How Does Life Insurance Work?

When purchasing life insurance, it’s important to understand how it works and how your beneficiaries can receive the proceeds of your policy. Learning about the process helps you choose the right payout option to meet your goals.

Life insurance is a common asset in many people’s long-term financial planning. Purchasing a great life insurance policy is one way to protect your loved ones, providing them with the financial support they may need after you die. For example, you may purchase life insurance to help your spouse cover mortgage payments and everyday bills or to fund your children’s college education.

KEY TAKEAWAYS

• Life insurance is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person passes away.
• There are several kinds of life insurance, including term and permanent plans.
• Contact the life insurance company as soon as possible following the death of the insured to begin the claims and payout process.
• It’s important to always name life insurance beneficiaries, whether they are individuals or organizations.
• There are different ways a beneficiary may receive a life insurance payout, including lump-sum payments, installment payments, annuities, and retained asset accounts.

Life Insurance Basics

Life insurance is a type of insurance contract. When you purchase a life insurance policy, you agree to pay premiums to keep your coverage in force. If you pass away, the life insurance company can pay out a death benefit to the person or persons you named as beneficiaries of the policy. More than half of American consumers have life insurance, according to industry research firm LIMRA.1

You can expand basic insurance features by adding optional coverages known as riders. Some life insurance policies offer both death and living benefits. A living benefit rider allows you to tap into your policy’s death benefit while you’re still alive. This type of rider can be beneficial in situations where you’re terminally ill and need funds to pay for medical care.

“Some life insurance companies have designed policies that allow their policyholders to draw against the face value of the policy in the event of a terminal, chronic, or critical illness,” said Ted Bernstein, owner of Life Cycle Financial Planners LLC. “These policies enable the policyholder to be the beneficiary of their own life insurance policy.”

When purchasing life insurance, it’s important to consider:

• How much coverage you need
• Whether a term life or permanent life policy makes more sense
• What you’ll pay for premiums
• Which optional coverages, if any, you’d like to include
• The differences between life insurance quotes for each potential policy

In terms of coverage amounts, a life insurance calculator can be helpful in choosing a death benefit. Term life insurance covers you for a set number of years while a permanent life insurance policy covers you for life (as long as premiums are paid). Between the two, term life tends to be cheaper, but permanent life insurance can offer benefits such as cash value accumulation.

Life insurance premium costs can depend on the type of policy, the amount of the death benefit, the riders you include, and your overall health. Often you will need to complete a paramedical exam as part of the underwriting process.

Hybrid life insurance policies allow you to combine life insurance coverage with long-term care insurance.

What Does Life Insurance Cover?

Depending on the life insurance you purchase, the death benefit can cover many expenses. After a partner, spouse, or parent dies, their annual income also ends. A life insurance policy can help fill in the gaps to pay financial obligations such as rent or mortgage costs, funeral and burial expenses, school tuition, and personal debt such as student loans or credit cards. It can even supplement the lost income, helping pay for day-to-day expenses.

Of course, many individuals who purchase life insurance aim to safeguard their beneficiaries against financial hardship.

It is possible to purchase an insurance policy to leave an inheritance to your grown children or grandchildren, an extended family member, or a nonprofit. Some policies, such as whole or universal life insurance, allow you to access your life insurance funds while you are alive. You may be able to borrow against your policy as long as you continue to pay premiums, and use those funds to buy a home or cover your children’s college expenses. While you run the risk of lowering the death benefit if you do not repay the loan, these life insurance policies can be helpful.

The policy itself usually covers natural and accidental causes of death and homicide. In some cases, it covers suicide, although it is wise to research the policy you want to purchase. In some instances, there may be conditions attached that must be met before beneficiaries receive their death benefits.

Term Life Insurance vs. Permanent Life Insurance

Term life insurance provides coverage for a set amount of time (such as 15, 20, or 30 years). Timelines may vary, depending on the insurer. The term life death benefit is not paid out after the term of the life insurance policy ends, even if all premiums have been paid. However, premiums on term life policies are usually more affordable compared to permanent life insurance.

Term life can be useful if you want coverage during prime working years (or while your children are young) to provide some financial protection to your partner, spouse, or children. Term life insurance does not contain a cash value, and you cannot borrow money against your death benefit. Some term life insurance policies can be converted into whole or universal life policies or extended beyond the original term; however, those premiums will be much higher than the initial cost.

There are two types of permanent life insurance, whole and universal. All permanent life insurance combines a death benefit with a cash value account. Permanent life insurance allows the insured to borrow against your life insurance policy. If you don’t pay it back, your beneficiaries will receive a smaller payout. Some policies pay dividends on earnings, which can be used to pay much higher premiums than term life insurance or to increase your cash value. Both whole and universal life insurance cover you until you die unless you stop paying the premiums. However, your death benefit shrinks as you borrow from the cash value.

How Much Does Life Insurance Cost?

The cost of life insurance depends on several factors, such as the type of insurance you purchase, the insurance company selling the policy, and your overall individual health, wellness, and family history (in most cases). For example, if you go with a 20-year term life policy, and you are a healthy adult, you could pay as little as $30 dollars a month for a half-million-dollar death benefit. Term life is less expensive than whole or universal life insurance, yet all insurance gets more expensive as you grow older.

Whole or universal life insurance is considerably more expensive than term and could cost upwards of $125 to more than $200 a month, depending on your age, health profile, and the amount of death benefit.2

Choosing a Life Insurance Beneficiary

As part of the process when buying life insurance, you’ll need to designate one or more beneficiaries. This is who you want to receive the death benefit from your policy when you pass away. A life insurance beneficiary can be:

• A spouse
• Parent
• Sibling
• Adult child
• Business partner
• Charitable organization
• A trust

You can choose to name a single beneficiary, or a primary beneficiary and one or more contingent beneficiaries. A contingent beneficiary would receive death benefits from your life insurance policy if the primary beneficiary passes away.

Minor children can’t be named as beneficiaries of a life insurance policy.

Filing a Claim

Death benefits are not paid out automatically from a life insurance policy. The beneficiary must first file a claim with the life insurance company. Depending on the insurance company’s proceses and procedures, this may be done online or it may require filing a paper claim. No matter how you file, the company normally requires paperwork and supporting evidence to process the claim and payout.

Your beneficiaries may be required to provide a copy of the policy, along with the claims form. They must also submit a certified copy of the death certificate, either through the county or municipality or through the hospital or nursing home in which the insured died.

Policies owned by revocable or irrevocable trusts must ensure that the insurance company has a copy of the trust document identifying the owner and the beneficiary, added Bernstein.

There’s no set deadline for how long you have to file a life insurance claim but the sooner you do so, the better.

When Benefits Are Paid

Life insurance benefits are typically paid when the insured party dies. Beneficiaries file a death claim with the insurance company by submitting a certified copy of the death certificate. Many states allow insurers 30 days to review the claim, after which they can pay it out, deny it, or ask for additional information. If a company denies your claim, it generally provides a reason why.

Most insurance companies pay within 30 to 60 days of the date of the claim, according to Chris Huntley, founder of Huntley Wealth & Insurance Services.

“There is no set time frame,” he added. “But insurance companies are motivated to pay as soon as possible after receiving bona fide proof of death, to avoid steep interest charges for delaying payment of claims.”

Payout Delays

There are several possible situations that may result in a delay in payment. Beneficiaries may face delays of six to 12 months if the insured dies within the first two years of the issuance of the policy. The reason: the one- to two-year contestability clause.

“Most policies contain this clause, which allows the carrier to investigate the original application to ensure fraud was not committed. As long as the insurance company cannot prove the insured lied on the application, the benefit will normally be paid,” said Huntley. Most policies also contain a suicide clause that allows the company to deny benefits if the insured dies by suicide during the first two years of the policy.3

If you or someone you know is suffering from depression or mental health issues, get help now. You are not alone. If you or a loved one is contemplating suicide, contact the National Suicide Prevention Lifeline at 1-800-273-8255 or via live chat. It’s available 24 hours a day, seven days a week, and provides free and confidential support.

Payments may also be delayed when homicide is listed on the insured’s death certificate. In this case, a claims representative may communicate with the detective assigned to the case to rule out the beneficiary as a suspect. The payout is held until any suspicion about the beneficiary’s involvement in the insured’s death is clear. If there are charges, the insurance company can withhold the payout until charges are dropped or the beneficiary is acquitted of the crime.

Delays to payouts may also arise if:

• The insured party died during the course of illegal activity, such as driving under the influence.
• The insured party lied on the policy application.
• The insured omitted health issues or risky hobbies or activities, such as skydiving.
• The insured died while committing a crime.

Insurance companies can delay payment for six to 12 months if the insured party dies within the first two years of the policy.

Payout Options

You can also help decide how your death benefit will be paid out after you die. Here are a few of the payout choices available to you and your beneficiaries.

Lump-Sum Payments

Since the inception of the industry more than 200 years ago, beneficiaries have traditionally received lump-sum payments of the proceeds. The default payout option of most policies remains a lump sum, said Richard Reich, president of Intramark Insurance Services, Inc.

Installments and Annuities

Modern life insurance policies have seen a monumental improvement in how payouts can be delivered to the policy’s beneficiaries, said Bernstein. These include an installment-payout option, or annuity option, in which the proceeds and accumulated interest are paid out regularly over the life of the beneficiary. These choices give the policy owner the opportunity to select a pre-determined, guaranteed income stream of between five and 40 years.

“For income-protection life insurance, most life insurance buyers prefer the installment option to guarantee the proceeds will last for the necessary number of years,” added Bernstein.

Beneficiaries should remember that any interest income they receive is subject to taxation. You may end up better off with the lump sum than installments, as you’ll end up paying more in taxes on the interest if the death benefit is fairly high.

Consider talking to an insurance agent and/or estate planning attorney about which payout option might work best.

Checking Account

Some insurers offer beneficiaries of significant policies a checkbook instead of a lump sum or regular installments. The insurance company, acting as a bank or financial institution, keeps the payout in an account, allowing you to write checks against the balance. Such an account would not allow deposits but would pay interest to the beneficiary.4

Retained Asset Account

A retained asset account can also be used to allow the insured to receive cash advances against the death benefit before they die. This feature is known as an accelerated death benefit or living benefit, which may be provided through accelerated benefit riders. Traditionally, life insurance policies will only payout at the policyholder’s death. Talk with your insurance agent about whether this option makes sense for you.

How Does Term Life Insurance Work?

Term life insurance is often the most accessible type of insurance to purchase. Depending on the type of policy, you may not need a medical exam. Tthe policy will last for an agreed-upon number of years, often 20- or 30-years. You pay monthly premiums to cover your death benefit. If you die before the term is up, the insurance company pays your beneficiaries. Once you reach your term limit, your policy ends.

How Does Whole Life Insurance Work?

Unlike term, whole life insurance is a permanent form of insurance, allowing fixed death benefit coverage over the policyholder’s life. The premiums for whole life insurance are higher than what you pay for a term life policy. Whole life contains a cash-value account, which can accumulate as interest accrues on a fixed rate and a tax-deferred basis.

You can borrow against your whole life policy, but the benefit acts as the collateral, so your benefit shrinks if you don’t repay the loan. If you don’t pay the premiums or repay the loan, your policy will be canceled. Any money you borrowed may be considered income and subject to taxation.

How Does Universal Life Insurance Work?

Universal life insurance is another form of permanent life insurance. These policies offer a death benefit and a cash value account. Universal life insurance stays with you until the end if you pay your monthly premiums. There are three kinds of universal life insurance ⁠— variable, guaranteed, and indexed⁠. Unlike other types of policies, all three version of universal life provide, you the flexibility to change your death benefit or lower your premiums. Your cash value account’s earnings can help pay the premiums on your account.

Can You Get Life Insurance With a Pre-Exisiting Condition?

If you have pre-existing conditions, you may find it difficult, but not impossible, to purchase life insurance. Coverage will depend on various factors, but primarily your individual health situation. Depending on the life insurance company, some pre-existing conditions such as diabetes, high blood pressure, and anxiety may be covered but with higher premiums.

How Long Do You Have to Pay Into a Life Insurance Policy Before It Pays Out?

Life insurance will pay out upon the death of the insured as soon as it is in force with the first premium payment. Some life applications, however, come with the option of binding a certain amount of coverage while the underwriting process takes place in case the applicant dies before the policy is issued. Known as a binder, this process usually requires payment up-front when the application is taken. The payment will either be returned or credited toward the first premium once approved.

The Bottom Line

Life insurance policies provide both policyholders and their loved ones peace of mind that financial difficulties may be avoided if the insured dies. Understanding how the process works, from buying life insurance to filing a claim to receiving a payout, can help you proceed with your plans to purchase coverage confidently.