What is life insurance? And how does life insurance work?

Ask most people what life insurance is, and they'll tell you it's a policy you purchase that pays money to your family if you pass away. Ask them to explain key policy features, the different kinds of policies available, and how life insurance works — and they'll probably try to change the subject. But if you're looking to get life insurance — or make a claim — those things are important. This article can help answer key questions, including:

• What are the key features of a life insurance policy?

• How do different kinds of life insurance policies work?

• What are the benefits of life insurance at different stages of life?

• What beneficiaries need to know about making a claim

What does life insurance cover, and what are the key features of a policy?

A life insurance policy is an agreement -- actually, a contract — between an insurance company and a person (or legal entity) to pay a benefit if the insured person passes away. 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 state insurance departments regulate them. Before purchasing, review ratings for all life insurance companies.

• The policyholder: The person or entity (such as a family trust or a business) that owns (or “holds”) the policy. The policy can insure 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 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 life insurance policy has no cash value.

Things life insurance doesn’t cover

Life insurance companies — or the terms of a specific policy — may not cover certain types of situations surrounding a policyholder’s death. This typically will prevent the insurance payout; in other words, no death benefit will be paid to beneficiaries. Common exclusions may include some or all of the following:

• The death was caused by a pre-existing condition the policyholder was found to have lied about during their initial medical exam or underwriting process.

• Deaths caused by high-risk hobbies, like parachuting or scuba diving.

• Deaths caused by acts of war or while serving in the military.

• Deaths that occur while traveling abroad, particularly in a high-risk area.

• Deaths ruled as suicides by medical examiners.

• Deaths that occur during or as the result of an illegal activity, such as when committing a crime.

• A payout will also be denied if the beneficiary is found to be responsible for the death of the policyholder.

Policies differ, so it's important to look at your specific contract to know what's covered. For example, while some life insurance policies won't cover certain types of deaths for the duration of the policy, others may only have temporary restrictions: for example, they may stipulate that death resulting from suicide, extreme hobbies, or travel in specified countries may not be covered for a one-year period.

The different kinds of life insurance policies and how they wor

There are two basic types of life insurance: Term and permanent life insurance. A term life insurance policy provides coverage for a specific period of time, typically between 10 and 30 years. Term life insurance policies are sometimes called "pure life insurance" because, unlike the permanent policy or whole life insurance, there's no cash value component. Once the term is over, there's nothing left.

Permanent life insurance provides coverage that lasts your entire life.⁴ Unlike term, it’s not a “pure life insurance” product because it includes a cash value component that helps make coverage last while the insured is alive. Premiums are paid while providing other potential financial benefits. A portion of your premium dollars grows income tax-deferred⁵ over time – but the entire death benefit is immediately payable from the first day you have the policy. On the other hand, the cash value may take some years to build up to a significant amount.⁶

There are two main types of permanent insurance: whole and universal life. Whole life insurance is simpler — the premium remains the same for life, the death benefit is guaranteed, and the cash value grows at a guaranteed rate. Universal life insurance can be less expensive, but the premiums, death benefit, and cash value growth rate can vary, making the policy more complex.⁷

The following chart highlights the key differences between the three main types of life insurance policies.

The benefits of coverage at different stages in life

Life insurance can be a powerful tool to help protect and build finances — especially the finances of the people who depend on you. That's why so many adults decide to get life insurance. However, before you get a policy, you should ask yourself: what type of financial protection do you need at this point in your life? If you're a young adult with no family, your needs are likely very different from those of a married friend with children— or, for that matter, a middle-aged entrepreneur leaving the corporate world to start their own business. The amount of coverage you get, the type of policy (term or permanent) and policy cost all impact how well a policy will meet your needs. And if you're not sure how to decide what's best for your current situation, consider talking things over with a financial professional.

How insurance companies set premiums

Life insurance rates are largely dependent on mortality risk, or the chance of dying while coverage is in effect. So insurers use mortality tables to estimate the statistical likelihood of death for different age groups. But in addition to age, a number of factors can impact the price you’ll actually pay for a policy, including:

• Gender: Women typically live longer than men and pay less than men for life insurance.

• Health and family medical history: Generally speaking, applicants who are healthier, and have fewer health issues in their family receive lower premiums

• Lifestyle risk factors: These typically include habits like smoking or drinking, a dangerous hobby or occupation, and may include your driving record

• Type of policy: As noted, term life insurance will almost always have lower premiums than a permanent whole or universal policy with the same coverage amount or death benefit.

• Expenses: Different insurance companies have different cost and commission structures that must be covered, and this is factored into the premiums

Making a claim: What beneficiaries need to do to receive the death benefit

When you buy a policy, you need to designate one or more beneficiaries: the person or people who will receive the death benefit if you pass away. Beneficiaries typically include family members such as spouses, children, parents or other adult dependents. You can, however, choose anyone to be your beneficiary, including charitable organizations. Business partners often use life insurance to fund a buy/sell agreement; the surviving partners are beneficiaries of the policy and use the proceeds to buy out the deceased partner's share of the business from the family

Life insurance beneficiaries have to file a claim

Life insurance benefits aren’t automatically paid out: in order to receive the death benefit, named beneficiaries need to file a claim, typically by doing the following:

1. Notify the claims department of the policyholder’s insurance company.

2. Complete the paperwork sent from the insurance company and return it along with a certified copy of the insured's death certificate and (if needed) a copy of the policy; mail it with a return receipt requested. Increasingly, this part of the process may be completed online.

How long does it take to receive the death benefit payout?

There is no deadline for when you must file a life insurance claim, but the sooner you file, the sooner you may receive a payout — which may be as soon as the claim is processed. Insurance companies usually make every effort to process claims quickly, with averages ranging from as little as two weeks and up to two months, but longer delays can occur. However, potential delays may be caused by the following:

• Missing paperwork

• Claims requiring an investigation, which may be triggered by deaths that occur under suspicious or potentially-excluded circumstances.

• Suspicion of fraud, which includes verification of the claim’s paperwork

• Contestability periods, which allow insurers to look more closely for anything that may not have been disclosed, such as smoking or certain health conditions.

How life insurance benefits are paid out

Life insurance benefits are, in almost all cases, paid out free of income taxes. Beneficiaries may receive payment from the death benefit in a number of different ways. The most popular options include the following:

• Lump sum: Beneficiaries receive the full death benefit in a single sum at once.

• Installments: Installments can be paid monthly, quarterly, or annually to provide a steady income stream.

• Annuities: Beneficiaries may receive fixed, regular payments over a fixed period or for the rest of their lives.

• Retained asset accounts: The insurer keeps the death benefit in an interest earning savings account, which the beneficiary can access through checks. The interest earned may be subject to taxes.

How to get a policy that works for your needs

You should know one more thing about purchasing life insurance: the longer you wait to buy it, the more expensive it typically gets. Don't put things off. If you can buy life insurance through your employer, that's a great place to start. You can get a basic level of coverage at very attractive group rates – but it may not be enough.

Life insurance is one of the most consequential financial purchases you can make – and it's worth taking the time to look into all your options to get the coverage that best fits your needs. If you have a financial professional you trust, talk to them about your needs. If not, Guardian can connect you with a financial professional who will listen to your needs, help you meet those needs within your budget and help you decide. You can also get an online quote using our term life insurance calculator.

If you are an employee, taking advantage of your benefits at work may be a smart and cost-effective way to get the financial protection you want for yourself and your family. Contact your HR department to review your benefit details and determine how much life insurance is available from the Group life insurance company selected by your employer. Your employer may provide a term life insurance policy as a benefit. Alternatively, you may opt for additional life insurance, which allows you to pay any life insurance premiums through payroll deductions.