How Does Life Insurance Work?
At its most basic, life insurance pays a death benefit to beneficiaries when the insured person dies. However, there is some variation with policy types, such as the potential to use a life insurance policy as a savings account.
Key Takeaways
- Life insurance provides financial security for surviving loved ones, helping them cover living expenses and debts to final expenses if the insured passes away.
- The primary categories of life insurance are term, which lasts for a specific period of time, and permanent policies like whole and universal, which also include a cash value component.
- The cost of life insurance is determined by controllable factors like policy type and smoking status, as well as uncontrollable factors such as age, gender and health conditions.
While there is some variation based on your policy type, generally, this is how life insurance works:
- Insured chooses beneficiaries: The insured will choose their beneficiaries, who will receive the death benefit when the insured passes.
- Insured pays premiums: The policy will stay active as long as the insured pays their premiums on time and has sufficient cash value, with permanent policies.
- Cash value accumulates: Permanent policies have a cash value component that will accumulate over the years via different methods, depending on the type of policy. Whole life insurance, for example, has cash value that grows based on a fixed interest rate, guaranteeing a certain amount of accumulation. The insured can borrow or make withdrawals from this cash value during their lifetime.
- Insured dies and beneficiaries receive death benefit: If a policy is still active and the insured’s death isn’t specifically excluded from the policy, the beneficiaries will receive the death benefit, which they won’t owe income tax on.
Life insurance can be used to cover:
- The current and ongoing living expenses of your dependents
- Your final expenses, including funeral costs and out-of-pocket medical bills
- Your debts, like a balance remaining on your mortgage
- An inheritance or charitable donation after your death
However, if you don’t have any dependents or debt, don’t want to leave an inheritance or charitable contribution and have enough money to cover your final expenses out-of-pocket, life insurance may not be necessary.
What Happens If Someone Dies Without Life Insurance?
If someone dies without life insurance, it may still be possible for the beneficiaries to receive a benefit, though it won’t be from a life insurance company. Rather, some people may be entitled to government benefits. You can see if you’re eligible by answering a few questions on the U.S. General Services Administration website. If you lived with the deceased person, you may be eligible to receive a one-time payment of $255 from the Social Security Administration, for example.
In the same vein, you may be eligible for government programs that fund funerals. However, if you’re not eligible for any local, state, or government programs, the loved ones of the insured will be responsible for the funeral costs. The national median cost of a funeral, viewing, and burial was $8,300 as of the latest 2023 data, while cremation costs $6,280, according to the National Funeral Directors Association.
To find out how much life insurance you need, it’s best to speak with an insurance agent or financial advisor. To calculate it yourself, there are several methods to choose from.
The cost of life insurance varies based on many factors, some of which are in your control, and some of which are not. For example, while you can control your tobacco/nicotine usage, the size of your death benefit, the type of your policy and your occupations, hobbies and driving record, you cannot control your age, gender or preexisting health conditions, in some cases.
Below are the average costs for term and whole life insurance, but note that the only way to find out exactly how much you’ll pay is to request a quote from a specific company.
Term Life Insurance Cost
The following costs are for a $1 million term policy for a nonsmoker in average health.