stays the same year over year.

Value: Whole life insurance accumulates cash value as you pay into it, and has an investment component. The value grows at a steady rate and is tax-deferred so you don’t have to pay any taxes as the money grows. The extra money accumulated can either be added to the death benefit or be borrowed as a loan with interest. If your circumstances change, you can also end the policy for a cash value—though you’ll no longer have any coverage. Some life insurers also pay out annual dividends on whole life policies, based on their financial surplus for the year.

Term Life Insurance

Term life insurance pays out if the insured dies during a certain term. For example, if you purchase a 20-year policy, your beneficiaries will receive a payout if you pass on during that 20-year period. If you’re still living at the end of the period, nothing is paid out and the money paid over that period is lost. Term life insurance is temporary life insurance.

In order to have coverage again, a new policy needs to be purchased after the period ends. The risk is that your term life insurance rate could go up in price or be difficult to find if you’ve developed health issues.

Price: Term life insurance is cheap compared to whole life. In fact, term life is often only a couple hundred dollars per year while whole life coverage may be ten times that amount, costing thousands of dollars per year.

Value: Young people may have a high need for life insurance, especially if they have families to support, but they may not have a high cash flow. As a result, term life insurance can be a good option because it provides protection for a certain number of years. However, it may be best to convert the term policy to whole life insurance during the specified period so that the coverage will last a lifetime.

Which Type Is Better?

Term insurance will always be significantly cheaper than whole life because it’s only temporary. However, that doesn’t mean term insurance is always the best choice.

One type of life insurance isn’t always better than the other. There is not a clear winner—rather the best choice for you depends on your individual situation. Consider your finances, life stage and future goals. Term life insurance may only be a few hundred dollars per year, and that may work out better for immediate coverage needs. On the other hand, some policyholders would rather purchase term life and invest the difference between that and a whole life insurance rate for a better return, while others would prefer to pay into a coverage that already has an investment component and will last a lifetime. Weigh out these coverages and choose the right insurance for you.  

Remember, your life insurance premium is determined by many factors. These include your age, health, location, lifestyle and more. There is not one set rate. Be sure to compare a few quotes before you make your decision.