How Does Life Insurance Work

how does life insurance work

It may seem like a simple question, but it’s one that gets asked all too often and deserves a clear answer.  How does life insurance work?

With life insurance coming in all different shapes, sizes and structures it’s not an easy question to answer but it also explains why so many people are trying to figure out exactly how does life insurance work.

I’m going to break life insurance down into three categories to keep it really simple. I know there are subsets and variants that break off of each of the categories but hey, let’s not jump the gun here.  In this article we’ll look at term insurance, permanent insurance and universal insurance.

first up…

Term Life Insurance

Term life insurance can be compared to renting a home instead of buying one.  When you buy term life insurance you are renting death benefit – terms vary anywhere form 10 to 30 years and when the term expires you have nothing to show for it.  Just like renting a home, when you stop paying rent you have nothing to show for it.  Because only about 1% of term life policies actually end up paying a death claim the cost is dirt cheap.  Statistically speaking you are 99% likely outlive the term or cancel the policy early.

Term is essentially a cash cow for an insurance company.  Statistically they’ll only have to pay 1% of all polices they have.

If the insured person dies within  the specified term his beneficiaries will receive the death benefit in the form of an income tax free check.  Just like other forms of insurance the death benefit is income tax free but may be subject to estate taxes.

Permanent Life Insurance

Also known as whole life insurance, permanent insurance can be compared to owning the home instead of renting it.  How does permanent life insurance work?  It’s simple, you pay a set premium that is guaranteed to never increase throughout your life and in return the insurance company guarantees they will pay the death benefit when you kick the bucket – no matter how old you are.

Because there are many more permanent policies that actually end up paying a death claim, the cost for whole life is higher than term.  Don’t forget, though, that you “own” the home instead of renting it.  There is a cash value component of whole life that can be compared to equity in a home.  As time goes on your cash value, or equity, increases – it can be accessed by you for whatever reason your little heart desires via policy loans or withdrawals.   Check out our 8 things you didn’t know about life insurance infographic for some other little know tidbits.

Permanent life is pretty simple – it can however be adjusted and customized in many different ways depending on goals and situations.  A quick example: let’s say you’ve paid your whole life premium for 10 years and you have had enough.  You have the option to “freeze” the policy and eliminate your out of pocket premium cost while holding onto the majority of the death benefit and allowing the cash value to grow with interest and dividends.

Long story short, don’t look at whole life as a noose you are putting around your next until you die.  You have options as time goes on and understanding them is key.  When you graduate from this life your beneficiaries receive an income tax free check in the form of a death benefit.

Universal Life Insurance

You are not alone if you’re sitting there scratching your head asking, “how does universal life work?”  Out of all life insurance products available, universal life is by far the most confusing.  I consider myself to be a pretty bright guy and after having talked to many UL experts I still have a slew of questions that need answering.

Here is the gist of it….. Universal life combines an annual renewable term policy with an investment account that is usually tied to an index like the S&P 500.  Annual renewable term simple means that each year you are insured with a term policy that last 1 year.  After that year is up you will be re-qualified for the next year and so on.

In case you weren’t aware the older you get the more expensive term insurance becomes.  So each year your cost of insurance is steadily climbing and will eventually become outrageous.

In the mean time you are contributing extra money to the policy that goes into the investment account.  The investment account rises and falls with whatever index you chose to tie it to.


About The Author

Nick D.

By Nick | Follow Nick on Twitter