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 60% 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.

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 life insurance terms to help you understand how it 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
  • Death Benefit – the 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 pass away 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.