Comprehensive guide to life insurance: What it is and how it works

Life insurance is a financial tool designed to provide security to your loved ones in the event of your passing. It involves a contract between you and an insurance company, where you pay premiums in exchange for a death benefit to your beneficiaries. This benefit can help cover expenses like funeral costs, debts, or replace lost income. Different types of life insurance, such as term life, whole life, and universal life, offer various features to fit your needs and goals.

Understanding how life insurance works is key to choosing the right policy. Factors like age, health, and financial obligations will determine the coverage and premiums best suited for you. Whether you want to protect your family’s future, leave a legacy, or cover specific expenses, this guide will help you navigate your options for peace of mind and financial security.

“If you are planning to start a family, purchase a home, or simply need to cover your final expense costs, you are among the perfect candidates for life insurance,” says Christopher Steven, licensed insurance producer at Ethos Life.

What is life insurance?

Life insurance works by providing a financial safety net for your loved ones in the event of your death. When you purchase a policy, you pay regular premiums to the insurance company. In return, the insurer promises to pay a lump sum, known as the death benefit, to your chosen beneficiaries if you pass away while the policy is in force. The amount of this benefit depends on the coverage you select, and it can be used to cover various expenses, such as funeral costs, outstanding debts, or everyday living expenses.

There are different types of life insurance, including term life, which provides coverage for a specific period, and permanent life, such as whole or universal life, which offers lifelong protection.

What does life insurance cover?

Life insurance generally covers most causes of death with a few exclusions. If your life insurance policy is active when you die, the life insurer will pay out if the death is caused by:

• Natural causes: Such as illness, disease, or old age.

• Accidental death: Includes deaths caused by accidents and injuries.

• Suicide: Coverage is provided if death by suicide occurs after the two-year suicide clause period outlined in the policy has ended.

• Homicide: As long as there is no evidence of the insured’s involvement.

• Exclusions: Life insurance covers most causes of death, but certain exclusions may apply. These exclusions vary between insurance companies and policies but commonly include deaths resulting from war, terrorism, participation in hazardous activities (e.g., extreme sports), or illegal activities.

What does the death benefit cover?

The life insurance death benefit can be used however your beneficiaries choose. Beneficiaries typically use the death benefit for:

• End of life expenses:  The death benefit can be used to pay for end of life expenses such as funeral or final medical expenses after the policyholder’s death.

• Debt repayment: Life insurance can be used to pay off outstanding debts, such as mortgages, personal loans, credit card debt, or other financial obligations.

• Education expenses: Life insurance can fund education costs for children or dependents.

• Childcare: Life insurance can cover childcare expenses, such as daycare, nannies, or other childcare services.

• Everyday expenses: Life insurance can provide a death benefit to help cover everyday expenses, such as mortgage payments, utilities, groceries, and other living costs, ensuring your family maintains their standard of living in your absence.

How to get life insurance

Buying a life insurance policy requires a few simple steps:

• Assess your needs: Determine the amount of coverage you need based on your financial responsibilities, such as debts, living expenses, and future goals for your beneficiaries.
• Choose a policy type: Decide between term life insurance, which provides coverage for a set period, or permanent life insurance, which offers lifelong coverage with potential cash value growth.
• Compare quotes: Research and compare quotes from multiple insurance providers to find the best rates and coverage options that fit your budget and needs.
• Complete the application: Fill out a life insurance application, providing accurate information about your health, lifestyle, and medical history.
• Undergo a medical exam: In some cases, you’ll need to complete a medical exam or answer detailed health questions to help the insurer assess your risk level. However, there are no-medical exam policies that offer competitive coverage.
• Review and finalize your policy: Carefully review the terms of the policy, ensure it meets your needs, and then finalize the purchase by signing the agreement and setting up premium payments.

Types of life insurance

There are two primary types of life insurance: 

• Term life insurance
• Permanent life insurance

Term life is typically the more affordable life insurance option, representing the simplest form of life insurance.

“Term life pays out only if death occurs during the term of the policy, which is usually between one and 30 years,” explains Mark Friedlander, director of corporate communications for the Insurance Information Institute in St. Johns, Florida. “Most term policies offer no other benefits than payout upon death.”

Permanent life insurance, which includes whole life insurance, also pays a death benefit when the policyholder dies. However, it doesn’t need to have a set duration; instead, it is designed to provide coverage for the policyholder’s entire lifetime.

Permanent life insurance not only provides lifelong coverage but also builds cash value over time, which grows tax-deferred. This cash value can be accessed through loans or withdrawals, offering a source of funds for emergencies, retirement, or other financial needs. However, tapping into the cash value may reduce the death benefit, so it’s essential to manage it carefully.

There are several types of permanent insurance, including:

• Whole life
• Universal life
• Variable life

How does term life insurance work?

Term life insurance is a policy that protects you over a limited amount of time or “term” — such as 10-, 20-, or 30-years.

“Term life insurance is like renting an insurance policy. When you pay for it, you have it. But when you stop paying for it, you no longer have the coverage,” says Christan Hiscock, co-founder/CEO of Kardia Financial Group in Cowichan Valley, British Columbia, Canada.

Advantages of term life insurance 

• Affordability: Term life insurance typically offers lower premiums compared to permanent life insurance, making it an affordable option for those seeking high coverage at a lower cost.
• Flexibility: Provides coverage for a specific period, such as 10, 20, or 30 years, allowing you to tailor the policy to align with your financial responsibilities and goals.
• Simplicity: Term life insurance is straightforward, focusing solely on providing a death benefit without the complexities of investment components or cash value accumulation.
• Renewable and convertible: Many term life policies offer options to renew coverage after the term ends or convert to a permanent policy, providing flexibility as your needs change over time.

Disadvantages of term life insurance

• No cash value: Unlike permanent life insurance, term life does not accumulate cash value, meaning you won’t build any savings or investment component over time.
• Coverage expires: Once the term ends, the policy expires, and you will need to obtain new coverage, which can be more expensive due to age or changes in health.
• Premiums may increase: If you renew the policy after the initial term, premiums may significantly increase, making it less affordable over time.
• No lifelong protection: Term life insurance only provides coverage for a set period, so if you outlive the term, your beneficiaries will not receive any benefit unless you purchase a new policy.

How does whole life insurance work?

Permanent life insurance provides lifelong coverage, as long as premiums are paid, and includes a cash value component that grows over time. Unlike term life insurance, which expires after a specific period, permanent life insurance offers continuous protection and the opportunity to build savings that can be accessed during the policyholder’s lifetime. There are several types of permanent life insurance, each with unique features. Below, we’ll explain the three most popular types.

Variable life insurance: Allows policyholders to invest the cash value in various sub-accounts, such as stocks or bonds, potentially increasing the cash value based on market performance. However, this also comes with a higher risk, as the cash value can fluctuate depending on investment performance.

Whole life insurance: Offers fixed premiums, a guaranteed death benefit, and a guaranteed cash value that grows at a predetermined rate. It’s a straightforward option for those seeking stability and predictability in both premiums and cash value growth.

Universal life insurance: Provides flexibility in premium payments and death benefits, allowing policyholders to adjust these elements according to their changing financial needs. The cash value grows based on the insurer’s declared interest rate, which may vary over time.

Should I get term or permanent life insurance?

Choosing between term and permanent life insurance depends on your financial goals, budget, and coverage needs. Term life insurance is ideal if you need affordable coverage for a specific period, such as while paying off a mortgage or raising children. In contrast, permanent life insurance offers lifelong protection and builds cash value over time, making it a better choice if you want a policy that serves both as insurance and a long-term financial asset.

“You should consider term life insurance if you need life insurance for a specific period. For example, if you have young children and want to make sure there will be funds to pay for their college education, you might purchase 20-year term life insurance. Or, if you want insurance to repay a debt that will be paid off over a specified time, buy a term life policy for that,” suggests Friedlander.

Alternatively, if you want life insurance coverage for your entire lifetime, a permanent policy will provide a death benefit whether you pass away tomorrow or live past 100.

“If you want to accumulate a savings element that will grow on a tax-deferred basis and could be a source of funds you can borrow from for a variety of purposes, a whole life policy is worth exploring,” adds Friedlander. 

“The savings you earn can be used to pay your premiums or for any other purpose. You can borrow from these funds even if your credit is shaky as well. The death benefit is collateral for your loan and if you die before it’s repaid, the insurance company collects what is due before determining what goes to your beneficiary,” Friedlander says.

Premiums for permanent life insurance policies are usually much higher than premiums for term life policies.

Types of life insurance riders

Life insurance riders are additional benefits that can be added to a basic life insurance policy, usually for an additional price, though some can be included at no cost. Adding one or more riders enables you to customize your policy to your needs and add extra financial protection your coverage.

Popular life insurance riders include:

• Waiver of premium disability rider: An optional add-on that lets you skip premium payments if you become disabled or unable to work due to illness or injury, while maintaining your life insurance coverage.
• Daily living rider: Provides accelerated benefits to help cover costs when you are unable to perform basic daily activities, such as bathing or eating, due to a chronic illness or disability.
• Long-term care rider: Offers access to a portion of the death benefit to cover expenses for long-term care services, like nursing home or in-home care, if you become chronically ill or disabled.
• Cost of living rider: Increases your policy’s death benefit over time to keep up with inflation, helping ensure the benefit maintains its value as living expenses rise.
• Chronic illness rider: Grants early access to a portion of your death benefit if you are diagnosed with a qualifying chronic illness that prevents you from performing daily activities independently.

Life insurance terminology

It’s important to understand the common terms and phrases used in your life insurance policy. You’ll encounter these terms in the policy itself, and your insurance agent may reference them during your discussions.

Here are several of the most important terms to understand:

Accelerated death benefit: This option allows the insured to receive a portion of the policy’s death benefit while still alive, typically if diagnosed with a terminal illness and a life expectancy of 12 months or fewer.

Accidental death and dismemberment (AD&D): A policy that pays a benefit only if death results from an accident or if there is a loss or loss of use of a body part. AD&D can be a standalone policy or added as a rider to a life insurance policy.

Beneficiary: The person(s) or entity(ies) designated in a life insurance policy to receive the death benefit payout when the insured passes away.

Cash surrender value: The amount the owner of a permanent or whole life insurance policy is entitled to receive if the policy is surrendered before the insured’s death, prior to adjustments for policy loans and other factors.

Coverage period: The duration for which a life insurance policy remains active and in force.

Death benefit: The amount paid out to the designated beneficiary(ies) upon the death of the insured.

Group life insurance: A single policy that provides coverage to a group of individuals, such as employees or members of an organization, often owned by an employer to cover its employees and their dependents.

Insured: The person whose life is covered by the life insurance policy and whose death triggers the payment of the death benefit.

Living benefits: Benefits that can be paid while the insured is still alive, such as in cases of critical illness or severe disease, allowing a percentage of the policy benefits to be paid out.

Living will: A legal document in which the insured specifies their wishes for end-of-life medical care, including preferred procedures or medications, in case they become unable to communicate those decisions.

Mortgage life insurance: A form of decreasing term insurance designed to cover the balance of a mortgage loan. The death benefit decreases over time as the mortgage debt decreases.

Premium: The payment made to keep a life insurance policy active and in force.

Rider: An add-on or attachment to a life insurance policy that modifies its terms or coverage.

Underwriting: The process of evaluating, accepting, or rejecting insurance risks and classifying accepted applicants to determine appropriate premium levels, typically handled by a team of experts.

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