How does life insurance work? 

Key points

• Life insurance can provide your loved ones with financial support after you die.
• There are two primary types of life insurance: term life insurance and permanent life insurance.
• Term life insurance locks in rates and coverage for a set period of time.
• Permanent life insurance is long-term coverage, typically with a cash value component.

Life insurance can provide financial security for your loved ones after your death. But which type of policy is right for you? 

We’ll help you understand how life insurance works and explain some key factors that can help you narrow down the best life insurance for your needs and budget. 

What is life insurance?

Life insurance is a legal agreement between a policyholder, often the insured, and a life insurance company. When you enter into this type of contract, you agree to pay a regular premium — often monthly — in exchange for life insurance coverage.

If you die while your policy is in force, your named beneficiary will receive a death benefit, or a lump sum paid out after a life insurance claim. A life insurance policy can include more than one beneficiary. 

Some permanent life insurance policies also include a cash value component. In this case, a portion of your premium goes to a savings or investment account. Once the cash value accumulates, you can tap into it while you’re alive.

Types of life insurance 

There are two primary types of life insurance: term and permanent.

Term life insurance

Term life insurance locks in level rates and coverage for a specific period of time, or term. Terms can last anywhere from one to 30 years, though some policies may last longer.

If you die during the policy term, your beneficiaries will receive the death benefit, as long as you have been paying your premiums. If your term expires, you may be able to renew it annually, typically at a higher rate each year. Some insurers offer automatic policy renewal.

If you die after the level term period ends and you have not renewed your policy, your beneficiaries will not receive a death benefit. 

Term life insurance is usually the most affordable type of coverage available and may be a good choice if you want coverage for a specific period, such as while you’re paying a mortgage, covering a child’s tuition payments or waiting for your spouse’s retirement benefit to kick in.

Term life insurance does not have a cash value component.

Permanent life insurance

Permanent life insurance provides coverage for your entire lifetime, and it typically includes a cash value. There are several types of permanent life insurance available. Here are a few of the most common types.

Whole life

Whole life insurance, also known as “ordinary life,” is one of the most common types of permanent life insurance. It offers a guaranteed death benefit and level premiums. 

If you purchase a whole life policy, part of your premium goes toward building cash value. In most cases, the cash value has a guaranteed rate of return, though it could take years for a meaningful amount to accumulate. 

Because whole life insurance offers a cash value account, it is typically more expensive than term life insurance. Still, this coverage may be a good option for someone who wants to ensure their coverage lasts a lifetime.

Universal Life

Like whole life, universal life insurance offers permanent coverage, usually with a cash value component. There are several types of universal life insurance, and some offer flexible premiums and death benefits, within limits. 

How fast a universal life cash value account grows depends on the type of coverage you buy. Some, like guaranteed universal life, offer minimal cash value but have less risk. Others, like indexed universal life, are tied to the performance of market indexes, such as the S&P 500, which may lead to increased growth, or you could lose money. 

If you’re shopping for universal life insurance, be sure to fully understand the benefits and drawbacks of each type before purchasing.

Variable Life

Variable life insurance offers permanent coverage with level premiums and a cash value component. When you open a variable life account, you can choose sub-accounts in which to invest your money. This gives you more control over how your cash value grows. 

When the sub-accounts perform well, your cash value will grow. But you can also lose money if your investments don’t perform well. Losses can impact both your cash value and your death benefit. 
If you want to play a more active role in how your cash value grows, this type of coverage may be worth considering. However, it does present an enhanced risk when compared to other types of cash value life insurance, so be sure to fully understand the implications or speak with a financial advisor who can offer guidance.

Guaranteed life

When you apply for life insurance, the insurer will often factor in your medical history and overall health when determining eligibility and rates. Some may also require a medical exam. Guaranteed life insurance does not require this. Applicants are “guaranteed” to be approved as long as they meet the age requirements. 

Guaranteed life insurance is generally permanent coverage, though term policies exist, and death benefits are typically low, such as $25,000 or less. 

If you have a medical condition that is preventing you from getting coverage, guaranteed life insurance might be worth considering. However, if you’re relatively young and in good health, you likely have better options.

Burial life insurance

Also known as final expenses or funeral insurance, burial insurance offers a relatively low amount of coverage (ranging from $5,000 to $25,000) to be used for funeral costs and other end-of-life expenses. No medical exam is required and approval is generally guaranteed. 

When compared to the amount of coverage you get, burial life insurance can be more expensive than other coverage options. Still, it can be an option if you wouldn’t otherwise be approved for coverage and want to ensure your loved ones can cover funeral expenses.

Life insurance riders

Another factor to consider when purchasing life insurance is riders. A rider is an extra feature or benefit you can add on to customize your life insurance policy. Some may be included at no extra cost, others will increase your premium. 

Rider availability can vary by insurer and policy type, but here are some common riders you may encounter.

• Accelerated terminal illness rider. Gives you access to a portion of your death benefit if you’re diagnosed with a terminal illness.
• Accidental death rider. Pays an additional death benefit to your beneficiaries if you die due to an accident. 
• Child term rider. Allows you to add term life coverage for a child. 
• Critical illness rider. Lets you take an advance on your own death benefit money if you’re diagnosed with a critical illness.
• Guaranteed insurability rider. Lets you increase your death benefit without having to provide evidence of your insurability or take another medical exam.
• Term conversion rider. Allows you to convert a term policy to a permanent policy.
• Waiver of premium rider. If you become disabled and are unable to work, this rider would pay your premiums so that you can stay insured. 

What kind of life insurance do I need?

The best life insurance for you is a policy that provides the coverage you need for the amount you can comfortably afford to spend. Here are some factors to consider as you shop for life insurance.

Term vs. permanent life insurance 

Term life insurance may be a good option if you want to ensure your beneficiaries are financially protected over a specific period of time. For instance, if you just signed a 30-year mortgage, a 30-year term life insurance policy could give you peace of mind that your beneficiary could pay off the house if you die. 
Permanent life insurance may be a better fit if you want to ensure your coverage lasts for a lifetime or don’t want to have to worry about renewing a policy.

Cash value insurance 

Term life insurance does not include a cash value component, but most permanent life insurance types do. 

The cash value of your life insurance policy can help you amass a savings while paying your premiums, and you can withdraw from or borrow against your cash value once you’ve accumulated enough. 

Not all cash value life insurance policies are the same. Most whole life insurance has a cash value that grows at a guaranteed rate of return, though it’s typically modest. Some, however, like variable life insurance, can have significant growth depending on market performance, or significant losses. 

Cash value growth also depends on other factors, like internal policy costs. 

When shopping for coverage, ask to see the policy illustration which shows how the cash value is expected (but not guaranteed) to grow over the years.

Consider your budget

Term life insurance is cheaper than permanent life insurance. If you’re on a budget but need coverage, a term life insurance policy may be a better option. 

“If you’re cash strapped and can’t swing permanent life insurance like whole life or universal life, and you’re young, term life insurance might just get you the coverage needed. But remember, term life is for a temporary need,” cautions Chuck Czajka, a certified financial fiduciary and founder of Macro Money Concepts in Stuart, Florida. 

If you want to renew coverage after the term expires, you’ll likely face higher rates. That’s why it’s a good idea to ensure the term you choose is one that will fit your needs.

Your health and age play a part 

Your health and age impact your life insurance rates, and can also limit your options. 

Seniors looking for term life insurance may find that insurers only offer limited terms, such as 10-years, instead of the 20- or 30-year terms available to younger buyers. 

If you’re young and healthy, you may want to consider getting quotes for both permanent and term life insurance, as you’ll likely be able to lock in lower rates.

But if you have a health condition that makes it hard to get coverage, you might consider guaranteed life insurance.

Ultimately, the best way to find a policy that meets your needs is to get quotes from insurers. That way, you can compare rates as well as the features and riders that are available to you.

How much life insurance do I need?

How much life insurance you need depends on the reasons you want coverage. If your goal is to provide a financial safety net to your loved ones, a good place to begin is by assessing your current and anticipated household expenses. 

“It can be as simple as doing a balance sheet. Calculate what debt you owe and provide some dollars for financial expenses, like a funeral and other fixed amounts like future college or major expenditures needed,” says Czajka. 

Here are some of the factors and expenses you may want to include:

• Number of dependents.
• Household bills and debt obligations.
• Tuition or academic expenses.
• Overall amount required to help your family maintain their current lifestyle.
• Inflation.
• Financial goals.
• Burial expenses.

Czajka also recommends considering your “Human Economic Life Value.”

 “This calculation means that — given your age and your income — if you should die a premature death, what would the economic fallout be of your life? How could the family maintain the lifestyle you wanted for them?” 

For instance, if you earn $55,000 a year and you’re about 25 years away from retirement, that would mean you would be slated to earn more than $1.3 million dollars over that time period. 

“A really good number would be 10 to 15 times your earnings,” says Czajka. “In this example, using a number between $550,000 and $850,000 would be a good starting point to insuring your Human Economic Life Value. I believe the family could invest this to support the lifestyle.”

How much does life insurance cost?

The average cost of a $500,000, 20-year term policy for a healthy 30-year-old female is $205 a year. At 40-years-of-age, the average annual premium for the same person and policy increases to $307. A healthy 30-year-old male applying for a policy with the same term and coverage can expect an average rate of $252. At 40, the same male would pay an average of $360. 

Those are just estimates, and may not be indicative of how much you’ll pay for coverage. Life insurance premiums vary by insurer and life insurance product, including any riders you add on to your policy.

How much you’ll pay for coverage depends on various factors that insurers use to establish risk. These include:

• Your age, height and weight.
• Gender.
• Health and medical history.
• Prescription history.
• Medical history of your parents and siblings.
• Nicotine or marijuana use status.
• Type and amount of coverage.
• Credit history.
• Criminal history.
• Driving record (e.g., DUI, moving violations).

At the end of the day, insurers base life insurance rates on perceived risk. So, in general, the younger and healthier you are, the lower the rates you’ll get. 

Women also tend to pay less for life insurance because they’re considered to be less risky than applicants who are men. 

And, of course, the more coverage you want, the more the policy is going to cost.

Czajka advises focusing on the factors you can control, like avoiding smoking, drinking in moderation and exercising, to help keep your premiums as low as possible.

Shopping around and getting quotes can also help you compare rates and coverage offerings.

Average annual cost of a term life policy for a female by age

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Average annual cost of a term life insurance policy for a male by age

Average annual cost of whole life insurance by age

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Average annual cost of term coverage for females by insurer

^{Rates are based on a 30-year-old female in good health.}

Average annual cost of term coverage for males by insurer

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Who needs life insurance?

If you have people that rely on you for financial security, life insurance is worth considering. It can help a spouse, partner, child or other dependent meet financial obligations after your death. 

About 41% of Americans either need life insurance or don’t have enough coverage, according to the 2022 LIMRA Insurance Barometer Study. 

Here are some common reasons you may want to consider a life insurance policy: 

• You’re the primary earner.
• Your family would face financial hardship in the absence of your income, even if you aren’t the primary earner. 
• You have young children who depend on you for financial security.
• You have a mortgage payment your partner or spouse won’t be able to comfortably cover in your absence. 
• You want to cover end-of-life expenses, like funeral costs, which average $7,848. 

Who doesn’t need life insurance? 

If you’re young and unmarried or don’t have anyone relying on your income, life insurance may not be worth it. The same may be true if you’re older and have accumulated enough savings to support loved ones or cover end-of-life expenses.

Frequently asked questions (FAQs)

What is a death benefit?

A death benefit is the amount of money a life insurance company pays out after an insured individual dies. For example, if you purchase a 10-year, $1 million policy and you pass away while the policy is in force, your beneficiary will receive a $1 million death benefit, as long as you paid your policy premiums.

What is cash value life insurance?

Cash value life insurance is an umbrella term referring to any permanent life insurance policy with a cash value component. In a life insurance policy, cash value is a savings or investment account separate from the death benefit. You can access the cash value of your policy while you are alive, making it a living benefit.