How Life Insurance Works: What You Need to Know

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Understanding how life insurance works will help you choose the policy that is best for you and your loved ones.

If you have questions about how life insurance works, you’re not alone.

According to Motley Fool, “15% of Americans don’t have a policy because they don’t know which kind to get,” and “11% of Americans say that the confusing nature of life insurance has driven them to avoid buying a policy.”

Anytime you have to deal with a legal contract, it can feel scary and overwhelming.

But that isn’t an excuse to not purchase life insurance.

Life insurance is one of the most important financial products you will ever buy, so educating yourself on how life insurance works is well worth your time.

What Is Life Insurance?

Life insurance is a specific type of insurance contract between a policyholder and an insurance company.

You agree to pay premiums so that your loved ones (aka beneficiaries) will receive a death benefit when you pass away.

What Do You Pay for Life Insurance?

Recent data shows, “More than half of Americans don’t have life insurance because they think it’s too expensive.”

This is a clear example that many people don’t know how life insurance works.

Forbes explains, “More than half of respondents in the Insurance Barometer Report said a $250,000 term life insurance policy for a healthy 30-year-old would cost $500 a year or more. But the average cost is closer to $160 a year. That’s a pretty big discrepancy in perceived cost versus actual cost.”

The problem is that many people overestimate the costs of premiums.

When you purchase life insurance, you either pay for it upfront or you pay monthly or annual premiums over time.

As you can see, some premiums are inexpensive.

The amount you pay for life insurance annually or monthly is determined by several factors, such as the type of life insurance you choose.

For instance, term life insurance tends to be less expensive than whole life insurance.

The death benefit amount, such as $400,000 or $150,000, will also play a large role in determining how much you pay for life insurance.

[Related Read: The Types of Life Insurance Explained]

What Determines the Cost of Life Insurance?

While the type of life insurance and the death benefit amount affect how much you pay for the policy, those are not the only factors.

They are just the factors you are most in control of. There are others that are out of your control, such as gender.

Spend Me Not reports, “Women typically pay 23% less for life insurance. Historically women are considered less of a risk for insurers. They’re less likely to engage in risky behavior that could get them killed. Also, women tend to live longer than men, and this is reflected in lower premiums.”

Age is also a cost-determining factor.

The younger you are when you purchase life insurance, the less expensive it will be.

The same report shows, “The average cost for $250,000 cover for a 20-year-old man is $17.02 per month. Put off getting life insurance until you’re 60, and your life insurance cost will be about $141.36 per month.”

Your overall health and lifestyle also determine the cost of life insurance.

If the insurance company has reason to believe you are at higher risk than other policyholders, you will likely have to pay higher premiums.

For example, according to Policy Genius, “Being a smoker means paying two to three times the regular rate for life insurance.”

While the cost of life insurance is determined by a number of factors, some of which are out of your control, you can (and should) shop around and get quotes from different companies.

Ultimately, life insurance is a financial product someone is selling. Stop being sold!

What you spend on life insurance should be your decision.

Understanding the types of life insurance, knowing how life insurance works, and determining how much life insurance you need will help you purchase the right policy for your unique needs.

[Related Read: How Much Life Insurance Do I Need?]

Who Are Beneficiaries?

Once you have chosen a life insurance policy, it is time to choose a beneficiary –or the person you want to receive the life insurance policy death benefit when you pass.

Ideally, this is the person (or people) you had in mind when you were determining how much life insurance you need.

You may choose:

  • Spouse
  • Parent
  • Sibling
  • Adult child
  • Business partner
  • Charitable organization
  • A trust


However, you cannot choose a minor child as a beneficiary of a life insurance policy.

You may choose more than one beneficiary, and you may also designate the percentage amount each beneficiary receives upon your death.

It is also wise to choose a contingent beneficiary in case the primary beneficiary has passed away.

In this case, the contingent beneficiary will receive the death benefit.

How Does Life Insurance Work after the Policyholder Dies?

Upon the policyholder’s death, the beneficiary will need to contact the life insurance company and file a claim.

Once the claim is approved, the life insurance company pays the death benefits to the beneficiary.

It’s important to tell your loved ones (or beneficiaries) that you have a life insurance policy and provide them the name of the insurance company.

Do not store your life insurance policy in a brown paper bag or a box in the closet or in a drawer.

It’s vital you keep your policy stored somewhere that’s fireproof and in a place that someone in your family is aware of.

When and How Does a Beneficiary File a Claim?

Ideally, your beneficiary will begin the claims process shortly after your death.

Since life insurance is an emotional issue, the good news is that there isn’t a time limit on life insurance claims.

Your loved ones will have time to grieve before they start the claims process.

However, the sooner the beneficiary begins the claims process, the sooner financial help will arrive. Sometimes in a matter of weeks.

In order to file a claim, the beneficiary will need to contact the insurance company to get the ball rolling. (Again, this is why you want to file your policy somewhere safe and where the beneficiary can easily locate it.)

They will also need to submit a certified copy of the death certificate and complete the claims paperwork.

What Is the Payout Process Like?

After the claim has been filed with the life insurance company, it will be reviewed.

In most states, this happens within 30 days. If this sounds fast, it’s because insurance companies want to pay out as soon as possible to avoid interest charges for delaying the payment.

Once the claim is approved, the payout process begins.

The payout process depends on the specific insurance company.

Some may allow the beneficiary the option to choose the type of life insurance payout he or she would like to receive, such as a lump sum fixed amount (the entire death benefit in one payment), monthly income installments (such as $30,000 each year until the full death benefit is reached), or annuities.

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