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How Does Life Insurance Work?

Wouldn’t it be nice to buy insurance that replaced your actual life if you lost it? You’d never have to worry about dying because life insurance would give you another life and you could just keep going! While that sounds like an awesome sci-fi movie called Term Life: Clone Wars, unfortunately life insurance doesn’t involve cloning, reincarnation or resurrection.

So, how does life insurance work? Simply put, life insurance helps the people you love replace your income if you die way sooner than expected. (At least, that’s what it’s supposed to do. Some people try to make it do more, and it doesn’t work very well.)

Let’s take a closer look.


Key Takeaways

  • Life insurance works by paying a death benefit to your family if you die, which replaces your income so they can keep living.
  • You pay a premium every month for a life insurance policy worth a certain amount (which you choose).
  • There are several different types of life insurance policies, including term, whole, universal and indexed universal life insurance.
  • If you die, your beneficiary files a claim to receive the death benefit (that’s the amount of money your policy is worth).

Basics of Life Insurance

Life insurance is a funny thing. It’s the only thing you pay for hoping you’ll never use. Because that would mean you’re, you know . . . deceased. But let’s not get morbid—life insurance is a wise and wonderful way to give you peace of mind and take care of your family!

As long as you live, there’s always the risk you could die, and your spouse and children will suddenly have to make it without your income. So to offset that risk, you should buy a life insurance policy for a set amount (I recommend 10–12 times your annual income) and pay a premium every month. If you die, the insurance company will pay out the set amount to your family.


Here's A Tip

You should have a policy worth 10–12 times your yearly income.

As you can see then, you only need life insurance if you have someone depending on your income. If you’re single and the closest thing you have to a dependent is your temperamental fiddle-leaf fig tree, you probably don’t need life insurance quite yet. But life insurance is a must for anyone with a spouse, kids or someone else to financially support.

Here’s an example of life insurance in action: Jase is married with two kids and makes $70,000 a year. His wife, Lydia, is a stay-at-home mom. Jase owns a life insurance policy worth $700,000 and pays $50 a month for it. One day on his way to work, Jase gets in an accident and dies. Lydia files a claim with the insurance company, and they pay her $700,000.

Now, there are a few different kinds of life insurance you can buy, including:

I’ll get into these more in a sec, but each kind offers different protection and even some extra stuff. (Spoiler: You don’t need the extra stuff.)


How much term life insurance do you need?

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Coverage and Premiums

When you buy a life insurance policy from a company, your coverage is the death benefit—the total money paid to your beneficiaries when you die. You purchase a policy for a set death benefit amount (Jase’s was $700,000).

Paper and Pencil

Compare Term Life Insurance Quotes 

How long your coverage lasts depends on what kind of insurance you buy. With term life, your coverage lasts as long as the term is set for—15, 20, 25 or 30 years. With permanent life insurance, your death benefit coverage lasts until you die—even if that’s when you’re 100. (I know that might sound like a better deal, but usually it’s not. At a certain point, your kids should be grown and, if you were smart with your retirement, you should have enough saved that any spouse you leave behind will be fine.)

To get that insurance coverage, you pay premiums—usually monthly. With term life, your premiums are set for the entire term and never change. With any variation of permanent life insurance, your premiums go up as you age.

Here are some factors that impact how much your premiums cost:

  • Age: They get more expensive as you get older.
  • Health condition: The healthier, the better.
  • Lifestyle habits: Think smoking, DUIs or skydiving.
  • Policy value: A million-dollar policy will cost more than one worth a half million.
  • Type of policy: Term life premiums are cheaper than permanent life premiums.


How much does term life insurance cost?

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Policy Features and Options

When it comes to life insurance, don’t skip the fine print. Let me break down the different kinds of life insurance and riders (industry speak for add-ons) so you can get a better idea of how each one works and which ones you want to avoid.


Term life insurance: Provides coverage for a specific term (usually between 10 and 30 years, in increments of five).

Whole life insurance: Offers coverage for your entire life and comes with a cash value account that acts a lot like a low-interest savings account.

Universal life insurance: Also offers coverage until you die and a cash value account, but the value grows at an interest rate set by the insurer and your premiums are adjustable.

Indexed universal life insurance: Like the two before, provides coverage until you die and a cash value account, but the investment growth in the account is tied to the performance of an index fund.

The last three kinds are all types of permanent life insurance, and they’re marketed as a hybrid of life insurance and retirement investing.

Now, pardon me while I get on my soapbox for just a second.

This is where I differ with a lot of these so-called wealth strategists out there, like @mrmoneybagz77 on TikTok. I’m going to tell you—you only want life insurance to replace your income if you die. And it shouldn’t do anything else. Those other guys are going to say it’s smarter to also invest for retirement through life insurance.

It’s not smart. In fact, it’s a big waste of money. I won’t bore you by explaining all the reasons why life insurance as an investment is a bad idea because I already wrote an article that dives deep into that. Just know the investment returns are microscopic and eaten up with tons of fees.

Okay, done (steps off soapbox). I’ve got to say, as a shorter guy, the view up there was nice . . .


Here's A Tip

Life insurance has one job: to replace your income if you die.

One of the other features permanent life insurance offers is the ability to take out a loan against your policy. Essentially, you’re just borrowing your own money but paying interest on it to the insurance company. And if that isn’t enough to put you off, they’ll also reduce the death benefit for your loved ones if you don’t pay the loan back before you die. You had one job, permanent life! One job.

Okay, I said I was off my soapbox, but it looks like I’m back on it—so just one more awful thing about permanent life insurance. If you die before using your money in the cash value account, the insurance company usually keeps it!

Term life doesn’t come with any of these “features”—it does exactly what it’s supposed to do. As a dad and husband, I sleep better with term coverage because if anything ever happens to me, it would fulfill the only purpose of life insurance: replacing my income for my family.


Once you have a policy, you can add extra coverage called riders. Before I show you all the riders, I’m going to tell you up front, some are not a ride worth taking. I’ll explain as we go.

Some common life insurance riders are:

Accidental death and dismemberment: This rider will pay out extra money if you die in an accident or get pulled apart limb from limb. The thing is, you’re just as dead this way as another, so your family will need the same amount of money either way. It’s kind of a scam.

Accelerated death benefit: If you’re diagnosed with a terminal illness, this rider lets you get a partial benefit payout before you die to help with illness costs. Insurers have their own definitions of what qualifies as a terminal illness and it will cost you an administrative fee to enact it. But it could be helpful in some situations.

Waiver of premium: If you become disabled before a certain age, this rider waives your premiums until you’re able to work again. (But you should already have long-term disability insurance, so there’s no need to pay extra for this.)

Child term rider: This is basically a small term life policy on your kid. But unless that kid makes millions from unboxing and reviewing toys and games on YouTube, you'll want to pass on this. The only exception might be if you’re still in debt, don’t have a full emergency fund, and need a way to cover funeral costs. Then you could get a small child rider on your own policy.

Return of premium (term life): You pay a higher monthly premium, but if you’re still alive when your term is over, you get all the money you spent in premiums back. Sounds good, but if you took the extra money you paid in premiums over 30 years and invested it instead, you’d end up with more money.

The big thing to note with all these riders is they all make your premiums higher (or reduce your death benefit) and don’t really provide enough value for that extra cost.


Buying and Managing Life Insurance

When you go to buy a life insurance policy, the agent will ask you a few questions, and sometimes you’ll have to get a medical exam. Then the insurance company underwrites your application to determine if they will approve a policy. (Underwriting means assessing how risky you are to insure and setting your premiums based on that risk.)

Usually, people buy policies for themselves and name their own dependents (kids, spouse, etc.) as the beneficiaries—like we saw earlier in the example of Jase. But there are exceptions. You can buy a policy for someone else—for example, one that insures your wife or your dad—and name your kids or your special-needs brother as the beneficiary. These can be tricky when it comes to taxes though, and you must have a valid reason for owning a policy on another person.

Here are a couple terms you’ll want to be familiar with:

Policy owner: the person who owns the policy (typically the insured person)

The insured: the person whose life is insured by the policy

Beneficiary: the person who’ll receive the death benefit

Life insurance isn’t something you can set and forget like those great rotisserie ovens you could buy for five easy payments of $19.99. Every few years, you need to take a look at your life and make sure your policy is still the best option.

Maybe you’ve gotten a raise and had another kid or two—you should up the death benefit so they’ll still have enough to live on if you die. Maybe you bought a house and now have a mortgage—it could be a good idea to raise your death benefit so there’s enough money to pay off the house if you die. Maybe you got divorced and remarried—definitely update the beneficiary. These are the kinds of things you need to keep in mind when you review your policy.


Got Kids? Use These 5 Tips to Get the Right Length of Life Insurance.

If you have kids depending on your income, you might be wondering, How long should my life insurance policy last? Great question!

Try These Tips

Claim Process and Settlement

This is the part everyone hopes never comes. But in case it does, you should know how it works. If you’re the beneficiary of an insurance policy and the person insured by the policy dies, you’ll have to file a claim with the insurance company to get the death benefit.

Here’s a list of what you’ll need to do:

  1. Find the policy and contact the insurance company. They’ll give you a claim form.
  2. Collect the required documents and complete the claim form. Here’s the information about the insured person and the documents you’ll need:
    • Social Security number and insurance policy number
    • Name, date of birth, date and cause of death, state of residence
    • Death certificate
  3. Choose how you want to receive your death benefit payment.
  4. Submit the claim form and documents to the insurance company.

Insurance companies usually pay out the death benefit by check or direct deposit.

You can choose to receive it in one big payment or in a specific income payment. With the second option, the insurance company puts your death benefit into an account and sends you small payments from it regularly. I recommend you take it all in one lump sum. That way you can invest it and start earning interest on it right away.

Death benefits from life insurance aren’t taxable. But if you have any of the permanent life insurance options, interest earned in the cash value account connected with those is taxable. (One more reason to go with term life!)


Considerations and Planning

Hopefully you feel confident about how life insurance works now. Here are a few things to keep in mind when you’re looking at buying a life insurance policy.

You need to figure out how much to get. Your annual income, of course, is the biggest consideration—you want 10–12 times that—but you should also consider buying more if you have:

  • Debts
  • A mortgage
  • A beneficiary who may have a big specific expense in the future, like college

Another consideration is your estate. Dying can be expensive. There are taxes and sometimes lawyer fees to pay, a funeral, and maybe a few barrels of whiskey for your wake. Consider pushing the policy value up a bit if you think these expenses will be high.

Finally, don’t forget what I said earlier about reviewing your policy! There’s one thing we can always count on in this life: change (and of course, death and taxes). Make sure you go back and review your policy any time you go through life-change, like getting married or having kids.

If you need more life insurance or you’re looking for new coverage, the good people at Zander Insurance can hook you up with a term life policy that offers the right amount of protection for the right price.

They’ve served my family for over a decade now. Not only that, they’ve been serving fans like Ryan B. from the Ramsey Baby Steps Community on Facebook for over 20 years! When he switched to Zander, Ryan saved $19 a month.

“Seeing how Zander got me about 30 quotes in 30 seconds and I got to choose the best one, I’ll roll with Zander,” he said.


Next Steps

  • Learn more about term life and why it’s better than whole life insurance.
  • Figure out how much life insurance you should have with our calculator.
  • Check out how much a term life insurance policy could cost you.
  • Get in touch with RamseyTrusted partner Zander Insurance to get your free term life insurance quote today.
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George Kamel

About the author

George Kamel

George Kamel is the #1 national bestselling author of Breaking Free From Broke, a personal finance expert, a certified financial coach through Ramsey Financial Coach Master Training, and a nationally syndicated columnist. He’s the host of the George Kamel YouTube channel and co-host of Smart Money Happy Hour and The Ramsey Show, the second-largest talk radio show in America. George has served at Ramsey Solutions since 2013, where he speaks, writes and teaches on personal finance, investing, budgeting, insurance and how to avoid consumer traps. He’s been featured on Fox News, Fox Business and The Iced Coffee Hour, among others. Learn More.

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