What Is Life Insurance and How Does It Work?
What Is Life Insurance?

Life is beautiful, but also uncertain. Whatever you do, however smart and hard you work, you are never sure what life has in store for you.

If you haven’t gotten around to it yet, you’re not alone: 61% of Americans don’t have life insurance in place. 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 - Definition & Meaning

*Life insurance is a contract between you and an insurance company. You make regular premium payments to the life insurance company. In exchange, the company pays a death benefit to your beneficiaries when you die. Depending on the type of policy you buy, life insurance can cover natural deaths, accidental deaths, and even illness or injuries while you're still alive.

There are basically two types of life insurance: Term life and permanent life. Term life covers you for a fixed amount of time while permanent life insurance covers you until the end of your life.

Generally, term life insurance is cheaper to purchase than permanent life. However, permanent life policies, like whole life insurance, build cash value over time and don’t expire, if you’ve paid your premiums. Term life policies have no value if you outlive the contract.

*Life insurance, which can also be known as life cover or life assurance, is a type of policy that protects your loved ones with financial support if you die. It can help minimise the financial impact that your death could have on your family and offer peace of mind to those you care about most.

Most life insurance policies are designed to pay out a cash sum to your loved ones if you die while covered by the policy. It can help them deal with everyday money worries such as household bills, childcare costs or mortgage payments.


If you were to go by the dictionary definition, “life insurance” is a financial product that pays you or your dependants a sum of money either after a set period or upon your death as the case may be.

However, if you were to understand the term clearly and also appreciate its importance in your life, consider “life insurance” as a back-up plan for life. Life insurance in its simplest form means being prepared financially, come what may. It ensures that your family and you receive financial support in case you are not able to bring in the much-needed income yourself (maybe due to an accident, retirement, or untimely demise).

In legal terms, life insurance is a contract between an insurance policy holder (insured) and an insurance company (insurer). Under this contract, the insurer promises to pay a pre-decided sum of money (also known as “Sum Assured” or “Cover Amount”) upon the death of the insured person or after a certain period.

What is a life insurance policy, and what are its key features?

A life insurance policy is an agreement between an insurance company and a person (or legal entity). Each life insurance policy is different, and each state’s laws regulating insurance policies are different. In general, most insurance policies identify the following:

  • The insurer: Only certain companies can provide life insurance, and these companies are regulated by state insurance departments.
  • The policyholder: The person or entity (such as a family trust or a business) which owns (or “holds”) the policy. The policy can ensure the holder, or it can insure another person.
  • The insured: The person whose life is insured.
  • The death benefit: The amount the insurer will pay when the insured passes away.1
  • The beneficiaries: The people or entities that will receive the death benefit. It can all go to a single person (e.g., a surviving spouse) or it can be divided by percentage among many different people and entities (e.g., three children could each get 30% and 10% could go to a charity).
  • The policy length: The time period that the insurer agrees to pay a death benefit. This can be a specific term (e.g., 10 or 20 years) or it can be permanent – a policy that lasts for the life of the insured for as long as premiums are paid.
  • The premium: The monthly or yearly payments needed to keep the policy in effect.
  • The cash value: Permanent life policies, like whole life insurance, have a cash value component that builds over time2 and can be cashed out or borrowed against.3 A term policy has no cash value.

Why is life insurance important?

Most Americans don’t have enough emergency savings to last three months, let alone enough to cover their family’s expenses for years to come. That’s where life insurance comes in — you can protect your family even if you don’t have $1 million in the bank. Life insurance provides a contingency plan for as little as $20 to $30 a month and ensures your family isn’t left scrambling for funds after you’re gone.

It is therefore important that you do not leave anything to chance, especially ‘life insurance’. As death is the only certain thing in life, apart from taxes, it pays to insure it well in advance.

How does life insurance work?

What Is Life Insurance and How Does It Work?
Photo: financialmentor

Life insurance is an extricable part of any robust financial plan. In order to choose a policy that provides you the exact cover you and your family need, it’s important to understand the intricacies of available plans. Here’s what you need to know to get started:

When you buy a policy

  1. When you buy a policy, you have to take a series of decisions – what policy to buy, how much it will cover, how long it will last, etc. It thus acts as a contract between you and the insurance company. How the insurance company serves you depends on the type of policy you buy. For example, do you want to be insured only for a certain period of time? Do you want additional benefits? Do you want to earn some money during the insurance period?
  2. The life cover you opt for is the amount the insurance company promises to pay you in case of an unexpected death. This needs to be a well-thought-out decision, keeping in mind many factors such as your lifestyle, income, savings, and debt.
  3. Timing plays a big role here. The insurance is valid only for a certain duration of time. Some plans last your whole life, while some last only for a certain period – 10 years, 20 years, and so on. Usually, beyond this duration, you cannot claim the insurance money.

Paying premium

To buy an insurance cover you have to pay a certain amount regularly. This is called Insurance Premium. Consider this as the fee the life insurance company charges for providing you the life cover. You have to pay this amount every year till the policy lasts. For example, if you buy a term plan for 20 years, you have to pay a certain premium every year for 20 years. The amount you pay as a premium depends on the type of policy, the life cover, your age, and your medical condition.

How is the premium decided?

Before approving your insurance, insurers carry out the process of Underwriting. It involves assessing risk by ensuring that the cost of cover they intend to provide to you is proportionate to the risks they face by doing so. To do this, they require you to fill up an application form and undergo a medical examination, or at the very least, fill up a questionnaire. If it turns out you have a higher risk of developing chronic illnesses, or that you work in a high-risk occupation, you may be required to pay an extra premium to cover the risk you pose. If you are insured through your company, however, your insurer may do away with underwriting.

Claiming your money

In case of an untimely death, the insurance company will pay you the entire coverage amount. This is why it becomes essential to choose the duration of the policy very carefully and to buy cover as soon as possible.

What life insurance covers

Different life insurance products are designed to protect you from different events that can occur:

  • life cover — pays a lump sum when you die
  • total and permanent disability (TPD) insurance — pays a lump sum to help with rehabilitation and living costs
  • trauma insurance — covers you if you’re diagnosed with a major illness
  • income protection insurance — pays some of your income if you can’t work due to illness or injury

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 1760s!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!

Frequently asked questions about life insurance

What does life insurance cost?

The cost of a policy – for a given level of death benefit – can vary greatly depending on the type of policy (i.e., term or permanent) and all the variables that can affect your life expectancy – age, weight, health, gender, lifestyle, occupation, and risk factors such as smoking.

How can a life insurance policy be tailored to my needs?

Almost all life insurance policies have optional features called riders that can provide valuable added benefits that tailor the policy to your needs.12 For example, Guardian has riders that can help protect family assets by paying for chronic care and end-of-life needs while the insured is still alive.

Can I buy a policy that lets me increase my coverage later on?

Yes, certain permanent life insurance policies have a benefit increase rider that allow you to increase the death benefit at certain intervals (e.g., every three years) without a new medical exam or evidence of insurability.

Is life insurance only for people with children?

Raising a child is one of the obvious reasons people start to think about life insurance. After all, what is life insurance for if not to protect families? But it’s not the only reason you should think about getting cover. If you live with your partner and they would struggle to pay the mortgage if you were to die, then you should consider life insurance.

Our Life Insurance policy could be suitable if you have an interest-only mortgage, as the cash sum that could be paid out could help to pay off the mortgage. Or it could also be used to help your family with everyday living expenses.

Alternatively, our Decreasing Life Insurance is designed to help protect a repayment mortgage so the amount of cover reduces roughly in line with the way a repayment mortgage decreases.

Please remember that life insurance is not a savings or investment product and has no cash value unless a valid claim is made.

10 Best Life Insurance Companies In The World 10 Best Life Insurance Companies In The World

If you are wondering about the best life insurance companies to protect your family, here is the list of the top 10 best life insurance ...

What are the benefits of Life Insurance?

What Is Life Insurance and How Does It Work?
Photo: keyanfintech

Life insurance provides a number of useful benefits. Among them:

1. Life Insurance Payouts Are Tax-Free

If you have a life insurance policy and die while your coverage is in effect, your beneficiaries will receive a lump sum death benefit. Life insurance payouts aren’t considered income for tax purposes, and your beneficiaries don’t have to report the money when they file their tax returns.3

2. Your Dependents Won’t Have to Worry About Living Expenses

Many experts recommend having life insurance that's equal to seven to 10 times your annual income. If you have a policy (or policies) of that size, the people who depend on your income shouldn't have to worry about their living expenses or other major costs. For example, your insurance policy could cover the cost of your children's college education, and they won’t need to take out student loans.

3. Life Insurance Can Cover Final Expenses

The national median cost of a funeral that included viewing and a burial was $7,640 as of 2019.4 Because many Americans do not have enough savings to cover even a $400 emergency expense, having to pay for a funeral can be a substantial financial burden.5 If you have a life insurance policy, your beneficiaries can use the money to pay for your burial expenses without having to dip into their own savings or use credit.

Some insurers offer final expense policies. These policies have low coverage amounts and relatively inexpensive monthly premiums.

4. You Can Get Coverage for Chronic and Terminal Illnesses

Many life insurance companies offer endorsements, also known as riders, that you can add to your policy to enhance or adjust your coverage. An accelerated benefits rider allows you to access some or all of your death benefits under certain circumstances. Under some policies, for example, if you are diagnosed with a terminal illness and are expected to live less than 12 months, you can use your death benefit while you’re still living to pay for your care or other expenses.

5. Policies Can Supplement Your Retirement Savings

If you purchase a whole, universal, or variable life insurance policy, it can accumulate cash value in addition to providing death benefits. As the cash value builds up over time, you can use it to cover expenses, such as buying a car or making a down payment on a home. You can also tap into it if you need to during your retirement years.

However, a life insurance policy should not replace traditional retirement accounts like a 401(k) or an IRA. What's more, cash value life insurance is considerably more expensive than term life insurance, which has no savings component but simply a death benefit.

How to Choose a Life Insurance Policy Type

With all of the life insurance options available, it may seem complicated to choose the right one.

Start by deciding between term life and permanent life insurance.

Consider a term life insurance policy if you need life insurance for a specific amount of time. For instance, if you want insurance to cover your working years as possible “income replacement” if you were no longer around.

Term life insurance is also a good choice if your budget is limited. Since term life insurance provides protection for a specific amount of time, and it’s not a cash value life insurance policy, the rates will be lower than permanent life insurance.

As you enter different stages of life, your life insurance needs may change. Many term life insurance policies are convertible to permanent policies. The options will depend on your policy and insurer. Term life conversion allows you to switch to a permanent policy without re-applying or taking a life insurance medical exam.

On the other hand, a permanent life insurance policy will last for the duration of your life. If building cash value is important to you, look at permanent life insurance options. But if you’re purchasing a permanent policy only to capitalize on the cash value accumulation, depending on the policy, you’re better off putting your money into a savings or investment vehicle, so you’re not paying for the life insurance and charges within a permanent policy.

And cash value isn’t typically intended for beneficiaries. Upon death, any cash value generally reverts back to the life insurance company. Your beneficiaries get the policy’s death benefit, not the death benefit plus cash value. That said, some policy types will offer the death benefit plus cash value, but for a higher price.

Do I need life insurance?

The answer to this depends on your individual circumstances. But if there are people that depend on you financially, such as children or a partner who relies on you financially then life insurance could be a way of helping to protect them.

Ultimately, you should consider whether your family could manage if you were no longer around. How much money would they need to cover childcare costs, household bills, and day-to-day living expenses? If you’re retired and your children have long since flown the nest, you may have less need for life insurance, but for new couples, homeowners, young families, and those with older children, you should consider getting life insurance.

Most Weirdest Insurance Policies Around The World Most Weirdest Insurance Policies Around The World

What are the weirdest insurance policies in the world? Insurance is available even after the escape of aliens, vampire and bride run away in marriage, ...

What Is Mortgage Insurance and How Does It Work? What Is Mortgage Insurance and How Does It Work?

What is mortgage insurance, how it works, and what are its benefits? Scroll down to understand more details about the advantages of mortgage insurance.

What is Business Insurance: Definition, Types and Cost What is Business Insurance: Definition, Types and Cost

Business Insurance is one of the most important parts if you want to start a business, which will help protect your businesses against losses.