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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: 61% of Americans don’t have life insurance in place.

Think about that number for a minute. Imagine how many millions of people financially depend on someone who has no life insurance coverage. It's a risky situation because if that provider dies, their loved ones will be in a really bad place financially.

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. 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. In exchange for your monthly payments, the insurer agrees to pay a sum of money —a life insurance payout— to your loved ones when you die. (Oof!)

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Okay, it’s not a fun topic to think about, especially that last part. 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. FYI, there are two main kinds of life insurance: whole life coverage (which is not a great option) and term life (which we always recommend).

Life Insurance Basics

Wondering why we’re so keen on term life insurance as the only way to go? The reasons are really clear and simple:

  • It’s the least expensive type of life insurance anywhere.
  • Term life does the one thing life insurance is supposed to do—it replaces your income when you die.
  • It spares your loved ones financial stress at a really hard time.

And as we’ll see as we get into the other kinds of life insurance, they tend to be way more expensive, way more complicated—or usually both!

Have you come across a lot of confusing jargon while trying to find out about life insurance options? We would agree that reading a life insurance agreement can be tedious and overwhelming. But you only really need to know a few common terms to help you understand how life insurance works:

  • Policy – the contract betwe­­en you and the insurance company
  • Premiumsthe 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.

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A Brief History of Life Insurance

Life insurance dates pretty far back, with the first known policy in America being issued way back in the 1760’s!1 Over time, the same basic forms we’ve discussed above—term life to cover you for a period, or permanent to last your whole life—came to dominate the market. But the fact that both forms of life insurance are common doesn’t mean they bring you equal benefits. Let’s look at each one and see how they work!

How Does Term Life Insurance Work?

Premiums are usually monthly, and so long as you keep them current, the insurance company will pay a defined amount (sometimes called the death benefit) to your beneficiaries should you die. Similar to house or car insurance, term life is basically a kind of coverage that hedges you off from the full financial impact of big life events that most people face eventually, but at a relatively affordable price.

To decide on your rates, the insurance company looks at several factors:

  • Age
  • Health
  • Life expectancy
  • Sometimes lifestyle choices and a few other factors

In light of those factors, we’d recommend getting term life insurance while you’re still pretty spry. It’s the kind of coverage that costs more as you age.

For example, take Justin—a healthy (and nonsmoking) 35-year-old who makes $50,000 a year. Justin’s death benefit is $500,000 because he had the wisdom to get coverage that was 10–12 times his yearly income. Because he has young kids, he signed up for 20 years of coverage. (He’s hoping his efforts to become debt-free and invest in retirement will have paid off by the time he’s in his 50s, and figures he’ll be self-insured by the time his kids are grown.)

If Justin dies before his 20-year term is over, guess who gets $500,000 from the insurance company? That’s right—his wife and kids! (Most people make family the beneficiaries of a term life policy, but you can also name friends, charities or life insurance trusts to receive the death benefit.)

How Does Permanent Life Insurance Work?

The short answer to this question is that it’s complicated. That’s partly because there are several different kinds of permanent life insurance, and partly because the various kinds are often loaded down with bells and whistles.

The main difference permanent has from term is that with any form of permanent life insurance, you’re getting coverage until death, no matter how far in the future that happens. Now we know that might sound like a longer-lasting form of service. But trust us, it only sounds better because it’s a permanent solution to a problem that is temporary for most people (the risk of dying before you’ve had time to build up enough wealth to replace your income). Many people perceive permanent to be a better deal. But that’s totally wrong.

Here’s the real deal: As we’ve said, term life is always going to be more affordable than permanent life insurance. Term life is a simple policy that guarantees a defined death benefit if you die within that term. Very easy to understand and afford.

But most kinds of permanent life are not only going to be way more expensive, they’ll also be trying to do more than one job. Permanent life insurance tries not only to offer you a death benefit, but often a savings account, or a retirement account, or other investments, and sometimes all of them at once! No wonder these products get so expensive!

Here’s a list of the kinds of permanent life insurance. (Reminder: Stay away from these policies!)

  • Whole life
  • Universal life
  • Variable universal life

The Truth About Life Insurance

The truth is that life insurance is not supposed to be a retirement plan. It is insurance. So by definition it’s a form of financial protection against known risks. Retirement accounts, on the other hand, are wealth-building tools that have their own place in your overall financial strategy. But here’s the thing: When companies (or their customers) try to make life insurance do anything other than replace the policyholder’s income, a big mess is the usual result.

Trying to blend insurance with investing is a disaster that will cost you both in terms of higher premiums and in terms of lower return on investment (mutual funds are always going to be a better place to put cash than a savings account attached to a whole life insurance policy).

So focus on the simple, proven strategy for life insurance that works: cheap, term coverage that’s only designed to replace your income when you die. That’s it!

Maybe you’re wondering, Do I need life insurance? As a matter of fact, 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?

How much life insurance do you 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? We recommend RamseyTrusted provider Zander Insurance. Their insurance experts can give you a quick and free quote on a term life policy in a few minutes. 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. Learn More.

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