How Does Life Insurance Work?

Life insurance pays a tax-free death benefit to your beneficiaries when you die, as long as your policy is active. You pay regular premiums, and your insurer guarantees a lump-sum payout to the people you name.

Your beneficiaries must file a claim to receive this benefit. They can use the money for anything: funeral expenses, medical bills, debt payments or income replacement.

Life insurance comes in two main types:

• Term life: Covers you for a set number of years
• Permanent life: Lasts your entire life and may accumulate cash value

Each type works differently, so understanding both helps you choose the right financial protection for your family.

Life insurance is a financial contract between you and an insurance company. You pay regular premiums, and the insurer promises to provide a tax-free lump sum (a death benefit) to your chosen beneficiaries when you pass away.

Life insurance protects your loved ones financially after your death. The payout can cover funeral expenses, pay off debts like a mortgage or credit cards, replace lost income, or fund future needs such as a child's education. Some policies also include living benefits, which let you access part of the death benefit while you're still alive if you're diagnosed with a serious illness.

Your life insurance premium depends on factors like your age, health, policy type and coverage amount. Life insurance prevents your family or dependents from facing financial hardship when you're gone.

Life insurance comes in two main types: term and permanent. Both pay death benefits to your beneficiaries if you die while the policy is active. Your premiums also stay the same throughout the policy period.

Cost and length separate these two types. Term life insurance covers you for a specific time period at affordable rates. If you outlive your policy, your beneficiaries don't receive a payout.

Permanent life insurance offers coverage that lasts your entire life. Part of your premium goes into a cash-value account that grows over time. Once you accumulate enough cash value, you can borrow against it while you're still alive. These features make permanent life insurance more expensive than term coverage.

Term life insurance provides temporary coverage for periods you choose when you buy the policy. "Temporary" doesn't mean short-term — term policies typically last 10, 20 or 30 years. Term life costs much less than permanent coverage because you're only covered for a specific time period.

Term life works well for short-term needs like educational costs or your mortgage. For young, healthy people, term policies offer the most affordable coverage available.

When your policy expires, you have options: let it lapse if you no longer need coverage, renew it, or convert the term plan to a permanent policy. This flexibility lets you adjust your coverage as your financial situation changes.

Permanent life insurance provides coverage for your entire lifetime, guaranteeing your beneficiaries will receive compensation no matter when you pass away. Because of this guarantee, it costs much more than term life insurance.

Permanent life insurance includes an investment component, letting the policy serve as both financial protection and a growth tool. The policy accumulates cash value over time. Once the cash value reaches a substantial amount, you can borrow against it.

Permanent life insurance works better if you want your policy to double as an investment vehicle. It's also the better choice if you have a lifelong dependent, like a child with disabilities. Make sure you can afford the premium long-term because these plans cost more. Your policy will lapse if you miss premium payments.

Most people can benefit from life insurance — your loved ones get financial support if you pass away unexpectedly. Death benefits can cover expenses like tuition, mortgages and household costs.

You typically need enough life insurance to cover your current debts, future expenses and income replacement. Most experts recommend coverage equal to 10 to 15 times your annual income.

The right amount depends on your financial obligations. At a minimum, your policy should cover your mortgage balance, outstanding debts, college tuition for children, and provide enough income for your loved ones to maintain their lifestyle.

Coverage amounts can range from $100,000 to over $1 million, but higher coverage comes with higher premiums. Aim for a balance that provides meaningful protection without straining your budget.

Life insurance generally covers death due to illness, accidents and natural causes. Here's what a typical life insurance policy might cover:

• Death by Illness or Accident: The policy pays out if you die from an illness or accident.
• End-of-life Expenses: Funeral and burial costs are covered, easing the financial burden on your family.
• Estate Planning Costs: If you have a large estate, life insurance can cover taxes and legal fees.
• Monthly Bills and Mortgage Payments: The death benefit helps your family maintain their standard of living by covering ongoing expenses.
• Income Replacement: The death benefit serves as income replacement so your family can maintain their current lifestyle.
• Educational Expenses: You can allocate the death benefit to cover tuition and other educational expenses for your children.
• Debt Repayment: You can use the death benefit to settle debts like mortgages, car loans or credit cards, preventing the financial burden from passing to your family.

Coverage details vary depending on the policy and provider.

Life insurance offers broad coverage, but it's not complete protection. Here are some common exclusions:

• Pre-existing Conditions: Some policies won't cover deaths related to pre-existing medical conditions if you didn't disclose them during the application process.
• War and Terrorism: Most life insurance policies don't cover deaths that occur due to acts of war or terrorism.
• Hazardous Occupations: Insurance companies consider some occupations hazardous, and deaths related to these occupations may increase premiums or lead to exclusions. Examples include miners, loggers, fishermen, firefighters, police officers and construction workers.
• Death by Suicide within the First Two Years: Most policies won't pay out if the policyholder dies by suicide within the first two years. This suicide clause prevents beneficiaries from claiming benefits under these circumstances.
• Insurance Fraud: Providing false information on your application can lead to denial of the death benefit.
• Specific Exclusions: Some policies exclude deaths due to risky activities like skydiving or car racing.

Understanding these exclusions helps you choose the right policy and avoid surprises when filing a claim.

Life insurance's main benefit is the financial support your family receives if you unexpectedly pass away while the policy is in effect. Insurers pay a tax-free lump sum called a death benefit to your beneficiaries.

Some policies let you access your coverage while you're still alive through living benefits. These include:

Being informed about these benefits of a life insurance policy enhances your ability to make educated decisions about your policy.

Your policy's coverage amount determines how much your insurer pays out as a death benefit. Most people choose $100,000, $250,000 or $500,000 in coverage.

Your appropriate coverage amount depends on your financial situation. You can use the DIME method to estimate how much coverage you should purchase:

• Debt: How much debt would you be leaving for other people to pay? Include loans you've taken out.
• Income: Multiply your current income by the number of years you want to provide income replacement for your loved ones.
• Mortgage: How much is your current mortgage balance?
• Education: Consider how much college tuition, room and lodging costs.

Higher coverage amounts provide more financial protection, but you'll pay higher premiums. We've provided guides for the four common life insurance policy values:

To receive the death benefit from a life insurance policy, beneficiaries must file a claim with the insurer. Payouts aren't automatic and require documentation and review. Most claims are paid within 14 to 60 days, but delays can occur based on the circumstances of the death or missing paperwork.

Before purchasing a life insurance policy, learning about its tax implications would allow you to make sure it aligns with your overall financial plan.

Life insurance tax rules affect how much money your beneficiaries actually receive and what you owe while you're alive. Understanding these implications helps you choose the right policy and avoid unexpected tax bills.

Insurers use various factors to determine your life insurance cost, which is why premiums vary so much between people. Understanding these factors helps you get the best rates and choose the right policy.

Understanding these factors helps you shop smarter and find coverage that fits your budget and needs.

Choosing the right life insurance policy depends on your financial goals, how long you need coverage, and who relies on your income.

Start by Understanding the Two Main Types:

• Term Life Insurance: Offers affordable coverage for a specific period, such as 10, 20, or 30 years. It's a smart choice if you need protection during high-expense years like paying off a mortgage or raising children. Once the term ends, renewing the policy typically results in higher premiums.
• Permanent Life Insurance: Provides lifelong coverage and includes a cash value component. It's more expensive than term life but may be better suited if you want a policy that doubles as a financial asset or if you have a lifelong dependent.

Match the Policy to Your Needs:

• If you have short-term financial responsibilities like a loan or young children, term life insurance is often sufficient and more budget-friendly.
• If you have long-term obligations, such as caring for a child with special needs or planning for estate costs, a permanent policy may provide more lasting value.

Weighing your current financial responsibilities and future goals helps you choose a policy that offers the right level of protection for your loved ones.

Life insurance can benefit most people, but understanding what term and permanent life insurance offer helps you decide which type suits you best. The table below shows the benefits and drawbacks of each type.

When you're choosing a beneficiary for your life insurance policy, spouses and children are obvious choices. Financial support for the family is the most common reason people buy life insurance. If you're not married, you can name your siblings, parents or even a trusted friend as your beneficiary.

You can name two types of beneficiaries. A primary beneficiary receives the payout first. If the insurer can't find your primary beneficiary, the death benefit goes to the secondary or contingent beneficiary. A beneficiary doesn't have to be a person; you can set up your policy so a trust receives the payout.

If you don't name any beneficiaries on your policy, your death benefit goes to your estate, which could result in a delayed payout or reduced amount.

Most people see the need for life insurance but don't carry a policy, often because they don't know the steps involved in buying it. Understanding the process clears up confusion and helps you make the right decision for your needs:

Life insurance offers peace of mind by providing financial protection to your loved ones after you're gone. Whether you choose term or permanent coverage, select a policy that matches your family's needs, financial obligations and long-term goals.

Understanding how life insurance works, from paying premiums to how death benefits are claimed, helps you make confident decisions that safeguard your family's future.

Our answers to some of the most common questions can provide more information about how life insurance works.

Why Trust MoneyGeek? We analyzed 1,488 life insurance quotes alongside customer satisfaction, financial stability reports, product offerings and more to determine the best life insurance companies.

MoneyGeek created a scoring system to compare life insurance companies across five categories and ranked them based on their scores. We chose to review these companies based on their broad national coverage and ability to provide an online quote.

MoneyGeek’s Scoring System

MoneyGeek ranked the top life insurance companies for parents using the following weightings:

• Financial Stability: 35%
• Customer Satisfaction: 25%
• Buying Process: 20%
• Product Diversity: 20%

We did not include affordability in the calculation since we do not have quotes for whole life insurance policies. Of the companies that offer whole life insurance plans, we chose the one with the highest score.

Each company’s score incorporates the following:

• Cost data obtained through online quotes
• Financial strength ratings from AM Best and number of years in business
• Customer satisfaction data from the National Association of Insurance Commissioners (NAIC) customer complaint index (we reviewed annual complaint data from 2020 to 2022, the most recent year available)
• Availability of tools to aid in the buying process, such as online product materials and multiple payment options
• Diversity of life insurance products offered

Sample Customer Profile

MoneyGeek used a standard profile to obtain life insurance quotes:

• 40-year-old male
• Non-smoker
• 5 feet 11 inches tall and 175 pounds
• Excellent health rating

Premiums are based on the standard profile unless otherwise noted.

We modified the profile by age, gender, height, weight, tobacco use, health rating and geographic location to collect a variety of quotes and determine the best life insurance company for several types of customers. We collected quotes for term life insurance with varying term lengths and coverage amounts as well.

We identified trends in the data set and used those patterns to calculate projections and extend the data beyond what was originally collected.