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How life insurance works

There are many factors to consider when acquiring a life insurance policy that can help protect your family’s future financial needs. This life insurance guide can help make it easier to understand the basic process of purchasing life insurance. For example, how it works, the types of coverage available, why you need it, and how to go about choosing a plan that’s right for you.

What is Life Insurance, and How Does it Work?

Life insurance is a contract between you and an insurance company to provide coverage based upon your timely payment of insurance premium. Life insurance provides a death benefit to your named beneficiary (usually a spouse) upon your death. When you pass away, your beneficiary files a claim with the insurance company to submit proof (a death certificate) of one’s passing. If an agent usually works with your family, your beneficiary can contact the agent who will help them complete the needed paperwork. Or, your beneficiary can get the insurance company directly, and a claims representative will instruct them on what to do. After the insurance company receives all the documents, your beneficiary will be issued the death benefit payout.

If you name a minor as a beneficiary, then a custodian of the policy would have to file the claim. This could be someone you named to manage the money from the policy if you died while your child is still a minor. If you didn’t call anyone, then a court will appoint someone.

Main Types of Life Insurance

Life insurance can either be temporary or permanent. Temporary insurance is more commonly called term insurance, and policies are issued for a specified number of years, often from 5 to 30. Permanent insurance covers you for your entire life or up to a certain age, usually 100-years-old.

The main differences between term and permanent life insurance.

Term pays a death benefit to your beneficiary only if you die during an active policy until age 95 Pays a death benefit to your beneficiary regardless of when you die as long as the policy is in force.

In most cases, death benefit and the right to convert to a permanent policy without proof of insurability are the primary features that Include both a death benefit and a savings feature.

The policy has no value at the end of the term Policy builds cash or loan value you can borrow against, withdraw, or invest.

Types of Term and Permanent Insurance

Most term insurance policies sold to individual consumers are level premium term policies. This type of policy guarantees that your premium will stay the same for a set period, which could be the entire term or just a portion. Other less common types of term insurance include annual renewable time and decreasing term coverage. However, most insurance companies don’t offer these plans to individual insurance shoppers because they are generally not the best fit for families looking for the most protection due to the guaranteed premium.

Two of the most popular types of permanent insurance are whole life and universal life. Most life policies provide a level premium, so the rate you pay stays the same for the entire procedure. You can get a more considerable death benefit with most life insurance policies by passing a medical exam. Other permanent insurance policies available include variable life and variable-universal life.

How Life Insurance Policies Are Issued

Policies are either simplified issues or fully underwritten. Simplified issue policies only require that you answer questions about your health when completing the insurance application. These policies may cost more since the insurance company has less proof about your health. Fully underwritten policies require that you take a medical exam and complete lab work. You usually get a lower premium with these policies if your results show good health.

Factors That Determine Your Premium Amount

A general rule of thumb with life insurance is that you will pay less the younger and healthier you are. Age is typically the most crucial factor in calculating your premium rate. Other factors include:

  • Gender—females usually get lower rates because of longer life expectancy.
  • Answers to health questions on the policy application
  • Results from medical exam and lab work
  • Family medical history
  • Marital status
  • Location
  • Lifestyle—smoker/nonsmoker, alcohol consumption, risky hobbies like skydiving

Why Do I Need Life Insurance?

There are three main reasons why many Americans get life insurance:

  1. To pay for burial and final expenses: even a simple funeral can cost thousands of dollars. The National Funeral Directors Association reports that Americans’ median price for a funeral is $7,181 as of 2014. When you include the vault price, something that most cemeteries require, this comes out to a median price of $8,508. About 51% of Americans get life insurance for this reason, according to LIMRA.
  2. To replace income: if you die leaving behind a spouse and young children, it may be hard for them to make ends meet without your payment. Money from a life insurance policy can help maintain your family’s standard of living and pay for expenses that go along with raising children. LIMRA reports that 34% of American households get life insurance for this reason.
  3. To pay off a mortgage: a large part of your working adult life is dedicated to paying off the mortgage on your house, which can take 30 or more years. Life insurance can help ease the financial burden your family may face to keep a roof over their head after you’re gone. Money from a policy can help them continue to make monthly payments or pay off the entire balance. LIMRA states that 26% of Americans get life insurance for this reason.

How to Buy Life Insurance

  1. Determine your needs: calculate how much debt you have, your monthly living expenses, and your final costs. Include any future expenses, such as college tuition. Figure out how long you need replacement income and how much revenue it would take your survivors to pay for immediate and future expenses.
  2. Get a quote from different insurance companies: compare rates, policy features, and benefits to ensure you’re getting the best deal.
  3. Choose a company with a solid financial rating: companies with the highest ratings offer more guarantee that they will have the finances to pay your claim. You can get financial strength ratings from rating agencies like A.M. Best Company.
  4. Make an appointment with an agent: after you narrow down your search to a specific company, speak with a licensed agent to go over more details about your needs.
  5. Make sure you can afford the premium: double-check how much income you have coming in and how much expenses you have going out to make sure the rate you’re getting is affordable.
  6. Read your policy: after you’ve been issued a policy, make sure you read all the fine print. If you don’t like your approach, state laws generally mandate that you have a certain number of days to cancel your policy and receive a refund of any premiums you paid. Depending on the state, this may be within 10 to 30 days after the policy issue date.

Understanding the Life Chart

A part of buying life insurance is knowing whether you should purchase term or permanent life insurance.

Young and married with small children: young families need the most death benefit from a life policy because the need for income replacement to cover growing children is more significant. Also, if a spouse who stays home to take care of the kids were to die, it would be an additional expense for the surviving spouse to pay for child care services. A term plan is typically the least expensive in the beginning. Longer-term policies like the 20-year or 30-year plan can be the most suitable for young families.

Young and married with no children: depending on your lifestyle, it may be hard to maintain the same standard of living if one of you is no longer around. According to a Kiplinger Magazine article, a modest amount of coverage may be enough to meet your needs. Since term policies allow you to get the essential coverage you need, you can pick a plan with a lower death benefit to get a more affordable rate.

Single-Parent: like young couples with children, single-parents with more youthful kids also need a policy that provides a significant death benefit. Studies show that most single-parents are women, and the average salary single-mothers earned as of 2014 was $36,780, according to Forbes Magazine. This is far less than the average wage for married couples with children under 18, about $107,054 (2013). With less income among the majority of single-parents, it’s more likely that there wouldn’t be enough savings that could be used as income replacement if the parent dies. The primary step in this situation is to get a low-cost term policy that can provide the most protection. The lower cost of term insurance makes it a good choice for single parents.

Recent empty-nester: so the kids are off to college, but that doesn’t mean your life insurance needs end. You may need to support your children through the college years to help pay for tuition, room and board, books, or even clothing. If your household runs on two incomes and you still have significant debts to pay off like a mortgage, you need income replacement protection. Depending on your age, you may also have a while to go before having enough retirement savings.

At this stage in life, a policy that has a death benefit your spouse could use to cover expenses if one of you dies. The procedure can also build cash value to supplement your retirement savings may be the most suitable. Depending on your needs, you could choose to go with a term plan that converts to permanent insurance or go straight for a permanent policy. For example, if you’re 55 and looking to have cash value in a policy by the time you’re 65, then a permanent plan may be best because it could take that long for the procedure to build cash value. This usually takes 8 to 10 years for whole life policies, according to a Kiplinger Magazine article.

If you don’t need supplemental income as fast, you could get a 10-year convertible term plan. So by the time you’re 65, you could have a whole life policy, and when you reach 75, you could have cash value in the policy. According to the Texas Department of Insurance, one thing to keep in mind when converting a term plan is that insurance companies usually only allow you to do this before you turn 65.


Retired senior citizen: if you’re under 80, you can still get a term life insurance plan. As the Texas Department of Insurance mentioned, this is typically the maximum age at which insurance companies provide term coverage. Although the cost would be more expensive because you’re older, premiums are usually lower than a permanent insurance policy, such as whole life.

If you need a policy that can help supplement your retirement savings, then the cash value from a permanent plan may meet your needs. However, keep in mind that it does take a while to build cash value. So depending on your age, you may want to weigh the odds of whether or not you will be around long enough to take advantage of this feature. You could also choose a type of permanent insurance: final expense insurance, typically offered as a whole life policy. This type of coverage is only meant to cover your burial and funeral expenses, not your long-term financial needs.

Making a Decision

Now that you have learned the basic information from this guide, it should be easier to decide what coverage you should get.

Life insurance payouts are sent to the beneficiaries listed on your policy when you pass away. But your loved ones don’t have to receive the money all at once. They can choose to get the proceeds through a series of payments or put the funds in an interest-earning account.

Read on to learn more about how life insurance works, the different payout options and if a final expense or whole life policy is a good option for your family.

What Is Life Insurance and How Does It Work?

At its most basic, life insurance works like homeowners or auto insurance: You pay an annual premium in exchange for a certain amount of coverage. If you pass away while the policy is active, your beneficiaries receive a death benefit equal to the coverage amount. The main difference between life insurance and other types of insurance is that some policies allow you to accumulate cash value on the policy, which you can use a few different ways.

Life Insurance Payout Options

Beneficiaries on life insurance policies have to file a claim to collect the death benefit. Most insurance companies process claims within a few days or weeks of receiving the completed claim form and a certified copy of the death certificate. However, there could be delays if the policy was recently purchased and the insurance company has reason to believe fraud may have occurred when the policy was issued.

Assuming the claim is approved, beneficiaries choose how to receive the death benefit. In most cases, proceeds can be paid out through one of the following options:

  • Lump-sum fixed amount: Beneficiaries who select this option receive the entire death benefit in one payment. It’s the most common selection but can be risky if the funds are not managed properly. Because bank account balances are only covered up to $250,000 by the Federal Deposit Insurance Corporation, it may be necessary to place funds in various accounts if the insurance payout exceeds this amount.
  • Specific income payout: Your beneficiaries can choose to receive monthly installments over a set period to ensure the money doesn’t run out too fast. To illustrate, they could request $30,000 in payments each year for 20 years if the death benefit was $600,000. The life insurance company will hold the money in an interest-earning account, and you’ll owe taxes on the interest earned on the balance.
  • Retained asset account: If your insurance company offers this option, policy proceeds can be placed in an interest-bearing account. Beneficiaries receive a checkbook if they need to access the cash, and any interest earned is taxable. Also, the insurance company guarantees the proceeds in the account, even if the balance exceeds the $250,000 limit set forth by the FDIC.
  • Annuity: Also known as a life income payout, the beneficiaries of this grant are guaranteed payments as long as they’re alive. Insurance companies use your beneficiaries’ ages when they file the claim and the amount of the death benefit to determine the payment amount. The amount of the death benefit remaining (if any) when your beneficiary passes away goes back to the insurance company unless they opt to receive an annuity for a set period. In this case, what’s left will then go to designated beneficiaries.

Who Needs Life Insurance?

Life insurance can give your loved one security and peace of mind if you pass away. It can help cover your final expenses, including funeral costs and outstanding debts that you cosign with a spouse, along with the costs associated with caring for your dependents.

But is life insurance a good investment for you? It depends. If you’re single with no dependents and have enough money saved to cover your final expenses and debts if you pass away, you may not need a policy. However, you may want or need life insurance coverage if:

  • You have dependents who rely on your income for survival.
  • You’re the sole wage earner in your home.
  • You’re a stay-at-home parent who handles most of the housekeeping and child care duties.
  • You provide financial support for aging parents.
  • You’re an empty-nester or don’t have children, but provide financial support for your spouse.

If you decide life insurance is a good option for you, you have to decide how much life insurance you need and whether a term or whole life policy is a better fit. Consult with a reputable insurance agent to learn more about what options may be available to you.

Which Life Insurance Payout Option Is Best?

Life insurance can help your family cover your final expenses and fill a financial void if you pass away. There are different types of policies to choose from, and you should work with a financial planner to determine how much you need.

Also, be mindful that your beneficiaries will have the right to decide how they receive the death benefit. So, it’s ideal to have a conversation about life insurance payout options with your beneficiaries to ensure they understand the options available to them and can make an informed decision when the time comes.

Life insurance is a policy that provides money to your beneficiaries when you die. The payout can be a lump sum or in installments over a set period of time.

The amount of life insurance you need will depend on your financial situation and how much your loved ones would need to cover your expenses if you died.

There are two main types of life insurance policies: term and whole life. Term life policies provide coverage for a certain number of years, while whole life policies last your entire lifetime.

Your beneficiaries will have the right to choose how they receive the death benefit from your policy. They can take the money as a lump sum or in installments over a set period of time.

When you purchase a life insurance policy, you can name one or more primary beneficiaries. They will receive the payout from your life insurance policy regardless of what you choose as your secondary beneficiary. This comes in handy if your primary beneficiary is financially unstable and would have trouble managing the cash flow after your death.

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