What Is Life Insurance and How Does It Work?

If you’re wondering what life insurance is and how it can benefit you in real terms, you’re not alone. The jargon and arcane policy details can make researching life insurance seem like a daunting task, but it doesn’t have to be. In this article, we aim to answer some of the most frequently asked questions about life insurance.

Initially, life insurance companies designed their policies to assist widows and orphans by covering burial expenses. Life insurance has since evolved into a versatile and powerful financial product. It ensures that your family receives a tax-free benefit upon your death while the policy remains active. Life insurance can help beneficiaries pay off debts or replace lost income after a certain period or when the insured person dies.

The Insured, the Policyholder, and the Beneficiary

Before we get into the details, let’s define a few key terms found in most insurance policies. In short, the following are the main participants in a policy:

  • The insured: The person whose life the policy insures.
  • The policyholder: The owner of the policy.
  • The beneficiary: The person who receives payments upon the death of the insured.

It’s critical to understand that these roles are not mutually exclusive. A person can take out a policy on their own life, in which case they are both the policyholder and the insured. An individual can also take out a policy on their spouse’s life, in which case the individual is both the policyholder and the beneficiary.

What Is Life Insurance?

Life insurance represents an agreement between a policyholder and an insurance company. It entitles the beneficiaries to a certain amount of money, known as a death benefit, upon the insured’s death. 

In exchange, life insurance companies require policyholders to make regular premium payments during the insured’s lifetime or for the duration of the policy. Life insurance binds the insurer and the policyholder to perform certain acts, namely making premium payments and disbursing financial death benefits.

How Does Life Insurance Work?

A life insurance policy is most effective when both the company and the policyholder fulfill their primary contractual obligations: premium payments and death benefit distribution. As so-called
“pure life insurance,” term life insurance policies use both components, whereas permanent, or whole, life insurance policies include an additional cash value component.

Death Benefits

The death benefit, also known as the face value, represents the total amount of money guaranteed to the named beneficiaries upon the insured’s death. The insurance company grants coverage based on specific requirements, such as age, health, and high-risk activities. The policyholder can choose the amount of the death benefit based on the estimated financial requirements of the beneficiaries and the affordability of the associated premiums.


Premiums constitute the policyholder’s monthly payments to the insurance company. When an insured person dies, the insurance company pays the death benefit to the beneficiaries only if the premium prices remain current. Factors such as age, medical history, gender, occupational hazards, and risky activities can impact the cost of the policyholder’s monthly premiums.

Whole life insurance policies allow the policyholder to deposit funds into a cash-value account, to which the insurer may also contribute. Permanent insurance policies accumulate cash value, insure high-risk individuals, and provide more considerable death benefits, but at higher premiums.

Premium payments for term life insurance may extend for 10, 20, or 30 years, depending on the policy. Whole, or permanent, life insurance premiums provide lifetime protection at fixed rates.

Cash Value

A permanent life insurance policy’s cash value functions as an account that the policyholder can access while the insured is still alive. The cash accumulates on a tax-deferred basis, accelerating the growth of the savings. 

The policyholder can utilize the money to pay for future premiums or to purchase additional insurance. Any outstanding loans against the cash value reduce the death benefit. 

Things That May Void Your Life Insurance Policy

Premium life insurance policies require policyholders to provide accurate information about the insured’s health, high-risk activities, and hobbies. The first two years of premium payments represent the contestability period. During this time, the insurance company may contest any claims after the insured dies. If the insurance company discovers inconsistencies in the information provided, the insurer reserves the right to reduce the death benefit or even cancel the policy.

Differences between Whole and Term Life Insurance

Life insurance remains divided into two classifications: term life insurance and permanent life insurance.

Term Life Insurance

Term life insurance covers the policyholder for a fixed amount of time, usually 10, 20, or 30 years. Once the insured outlives the contract, there is no cash value. Consequently, term life insurance policies are less expensive than permanent life insurance policies.

Whole, or Permanent, Life Insurance

Whole, or permanent, life insurance protects the policyholder throughout the insured person’s lifetime. As long as the policyholder pays the premiums, this type of life insurance policy includes a cash value component that lasts during the insured’s life. It also provides several financial benefits, such as immediate death benefits from the date of signing.

How Much Life Insurance Do I Need?

Life insurance constitutes one of the most important financial purchases a person can make. A thorough understanding of your current financial status and the funds required to meet the needs of beneficiaries will dictate the type of insurance needed. 

Factors That Determine How Much Life Insurance You Need

Thorough research into the estimated cost of maintaining beneficiaries after the insured’s death can help a policyholder determine the extent of coverage required. Future inflation considerations also play a role in the decision-making process.

In the future, marriage, divorce, major purchases, or the birth of a child may require you to reevaluate your life insurance policy. You may need to update the policy’s stated beneficiaries, increase or decrease coverage, or both.

How Much Does Life Insurance Cost?

The cost of life insurance depends on the desired coverage level and risk factors associated with the insured. Age, health, and lifestyle determine the amount of monthly premiums. People who engage in risky activities, such as smoking or skydiving, often pay higher premiums for their coverage. 

Healthy individuals pay smaller premiums because of the low risk of premature death. Younger policyholders who insure themselves, as well as women policyholders, tend to pay lower premiums.

Cost of Whole Life Insurance

A whole life insurance policy offers guaranteed payouts, potential cash value, and fixed premiums but comes at a higher cost than term insurance.

For example, if a policyholder took out a $500,000 whole life insurance policy, the premiums would cost about $3,750 a year. On the other hand, a policyholder with a $500,000, 30-year term life policy would make premium payments amounting to about $300 a year. Of course, a whole life policyholder can sometimes draw upon the policy’s value in an emergency.

Cost of Term Life Insurance

Term life insurance is less expensive than whole life insurance because it holds no cash value and only lasts 10, 20, or 30 years. However, a term life policy allows you to invest the money you would have otherwise used to pay the premiums for a whole life policy. 

For example, a 30-year-old male with $500,000 whole life insurance would pay $4,015 in annual premiums. In comparison, if he applied for a 20-year term life insurance policy, he would only pay $228 in premiums per year.  

What Riders Can I Add to My Life Insurance Policy?

Policyholders can tack life insurance riders onto their life insurance policies for an additional cost. By purchasing riders, they can customize their insurance policy to meet their specific needs.

Accidental Death Rider

An accidental death rider provides additional payments to beneficiaries in the event of the insured’s unexpected death. This rider presents a good option for insured individuals who work in life-threatening or hazardous conditions.

Waiver of Premium Rider

A waiver of premium rider exempts self-insured individuals from paying premiums if they are seriously injured, critically ill, or disabled. It is an excellent option for policyholders on a tight budget, who might find it challenging to make premium payments if disaster strikes.

Accelerated Death Benefit Rider

Accelerated death benefit riders allow a policyholder to receive a portion of the death benefit in advance if the insured is diagnosed with an incurable, fatal illness. Accelerated death benefit riders enable self-insured individuals with less than one year of expected survival to use the cash advances for medical treatments.

Family Income Benefit Rider

This type of rider provides the beneficiary with monthly installments equal to the insured’s monthly income. This rider mainly benefits families with a sole breadwinner.

Child Term Rider

A child term rider pays a small death benefit if the policyholder’s child dies. A child term rider can help pay for funeral expenses and has a different purpose from that of separate child insurance policies.  

Final Thoughts on Life Insurance

After you pass on, life insurance provides financial support to your loved ones. It serves as a critical income replacement plan and helps alleviate your family’s financial distress. While age is often a factor in the decision to purchase life insurance, anyone with a spouse or children should look into an affordable life insurance policy to prepare for the future.