How Does Life Insurance Work?

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How would your death affect your family's finances? Buying life insurance can give your loved ones a financial cushion in that unfortunate event. Like other forms of insurance, life insurance is a contract between you and the insurer: You pay premiums, and the insurer pays a death benefit to your beneficiaries if you die while the policy is in place.

What Does Life Insurance Cover?

Life insurance can offer financial support for your loved ones after you die. For instance, if you and your spouse have a mortgage and both work, your spouse might not be able to pay the mortgage alone. In families with a stay-at-home parent, the stay-at home parent may need to replace the deceased spouse's income. If the stay-at-home parent dies, the surviving spouse may need help paying for child care, housekeeping and other needs the stay-at-home parent took care of. Life insurance proceeds can also cover future expenses, such as your children's college tuition.

If you're single, childless and no one relies on you for financial support, you might not need life insurance, but you can still purchase it. Some people buy life insurance just to cover funeral and burial expenses. This type of policy is often called burial insurance and pays out a small amount (typically $5,000 to $25,000). If you don't have heirs, you can buy life insurance to leave money to friends, relatives or charities. Your life insurance policy may also accrue a cash value you can tap into if need be.

Types of Life Insurance

There are two basic types of life insurance: term and permanent. Term life insurance lasts for a set period, typically up to 30 years, and pays out a death benefit if you die during that term. Many people buy term insurance to protect their family during a certain period. For instance, a two-income couple who are both age 35 might buy 30-year term life insurance so if one of them dies, the other is provided for until retirement age.

Permanent life insurance lasts your entire life or up to age 99, assuming you pay the premiums. Unlike term life, it has a cash value that grows tax-free over time in addition to the death benefit. As a result, permanent life insurance is much more expensive than term life.

The most common type of permanent life insurance is whole life. Its cash value is guaranteed, and premiums generally stay the same your entire life. However, you can't change the policy once you've purchased it. Other types of permanent life insurance:

  • Universal life has a guaranteed cash value, and lets you adjust premiums and coverage.
  • Variable life doesn't guarantee cash value; instead, you can choose where to invest the cash portion of your account, potentially earning higher returns.
  • Variable universal life lets you modify premiums and coverage and control where your account is invested, with no guarantee of cash value.

Group life insurance is term life insurance that covers a specific group, such as association members or employees at a company. It generally costs much less than individual coverage. Employers typically pay for a certain amount of group life insurance and offer the option to purchase more at the group rate. If you leave the group, you'll lose coverage, although you may be able to switch to an individual life insurance policy.

Does Life Insurance Pay Out the Full Amount?

When you die, your beneficiaries must work with the insurance company to file a claim, which usually involves filling out a form and providing a certified copy of your death certificate. Insurance companies typically process life insurance claims within a few days or weeks.

After the claim is approved, your beneficiaries can receive the death benefit in one of several ways. Most beneficiaries opt for a lump sum. They can save, spend or invest it as they choose; however, this requires smart financial management to ensure the money doesn't run out.

Another option is to receive income payments at regular intervals, such as monthly, quarterly or annually. The insurance company keeps the death benefit in an interest-bearing account from which beneficiaries receive the payout. Some life insurance companies offer an annuity or life income payout, which guarantees payments as long as beneficiaries live.

If beneficiaries don't need the payout immediately, the insurer can put it in an interest-earning account (called a retained asset account) that beneficiaries can access as needed.

Sometimes people don't claim death benefits because they don't know a policy exists. The Insurance Information Institute recommends telling your beneficiaries about the policy, where to find a copy and how to reach your insurance agent. Your policy should list beneficiaries' full names and Social Security numbers (rather than "my niece" or "my grandson") so insurance carriers can find them if you die.

What Happens to My Life Insurance if I Don't Die During the Term?

Term life insurance pays a death benefit only if you die during the policy's term. After the term expires, you can apply for a new policy if you still want life insurance. This usually requires a medical exam, which could reveal health problems, making it harder to get coverage. Term life insurance with a renewal guarantee can be renewed without a medical exam, although premiums will rise because you're older.

Once the cash value of permanent life insurance reaches a certain amount, there are several ways you can use it before you die, including withdrawing money, using it to pay premiums, or borrowing against the cash value without a credit check. You may be able to trade in the cash value and increase the death benefit by that amount.

People who no longer need or can't afford their life insurance sometimes sell their policies to a third party, usually through a broker. This is called a life settlement or a senior settlement because sellers are typically retirement age or older. The third party pays you a lump sum, takes over the premiums and receives the payout when you die.

Selling a life insurance policy can have unintended costs and tax consequences. Before selling, investigate other options, such as borrowing against your policy or receiving accelerated benefits. Consult with a tax or legal professional to decide which option is best for you. Alternatively, you could talk to a credit counselor or seek financial assistance if you need help with your finances.

The Bottom Line

Life insurance can offer your family financial security if you die. However, insurers might check your credit when you apply for life insurance; poor credit could mean higher premiums. Before shopping for life insurance, get a free credit report and check your credit score to see if it needs improvement.