What Is Life Insurance and How Does It Work?

Every month the life insurance company charges you a premium to offer you coverage which is referred to as a death benefit. This death benefit will be paid out to your beneficiary if or when you die depending upon the type of life insurance you have. The death benefit passes to your beneficiary tax free meaning your beneficiary will not have to pay taxes on the death benefit they receive.

Your life insurance beneficiary is the person(s) that will receive your death benefit if or when you die depending upon the type of life insurance you have. For most life insurance policy owners, their beneficiary tends to be a spouse or immediate family member.

Life insurance can cover you in a broad range of circumstances. In general, most natural, or accidental deaths will be covered depending upon the type of life insurance policy that you have. Here is a list of what life insurance typically covers.

1) Natural deaths - Dying from a heart attack, old age, illness, etc.

2) Accidental deaths - Dying from car crashes, drowning, etc.

3) Suicide after 2 years - Life insurance will typically cover suicide after a waiting period which is usually 2 years for most carriers. This would mean that suicide would be covered if the policy is more than 2 years old and would not be covered if it was less than 2 years old.

4) Homicide - Life insurance does cover homicide, but the complexity of a homicide can affect the payout to the beneficiary(s).

Although life insurance can cover you in most instances, all life insurance companies have certain exclusions. Life insurance companies typically exclude covering you if you put yourself at a heightened risk of death. The following are some common examples.

1) Criminal activities - If you die while committing a crime, the life insurance company will deny coverage and your beneficiary will not receive the death benefit of the policy.  

2) Risky activities - Depending upon your policy, your insurance company may not cover you in the event that you died from participating in a risky activity. Think of things like scuba diving, car racing, hang gliding, base jumping and more.

3) Lying on your application - If you lie on your insurance application, a.k.a. commit insurance fraud, your life insurance company can deny coverage. For example, let's say that a carrier asks if you participate in any risky activities and you lie by saying no. This lie can result in the life insurance carrier denying coverage.

There are many types of life insurance, but they all fall into one of two categories - term or permanent life insurance. Term life insurance covers you for a set amount of time. Permanent life insurance covers you for your entire life.

As the name implies, term life insurance covers you for a set period. Typical terms are 10, 15, 20 or 30 year periods. During that time, you will pay your monthly premium for a specified amount of coverage, aka death benefit. If you die during that term, the life insurance company will pay out your death benefit to your beneficiary(s).

If you do not die during that term, your death benefit will not be paid out and your coverage will end. You can buy another term policy if you desire or convert your term policy into a permanent policy if available. Term insurance is the cheapest way to get life insurance.

Reason being is that most term life insurance policies do not pay out. Think about it this way. Let's say that a healthy 30 year old man with a young family buys a 20 year term life insurance policy to protect his family. Since he is young and healthy, there is a good chance that he will still be alive in 20 years.

For this reason, life insurance companies do not have to collect as high of a premium since they will only have to pay out a small number of all the term life insurance policies held by their customers.  

As the name implies, permanent life insurance covers you for your entire life if you pay your premiums. The policy is guaranteed to pay out whether you die at 30 or 90. There are a variety of permanent life insurance policies, but the most common is called whole life insurance.

Similar to a term life insurance policy, whole life insurance allows you to buy a set amount of death benefit coverage for your beneficiary(s). Unlike term life insurance, the death benefit of a whole life insurance policy is guaranteed to be paid out if you maintain coverage. A term policy would only payout if you die during the term under which you are covered.

Additionally, whole life insurance offers another feature called cash value. When you make your premium payments each month, part of your premium goes towards the cost of your insurance, part of it goes towards the insurance company's operating costs, and part of it goes into the cash value portion of your policy.

The life insurance company will take the portion of your premium that is allocated towards cash value and invest it into conservative investments on your behalf. Your cash will earn a fixed rate of interest based upon the underlying investments that the insurance company makes.

In the early years, more of your premium is allocated towards the cost of your insurance and the operating expenses of the insurance company. This flips as you hold onto the policy. For this reason, you typically won't build that much cash value in the early years of your policy. There are ways to accelerate the growth of your cash value. A life insurance agent can help you with this.

The cash value of your policy allows you to use the funds while you are still alive. First, you can withdraw the funds from the account. Note that when you withdraw from your cash value, your death benefit will be reduced by the amount that you withdrew.

Secondly, you can borrow against the cash value. For example, say that you built up $100,000 of cash value in your policy and it was earning 3%. Your life insurance company would give you a loan at a slightly higher rate (say 4%) using your policy as collateral.

In this instance you are not withdrawing from the $100,000 of cash value in your policy. You are instead using the insurance company's money. This can be advantageous if you need access to capital. For example, let's say that you wanted to buy a car for $20,000 and you were going to finance it.

Say that you went to credit unions and banks to obtain financing options and the best interest rate you got was a 6% interest rate. In this case, you could borrow against the cash value in your whole life insurance policy at a 4% rate and pay back your insurance policy as opposed to paying back a bank.

Thirdly, you can use the cash value in your policy to cover the cost of your insurance premiums. Keep in mind that using the cash value portion of a whole life insurance can be complicated. It is important that you talk to your insurance agent to discuss all applicable details before using the cash value in a whole life policy.

Most insurance companies that offer life products will use three factors to determine your eligibility for life insurance - your health, hobbies, and occupation. Life insurance companies will gather this information when you apply for coverage.

In general, most healthy individuals that do not have any pre-existing medical conditions can obtain life insurance. If you do have a pre-existing medical condition, you may have to pay higher premiums to obtain coverage.

Life insurance companies look at a variety of pre-existing conditions at the time you fill out your application. These can include cancer, heart disease, diabetes, depression or other mental health concerns, obesity, epilepsy and more.

If you have one of these pre-existing medical conditions it does not automatically disqualify you for life insurance, but it could mean that you could pay a higher premium. In addition to pre-existing medical conditions, your lifestyle choices can also affect your eligibility. Think of lifestyle choices such as excessive alcohol consumption, smoking, vaping, and nicotine use.

Life insurance companies will also look to see if your occupation or job increase the risk of you dying when determining eligibility. If you work in an environment that is considered safe, such as an office job, your occupation will not affect your eligibility.

However, there are jobs that life insurance companies deem as high risk. This can include firefighting, construction and roofing, certain types of police work and more. Furthermore, your hobbies can also come into play.

If you participate in hobbies that life insurance deem as high risk can impact your eligibility. Think of things like scuba diving, rock climbing, sky diving, and aviation. Any activity that increases your chance of death will come into play for the insurance company. If you do not participate in a high risk hobby, you should not see any problems.

The information related to the three factors above will be used by the life insurance company to assign you a risk class - how big of a risk you are to the insurance company. Each insurance can differ in their risk classes, but in general you will see these six.

a) Preferred plus - The preferred plus risk class is the best and therefore comes with the cheapest premium. If you get this rating, you are a person that has a BMI (body mass index) in the range of 18 to 29. You also only have one or two minor health concerns that are in control and no deaths in your immediate family from heart disease or cancer.  You will also have a safe job and not participate in dangerous hobbies.

b) Preferred - If you miss out on preferred plus, it is most likely because your BMI (body mass index) is too high to qualify for the preferred plus rating. Like the preferred plus rating, you only have one or two minor health concerns that are in control and no deaths in your immediate family from heart disease or cancer (some carriers allow for one). A preferred rating is still very good and offers the second cheapest premium.

c) Standard Plus - If you get the standard plus risk class, your BMI is again too high to get the preferred risk class. You will have well controlled mild to moderate health concerns. You can get this risk class if only one of your immediate family members has died from heart disease or cancer. If you get this risk class, you might have an occupation or hobby that is dangerous. Standard plus offers the third lowest premium.

d) Standard - If you get the standard risk class, your BMI is too high for the standard plus class. You will have well controlled moderate health concerns. If more than one of your family members has died from heart disease or cancer, you will get this rating.

Even without medical concerns, you can receive this rating if you quite smoking in the past two years or are recovering from substance abuse. You also might have an occupation or hobby that is dangerous. Standard offers the fourth lowest premiums.

e) Substandard or table rating - If you get this rating, you have a BMI that is high (typically in the 41 to 48 range). You also have a health condition that is more serious. This rating is often broken down into ten sub tables. The lower you are on the table, the higher your premium. Insurance companies will add 25% to the Standard rate each level down the table for a substandard rating.  

f) Tabacco/smoker - If you get this rating, you currently or have used tobacco or nicotine products within the past 12 months. There are typically three sub classes - preferred tobacco/smoker, standard tobacco/smoker, and tobacco/smoker. You can pay up to three times higher premiums if you get one of these ratings when compared to their non tobacco/smoker counterparts.

Ideally, you want to get a preferred plus or preferred risk class rating to get the most affordable premiums. If you do end up in a lower risk class, it does not mean that you are ineligible. Often it just means that you will pay more for coverage.

There are health concerns that are often out of your control. However, there are things that you can control to be eligible for life insurance or to get a better rate. These can include managing your weight, quitting smoking or excessive alcohol consumption, and managing any other pre-existing medical conditions.

The amount that you will pay for life insurance will vary depending upon a range of factors. We discussed risk class ratings in the section above. The better your risk class, the more affordable your coverage will be. However, lets look at some more specifics than can impact the price you will pay for coverage.

1) Age - The younger you are, the cheaper your premiums tend to be as you are less likely to die. A healthy 20 year old has much longer to live than a healthy 60 year old. If you want a life insurance policy, it is best to buy one when you are young to lock in an affordable premium.

2) Gender - Life insurance is cheaper for women than it is for men. On average women will live longer than men which means they will typically outlive their life insurance coverage if it is a term policy.

3) Health - Your health plays a huge factor in the price of your life insurance as better health will get you into a better risk class rating. Life insurance companies will look at your height and weight, and any pre-existing medical conditions that you have or previously had. The healthier you are, the less you pay.

4) Family medical history - In addition to your own health, life insurance companies will also look at the medical history of your family. If you have had family members that have died from cancer or heart disease, you could end up paying a higher premium.

5) Smoking/tobacco use - If you smoke, chew tobacco, use a pipe, vape, or use e-cigarettes, you will pay a higher premium for coverage. Life expectancy is 10 years shorter for smokers than it is for non-smokers. Life insurance companies charge more to take on the risk of insuring you.

6) Type of policy/coverage amount - Term life insurance is cheaper than permanent life insurance as it only offers a death benefit and does not build any cash value. Additionally, the more coverage you have, the higher your premiums will be. $1 million of coverage will obviously cost more than $500,000 of coverage.

7) Hobbies - As previously stated, dangerous hobbies can cause the price of your premiums to increase. Any activity than a life insurance company believes will increase your chance of death is more of a risk to them and you will be charged more for coverage.

8) Occupation - If your work increases the chance of death, you will be charged more for coverage. An office job won't affect this, but industries such as construction, roofing, certain types of police work, firefighting and others can cause your premiums to increase.

9) Driving and criminal record - If you have a reckless driving record with DUIs, a suspended license or frequent traffic violations, you are seen as a higher risk and will pay more for coverage. If you have a criminal record, you will pay a higher premium or not be eligible for coverage at all.

All of these factors can impact how much you pay for coverage. For this reason, there is no way to determine your exact price until you apply for coverage.

The amount of coverage needed will vary by person. With that being said, there are a couple of different ways that you can gauge how much coverage you need to have.

1) Multiply your income by 10 to 15 times

This is more of a general guideline as it does not take into account all of the specific details of your life. The basic premise is that you want to leave your beneficiary(s) that rely on your income enough to survive for the next 10 to 15 years as they figure things out. So, if you make $100,000 per year you would want to have between $1 million and $1.5 million in coverage.

2) Use a LIFE needs analysis

Each letter of a LIFE needs analysis represents a different area of your life that you could want covered if you were to pass away. Once you have determined how much coverage you need for each letter, you add up the total. It will give you a more precise number of the amount of coverage you need than simply multiplying your income by 10 to 15 times.

a) Liabilities - You want to list out all of the items that you owe money on that you would want to be covered in the even that you die unexpectedly. This can include a mortgage, car loans, credit cards, and others.

b) Income - You want to estimate how many years your family would be dependent upon your income if you were to pass away and add that to your coverage. For example, if you make $100,000 per year and estimate your family would be reliant upon that for 15 years, you would add $1.5 million in coverage.

c) Final expenses - If you pass away unexpectedly, your family will have to cover the final expense associated with that including your funeral and burial costs. You want to estimate what this would cost and add this to your coverage.  

d) Education - If you have children and plan on paying for their education, whether that be college or trade school, you want to estimate these costs and add them into your coverage.

3) Speak with an experienced life insurance professional

Ultimately the best thing you can do is speak an experienced life insurance professional. They will be able to help you determine the appropriate amount of coverage and can help make any necessary changes in coverage as your life changes.  

If you have a life insurance policy at work, it is called a group life policy. Your employer will pay for the premiums for a set amount of coverage. If you want more coverage than this amount you can pay for more out of your own pocket. It is better to be covered through work than not to be covered at all, but there are a few reasons why it would be a good idea to own your own policy.

1) It is not enough coverage

Often times your life insurance benefit at work does not provide enough coverage. A typical amount of coverage would be $50,000 or 5 times your salary. If you do a LIFE needs analysis, you will often find that this is not enough coverage. If you own your own policy, you can make sure you have enough coverage.

2) The policy does not follow you

Your life insurance benefit at work is dependent upon your employment with the company. If you were to leave that job or get fired, you would no longer be covered. This is a big risk to take on. If you own your own policy, it will follow you wherever you go so you are always covered.

There is an ongoing debate between term and permanent life insurance among financial experts. Some say that term is best, some say that permanent is best, some say a mix between the two is best and some are indifferent.

1) The case for term life insurance

The main reason that most individuals buy term life insurance is that it is cheap. If you are a young married couple with a family, you may only want coverage until your kids are no longer dependent upon you. This might be a 20 or 30 year long period.

If you opt to buy a term policy, you can get lots of coverage at a relatively low cost if you are young and healthy. The idea with term life insurance is to cover yourself over a period of time in which your beneficiary(s) would be most financially vulnerable if you passed away.

2) The case for permanent life insurance

Permanent life insurance is guaranteed to pay out whenever you die. It is often used to pass money from one generation to the next. If you want to leave your loved ones with guaranteed money and have the freedom to spend your other financial assets (401ks, IRAs, etc.) permanent life insurance can be a good option.

Permanent life insurance also provides the benefit of cash value. You may have heard that permanent life insurance can be used as an investment. This is where the anti permanent life crowd start to riot. They make they case that permanent life insurance is not an investment.

In some sense this is true, but it is also a bit unfair to the policy. You should not view permanent life insurance as an investment. Instead, you should view it as a safe place to store capital so that you can access money when needed.

Permanent life insurance allows you to borrow against the value of your cash value using the life insurance companies' money. This can be very beneficial at times. For example, lets say that you wanted to buy a new car and were going to finance it.

If current interest rates sat around 7%, but you had the option to borrow from your permanent life insurance policy at 4%, you would have a financial tool available that many other individuals was not. With all that being said, make sure to speak with an experienced insurance agent before opting for a permanent life insurance policy as they are difficult to understand.

1) Know how much coverage you need and what type of policy you want

The first thing you need to do is understand how much coverage you need. You can do a LIFE needs analysis as previously discussed or speak with an experienced agent. Once you figure out how much coverage you need, you also need to choose between a term or permanent policy. Again, an agent can help you make this decision.

2) Compare quotes

Once you have an idea of your desired coverage amount and policy type you can compare quotes from different life insurance companies. You can get quotes directly from a provider online or via the phone or use third party comparison sites. Although it is tempting to go with the cheapest option, make sure to thoroughly review each company that provides a quote.

3) Fill out an application

After you find a quote you like, simply fill out an application. These applications will gather information about your health, family health history, lifestyle, hobbies, occupation and more. Life insurance companies make sure to due their due diligence before issuing policies so expect to answer a lot of questions.

It is also important that you are honest about every question when filling out your application. Life insurance companies use third party sources to verify your application. They will be able to see medical records, prescription drug history, driving records and public records. There is a good chance you will be caught if you lie on your application.

4) Submit your premium to lock in coverage

Once your application is submitted, you can typically submit your first premium to bind coverage during the underwriting process. Underwriting is the process in which life insurance companies review your application before issuing the policy. If for whatever reason you are denied coverage, you will be refunded your premium.

5) Take a medical exam if necessary

During the underwriting process, you may be asked to complete a medical exam in addition to your application. This is standard practice for some companies. The life insurance company will typically send a medical professional to measure your height, weight, and conduct a blood and urine sample. The insurance company pays for this, and you will get a copy of your results.

The bottom line is life insurance is a contract between yourself and a life insurance company that will pay a death benefit to your beneficiary(s) in the event that you die. You can choose between term and permanent life insurance depending upon your individual needs. It is important to make sure that you have enough coverage to protect your beneficiary(s) in the event that you die unexpectedly.