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What Is Life Insurance and How Does It Work?

So you’ve got your home and auto insurance policies set up and crossed off your list. But what about life insurance? If you haven’t gotten around to it yet, you’re not alone: Last year, only 54% of Americans had some form of life insurance in place.1

Maybe getting life insurance is already on your radar. Or maybe it's not—because life itself is just so busy! If you have loved ones who depend on your income, it’s worth knowing how life insurance can protect them if anything happens to you. So here’s what you need to know about life insurance—how it works, what it costs, and which type is right for you.

What Is Life Insurance?

Life insurance is an agreement between you and an insurance provider that, in exchange for your monthly payments, the insurer will pay a sum of money to your loved ones when you die.

Okay, it’s not a fun topic to think about. But focus on this: You buy life insurance not because you’re going to die but because those you love are going to live—and you want them to be financially secure after you’re gone.

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So what does life insurance cover? Life insurance can cover loss of income, funeral expenses, debt and other financial needs that might come up after you pass away. Once you sign on the dotted line and start paying monthly, what you’ve really bought is peace of mind—peace that you’re providing financially for your loved ones even after your death.

How Does Life Insurance Work?

Reading a life insurance agreement can feel like the most boring thing in the world, right? But you really only need to know a few common terms to help you understand how life insurance works:

  • Policy – the contract between you and the insurance company
  • Premiums – the monthly or yearly payments you make to own the insurance policy 
  • Policyholder – the owner of the policy, which would normally be you (the one insured), but you could buy a policy for another person
  • Claim – a formal request to your life insurance company to receive the death benefit.
  • Death Benefit – the life insurance payout, or money given out when you die
  • Beneficiaries – the people you choose to receive the death benefit of your policy (like your spouse or children, but it can be anyone you name)

In a nutshell, once you (the policyholder) start paying your premiums, the insurance company guarantees they’ll pay the death benefit to your beneficiaries when you die.

Types of Life Insurance

Let’s start with the basics. There are two main types of life insurance: one that lasts for a set number of years (term life insurance) and one that lasts through your entire life (permanent life insurance).

Term Life Insurance

Term life insurance provides coverage for a specific amount of time. If you die at any time during this term, your beneficiaries will receive the death benefit from the policy.

A term life plan is more affordable than a permanent plan because it has a simple goal of paying out a death benefit—no other bells and whistles (like doubling up as an investment tool, which will just bloat your premiums).

Permanent Life Insurance

Permanent life insurance lasts throughout your entire lifetime. It comes in the form of whole life, universal life or variable life insurance—each differing slightly from the other. 

Besides the insuring-your-life part, permanent insurance adds an investing-your-money piece to your policy called cash value. The insurance company takes a chunk of your premium to start an investment account.

But here’s the deal: Cash value life insurance is one of the worst financial options out there! There are a ton of better places to invest that will give you a better return for your buck.

Do I Need Life Insurance?

Almost everybody needs life insurance. No matter what stage of life you’re at, life insurance makes up an important part of your financial security.

Let’s take a look to see where you might fit in:  

The Young Professionals

You may have some credit card and student loan debts that will need to be paid after death. But if you’re completely debt-free with no dependents, then all you really need to worry about are burial costs. And if you’ve signed up for a group life insurance plan through your employer, there may not be an urgent need to take out your own policy—yet!

The Newlyweds

Congratulations! You’ve just started your new life together, and that means you’re there for one another through thick and thin. But “Til Death Do Us Part” isn’t the end! You should both have a life insurance plan in place.

This isn’t just about paying off debts if one of you passes away—it’s about protecting and providing for the future of your spouse as they grieve your loss. Get enough life insurance to make sure they’re taken care of.

The Parents

If you have children, both you and your spouse need to be covered, even if one of you doesn’t work outside of the home. The absence of a stay-at-home parent would greatly impact the family budget. Childcare costs aren’t cheap these days.

Consider what it would take to run the household, provide for your kids (including college), and possibly pay off your home in the years following your death or the death of your spouse. Trust us—you want (and need) this peace of mind.

The Retirees

At this point, you might already have hefty retirement savings in place. You could even be well on your way to becoming self-insured and not need any life insurance. That’s a great place to be!

But let’s say you’re still paying off your house and trying to add to your retirement savings. If you died today and your spouse no longer had your income to rely on, would the amount in your savings accounts be enough to take care of them?

How Much Does Life Insurance Cost?

The cost of your life insurance premium will depend on the type you’re buying (whether it’s term life or permanent), but other things play a role too, like your age, health and lifestyle.

Let’s look at Sarah. She’s in her 30s, a nonsmoker, in good health, married with one child and earns $40,000 a year. On average: 

  • If she took out a 20-year term life policy with a $400,000 death benefit, she would pay around $18 a month for this plan.
  • If she opted for a permanent type of life insurance with a death benefit of $125,000, she would pay around $100 a month for it.

This is what insurance providers will look at when they’re working out your life insurance premium:

  • Age
  • Gender
  • Personal and family medical history
  • Weight
  • If you smoke
  • If your lifestyle includes risky hobbies like skydiving, shark wrestling and the like
  • If you regularly travel to dangerous parts of the world

After they have these details, the insurance provider will schedule a medical exam with you (unless you’re buying a no medical exam life insurance policy).

So, now that you know what they’re after, how can you reduce your premium? While you can’t do much about your age, you can quit smoking, take up regular exercise, and try to lose weight if you need to, to bring those premiums down. 

How Much Life Insurance Do I Need?

Financial experts like Dave Ramsey recommend setting your death benefit at 10–12 times your annual salary. This is for an important reason: providing for your family’s future.    

Let’s look at Sarah from our example earlier and how a death benefit of 10–12 times her income could really help her family:  

  • Sarah’s salary is $40,000, and her policy death benefit is $400,000 ($40,000 times 10).
  • If Sarah died, her family could invest the $400,000 in a mutual fund that makes a 10% return.
  • That investment could yield $40,000 per year—Sarah’s original salary.

The interest that Sarah’s family could earn each year would cover Sarah’s salary. And the original amount invested could stay there indefinitely as they use the interest to help get through life without Sarah.

Most importantly, this provides peace of mind and financial security for Sarah’s loved ones during a truly difficult time.

What Type of Life Insurance Is Right for Me?

In case it wasn’t clear in our discussion of the two main types, the only type of life insurance we’d recommend you get is term life. It’s not only cheaper than the permanent kinds of policies (allowing you to invest the difference in retirement accounts), it also expires right around the time you no longer need it. And when would that be?

At the point when you and your assets become self-insured. Being self-insured just means that:

  • You have a fully funded emergency fund with enough money in it to keep your Four Walls (food, utilities, shelter and transportation) covered for three to six months
  • Your kids are heading off to college or living on their own
  • Your retirement accounts are in great shape (meaning their yearly return could replace your income)

How Do Life Insurance Payouts Work?

The death of a loved one is not a time anyone wants to think about paperwork. So thinking ahead about how the life insurance payout works might help.

When making a claim, contact the life insurance company either online or by mail. The beneficiary is required to provide the company with a certified copy of the policyholder’s death certificate, either through the hospital or from the county or municipality in which they died.

As far as the timing of a claim, here’s good news: There’s no time limit on a life insurance payout. You can get this done on your own timetable, when you and your family are ready.

What about the form of the payout? You can go with either the lump sum or an installment plan. We definitely recommend you take the whole amount at once—installments have a lot of drawbacks and lack the level of control you get by taking the payout in a lump sum.

Is Life Insurance Worth It?

Life insurance is worth it, and the right type of life insurance makes all the difference!

Bottom line: Term life insurance is your best option because life insurance should be protection and security for your family—not an investment or money-making scheme. Let the mutual funds handle the investment part.

Ready to get started? The trusted experts at Zander Insurance can give you a quick and free quote on a term life policy in a few minutes. Don’t put it off another day—keep your momentum going and get started now!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

How much life insurance do you need?

Get Your Numbers

How much life insurance do you need?

Find the best term life policy for you with our free life insurance calculator.
Get Your Numbers

How much life insurance do you need?

Find the best term life policy for you with our free life insurance calculator.
Get Your Numbers