What is life insurance and how does it work? 

5 mins readLast updated January 24, 2024by Kate Morgan

Life insurance is a policy that pays out a sum of money to a beneficiary upon the death of the insured. Learn more about what life insurance is here.

Taking out life insurance is always wise if you have the financial means.

There are many different policies available to suit a range of needs and lifestyles, and payouts can offer great support to your loved ones after your death, helping with anything from funeral costs to mortgage payments.

Read on to find out what life insurance is and why it's worth the investment.

What is life insurance?

You sign a contract with a life insurance provider when you purchase life insurance.

In exchange for premium payments from you, usually made monthly or annually, that provider pays out a lump sum to your family/beneficiaries when you die.  

Some types of life insurance allow you to accumulate wealth along the way as well, even making withdrawals before you die.

This can be helpful if, for example, you need to finance your retirement plans. 

The benefits of life insurance

One significant benefit of life insurance, compared to other insurance contracts, is that there are minimal limits on what your family can choose to spend the money on when it comes to them.

They can do anything within the confines of the law, including using the money... 

  • for your funeral and burial costs (which is good news when the average burial costs $7,848

  • to pay off outstanding debts or mortgages 

  • toward tuition (your children’s, their own, their children’s, etc) 

  • for day-to-day expenses like groceries and utilities 

More generally, life insurance can improve your family’s financial position, set clearly defined financial goals, and ensure that you provide for your family after you’ve died.

Life insurance payouts are tax-free, so beneficiaries don’t have to pay tax on death benefits – in fact, they don’t even have to declare them in a tax return. 

What types of life insurance are available?

So, how does life insurance work?

Summarily, there are two main types of policy – “term” and “permanent.”

The type you decide to buy likely depends on your life circumstances and financial situation.

Term life insurance policies are the most affordable option and therefore are the most popular. They provide coverage for a fixed term of between five and 30 years, and premium payments remain the same throughout this period.  

Permanent life insurance policies, however, provide lifelong coverage. With these policies, you can accumulate cash value and use your policy as a type of savings account. You can either borrow against the policy’s cash value or make a withdrawal yourself.

These permanent policies are expensive, but they offer more flexibility.

There are four main types of permanent policy:

  • Whole life insurance 

  • Universal life insurance 

  • Burial insurance 

  • Survivorship life insurance 

Each policy offers a mix of benefits and has its own rate of return, so it’s wise to ask a trusted financial advisor which approach suits your situation best.

For example, an elderly couple might be more inclined to take out either burial insurance or a survivorship policy that covers them both. Additionally, some individuals opt for the unique features of indexed universal life insurance, which ties the policy's cash value growth to a specific financial index.

How much does life insurance cost?

In 2022, the average life insurance cost per month for a person living in the US is between $40 to $55.

This is only an estimate, and the actual total cost of life insurance depends on many factors.

One essential factor, as you might expect, is the policy type. Term life insurance policies, as mentioned above, are generally cheaper because they’re shorter.

Other elements affecting life insurance cost include coverage amount, age, gender, health, and lifestyle.  

Younger people generally pay less because their risk of death is lower.

Women tend to live longer than men, so men usually pay more for life insurance.

If you engage in extreme sports, your rates are likely to be higher.  

What life insurance do YOU need?

As of 2022, 50 per cent of Americans have a life insurance policy.

Common questions for people considering taking one out include “Do I need life insurance?” and “How much life insurance do I need?

The answer relevant to you depends on your life situation and preferences, but some recommendations are commonly offered.  

For instance, if you don’t have any dependents or possible beneficiaries, it’s probably not worth paying for life insurance.

But if you have young children or a house you want to keep in the family? It’s a good idea.

From protecting assets to supporting loved ones, life insurance – especially on a permanent plan – is a massive help. 

As for how much you need, the answer comes down to assessing financial goals, household income, and the needs of your beneficiaries.

Speak with a financial advisor and look for answers to questions like these, to figure out exactly how much health insurance will be beneficial to you: 

  • How will my death affect my dependents’ finances?  

  • How long would I like my insurance to provide for them? 

  • Do I want my insurance/part of my insurance to go to any charitable organizations?  

How to get life insurance

As with many other insurance types and coverage plans, figuring out how to buy life insurance that suits your needs is a bit of a game.

You need to do plenty of research, shop around for quotes, weigh up your options, and wait for approvals.  

Securing life insurance also requires the completion of some important administrative tasks.

Since your physical and mental health is crucial to your life insurance policy, you have to take a medical test.

You also have to provide personal identification on the application form and answer questions via a phone interview.

But, on the other side of all the effort, you’ll have a policy that protects and supports your beneficiaries in the event of your passing.

If you’d like more insurance advice, stay on our website and browse our in-depth articles on everything from life insurance to long term care insurance.

Content writer

Kate Morgan

Kate has written for leading publications and blue chip companies over the last 20 years.