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What Is Life Insurance and How Does It Work?
At its core, investing in life insurance is an act of love. Doing so helps ensure your death doesn't bring a financial loss on top of the emotional loss. People who buy life insurance want to take care of their loved ones even in the worst-case scenario.
When you’re ready to shop for life insurance, however, you might not feel the love. The industry often lacks transparency, and you’ve probably never bought anything else quite like life insurance before.
Fear not, family protector: you have backup. We’re going to help you wrap your brain around this life insurance thing (specifically what it is and how it works), so you can get back to enjoying life.
What is life insurance?
At its simplest, life insurance is a contract between you and the insurer. You agree to pay regular premiums, and the insurer agrees to pay far more to your beneficiaries when you die.
Simple enough, right?
Where things become complicated is in the “how” of life insurance. So let’s dive in.
How do life insurance policies work?
In a nutshell, the life insurance journey can be summarized into three parts:
1. Applying and getting approved for a life insurance policy
2. Paying a premium for your preferred policy value (coverage)
3. Your beneficiary claiming the value of the policy after you've passed away
Life insurance can be simple. Choosing a policy with an investment component, like universal life insurance, can make things a bit more complicated. And some folks have trouble wrapping their minds around how insurers make a profit if they’re constantly handing out large sums of money at claims time. We’ll cover these points a little later.
But for now, let’s just say that life insurance is mostly complex only during steps one and three. Some folks will make changes to their policy in the middle, but mostly, the hardest part of life insurance is buying it.
A lot of folks get hung up on choosing between term life and permanent life, so read more about the types of life insurance before you start applying.
Otherwise, read on.
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Applying for life insurance
Technically, you buy insurance, but you also have to apply for life insurance.
The application process can take a few minutes if you choose accelerated underwriting (you get to skip the medical exam) or a guaranteed issue life insurance policy. If approval depends on the results of a medical exam, however, it might be a few months before you hear back.
The good news is, most life insurance policies cover you for a decade or more, so you probably won’t have to go through the application process more than a handful of times in your life.
Buying life insurance isn’t like loading up on the latest apparel and hitting the checkout at Macy’s. It’s more like going to a tailor or dressmaker, choosing a design, having your measurements taken—then waiting to hear back if the clothier will even take you on as a client.
Going through that whole process without knowing if you’ll be able to buy what you want might seem ridiculous in the clothing industry, but with life insurance it’s normal.
Changing your coverage
Of course, purchasing the right life insurance policy requires long-term planning, and knowing your future needs is like predicting what your waistline will look like in ten or twenty years. If something unexpected happens, you can always change your coverage in the following ways:
- Add another policy. You will probably go through the same application process, even if you stick with the same insurer.
- Add coverage to your current policy. You’ll still need to prove you’re insurable, but you’ll face a less rigorous application process.
- Lower your current coverage. Most companies will let you do this with a phone call and a signature.
What happens if you don't pay your premiums?
One snag you might run into on your life insurance journey: forgetting (or not having the budget) to pay your life insurance premiums. If you default on a term life insurance policy, the insurer will revoke your coverage, usually after a handful of missed payments.
If you default on a permanent life insurance policy, however, you can ask the insurer to continue to pay your premiums using the cash value you’ve accumulated from your policy. But if your cash value runs out, you’ll receive a lapse notice.
If your policy lapses, you may be able to reinstate it within a few years, provided you make up all missed premiums payments. If you cancel the policy rather than let it lapse, you won't get this chance at a do-over.
Life insurance after death
When life’s journey comes to an end, it’s time for the conclusion of your life insurance policy too.
When you pass away, your beneficiaries will need to submit a claim to the insurance company and provide a copy of your death certificate. Make it easy for your loved ones: keep all your records in a single place they can easily access.
The insurance company has 30 days to review your claim and decide how to act. They can pay the claim, deny it, or ask for additional information such as your medical records or details about the way you died.
There’s no set time for how soon insurers pay out claims, but many pay within 60 days.
How is life insurance paid out to beneficiaries?
Most policies pay out a lump sum after the insured person dies. So if you have a $500,000 policy, that’s the check size for your beneficiaries. Of course, you can buy a rider (add-on) that alters the death benefit in some way:
- A family income rider allows for lower, regular payments over time—like an annuity.
- An accelerated death benefit rider releases a portion of your death benefit early if you become terminally ill. Unfortunately, using this benefit will reduce or eliminate what your beneficiaries can collect later.
- A long-term care rider pays out a monthly stipend if you must live in a nursing home. Receiving these payments may affect the payout your beneficiaries get, depending on your insurance company’s rules regarding riders.
How do life insurance companies make money?
Generally speaking, most folks never pay enough in premiums to equal the payout their beneficiaries receive. So how do insurers make any money?
Don’t worry. Insurance companies have done the math right. Insurers invest your premiums in stocks, mutual funds, bonds, and more. Earned interest covers the cost of keeping the lights on as well as payouts for your beneficiaries.
Additionally, insurers save money when they don’t pay out claims. Sometimes this happens unfairly, and the government punishes companies for doing it. But usually, claims go unpaid for the following reasons:
- Most term policies expire before the insured person dies.
- People stop paying premiums or cancel policies.
- The insured person lied on their application.
- Beneficiaries commit life insurance fraud, such as forging a death certificate.
How does life insurance make money for the policy owner?
Insurance companies aren't the only ones who can profit from life insurance. You can too if you buy a permanent life insurance policy. This policy type comes with a cash value insurers invest on your behalf. You’ll probably earn a lower rate of return than you would if you invested the same amount in the stock market or real estate, but it's an option.
Now that you have a general understanding of how life insurance works, it’s time to start your journey. Get over the initial hump of finding the right policy and start an application now. Your loved ones will gain the financial security they deserve, and you’ll enjoy the good night’s rest you’ve earned.
Your first step? Find out how much life insurance you need using our life insurance calculator.
See? You got this.