How Does Life Insurance Work?

If you’re considering purchasing life insurance, you’re probably doing so to protect the people you love in the event something happens to you.   

The primary purpose of life insurance policies is to protect loved ones and beneficiaries in the event of the insured’s death. But the death benefit that life insurance is known for isn’t the only way a policy can help you and your family. Depending on the type of life insurance you get, it can also provide benefits that you can use throughout your life—becoming an asset to help you reach many of your goals. That makes life insurance a critical part of a financial plan. 

When you start researching life insurance, it can be difficult to know where to begin. Here, we explore the basics: what life insurance is, different types of policies that exist and how it works. 

Life Insurance Basics 

When researching and reviewing policies, you’ll likely come across some common concepts related to life insurance. Here’s a quick rundown of terms you’ll need to know:  

• Policyowner (or policyholder): This is the person who owns the policy—typically the person who pays for the policy and is insured by it. You can, however, own a policy for someone else (like your kids).  

• Underwriting: When you apply for a policy, an underwriter will review your application to make sure that the company is able to insure you and keep the agreement laid out in your policy.  

• Beneficiary: In setting up a policy, you’ll need to designate a beneficiary(s), who is the person (or people) that would receive your death benefit. 

• Death benefit: The death benefit is the cash amount that will be paid out if you die. When selecting your death benefit amount, you usually consider your income, monthly expenses and dependent needs.  

• Premiums: Premiums are the regular payments you make to keep your policy in place. Typically, these are paid monthly, but some policies allow payment less frequently (like 1 – 4 times per year).  

• Dividends: Because an insurance company cannot forecast with absolute certainty how it will perform in a certain year, it makes predictions and assumptions when pricing policies. If a company performs better than its assumptions, it could find itself with extra funds at the end of the year. The company could choose to return some of those funds to policyowners in the form of a dividend. Dividends are only paid by mutual companies, which are companies that are owned or exist for the benefit of their policyowners, and are not guaranteed. 

• Cash value: If you have a permanent life insurance policy, it’ll grow cash value over time. You could choose to use any dividends received to buy additional insurance (which can help you grow cash value and your coverage amount more quickly). Once you have enough cash value, you can access it as a source of funds by borrowing against it or by surrendering some or all of your policy. While accessing your cash value will reduce your death benefit, this can become a great source of funding throughout your life. 

What is life insurance?  

Life insurance is a contract between you and an insurance company. Under the contract, you will owe regular payments (known as premium payments) in exchange for coverage and, with some policies, additional benefits. If you die while covered by a life insurance policy, the life insurance company will pay a death benefit in either a lump sum or installments to your beneficiary or beneficiaries—usually family members.   

In addition to paying out the death benefit in the event of your death, certain policies  may also accumulate cash value that can grow on a tax-deferred basis. You’ll be able to access this cash value at any time for any purpose while you’re alive, although it will reduce your death benefit to do so. To be clear, it takes several years of paying premiums for cash value to grow to an amount you’d want to use. 

Types of life insurance and how they work  

As long as you regularly pay your premium, you’ll maintain your coverage. However, exactly how your life insurance works depends on the type of policy you have. Let’s look at the differences below.  

Term life insurance 

Term life insurance is a policy that covers you for a preset period of time (the term). If you die during that time frame, then your beneficiaries will receive your death benefit. If your term ends before you die, there is no payout for your beneficiaries. (You may be able to renew some policies, while some will simply end at the end of your term.) 

There are two types of term life insurance: Annually renewable term life insurance and level term life insurance.  

Annually renewable term life insurance 

Annually renewable term life insurance typically offers the most death benefit at the lowest initial cost. However, the amount you pay for annually renewable term life insurance will increase in the future and can eventually become quite expensive. Annually renewable term typically lasts until you reach a certain age, like 80. However, most people cancel their policy before they actually reach that age.  

Level term life insurance 

Level term life insurance refers to a life insurance policy that lasts for a certain number of years. It is called “level” because your premium payments remain the same over the entire length of the term. That means you’ll initially pay higher premiums than you would with an annually renewable policy, but you’ll pay less in later years.  

The exact length of the term will depend on the specifics of your policy. Five-, 10- and 20-year terms are all common.  

Permanent life insurance 

Whereas term life insurance only covers you for a certain period of time, permanent life insurance covers you for life. So long as you pay your premium on time, your beneficiaries will receive the death benefit—no matter when you die.   

Compared to term life, permanent life insurance is more expensive for the same amount of death benefit. That’s because the policy will pay a death benefit and accumulate cash value that you can use throughout your entire life. Some permanent life insurance policies may also pay a dividend, which you can choose to receive (and spend) or reinvest into your policy to help it grow even more over time.  

There are three main types of permanent life insurance: whole, variable and universal.  

Whole life insurance 

Whole life insurance offers a number of guarantees including the amount you pay for premiums and the death benefit. In addition, because cash value in a whole life insurance policy is guaranteed to grow in value, it can play a unique role in your financial plan as an additional source of funding during your working years. In retirement, it can help you weather down markets and be more tax efficient.  

Universal life insurance 

Universal life insurance offers some additional flexibility when it comes to the amount of premium you pay each year as well as flexibility with the policy’s death benefit. Over time, you can choose to keep a death benefit that grows or level it off. Doing so has unique benefits depending on the desired policy performance. A financial advisor can help you with this.  

Variable life insurance 

Variable life insurance is generally a form of universal life in that the premiums and death benefit are flexible. The primary difference lies in the cash value. With a variable life policy, you have the option of placing your cash value into various sub-accounts, which can be tied to market performance. When the market performs well, your cash value can grow faster. But if the market performs poorly, your policy may even lose value. *   

How much does life insurance cost? 

There are a variety of factors that help determine the cost of a policy—some are based on choices you make and others are out of your control.  

Type of policy 

Term life insurance policies are typically less expensive than permanent life insurance policies because they only cover you for a set period of time, whereas permanent life insurance policies cover you for your entire life.  

Age and health 

Prices of policies are generally based on your probability of death. If you have a pre-existing health condition or if you are older, your policy will be more expensive because the probability of you dying is higher. When you’re younger and healthier, it’s less likely that you’d die, so you’re usually able to get a less expensive policy.  

Gender 

According to 2021 statistics from the CDC, women outlive men by almost 6 years. Life expectancy is an important consideration in pricing, so if you’re a woman, your coverage may be cheaper than a man’s. 

Hobbies and work 

How much risk you take on in your personal and professional life can also impact what you’d pay for life insurance. People with high-risk jobs or high-risk hobbies may find themselves paying a bit more—if they even can get coverage. 

Death benefit amount 

The higher the death benefit you select, the more you’ll pay for your policy.  

Term length 

Generally speaking, the longer a policy covers you, the more it will cost over time. With a longer policy, you’re paying for more years that a company will insure you—including years when you’ll be older and more expensive to insure.  

Life insurance beneficiaries 

When enrolling in a policy, you’ll designate who the beneficiaries of the policy are—meaning who will receive the death benefit if you die. Often, a spouse is the named beneficiary, but beneficiaries can also include elderly parents, other close family members, children or charitable institutions. You can also designate a contingent beneficiary, which would determine who the money would go to if your primary beneficiary dies.  

If your kids are minors, you can name them as beneficiaries, but the money will be managed by the child’s legal guardian until they reach legal age. If you have a unique situation that impacts who you’d like to leave your money to, establishing a trust that details your wishes may be a good move.  

How do life insurance policies pay out?  

After the death of the insured, the beneficiary needs to notify the life insurance company of the death and then submit the paperwork required (such as a copy of the death certificate) to initiate a claim. Once the claim has been processed, the insurer will get in touch to go over the payout and options for how you’d like to receive the money. How long it takes to receive the death benefit can vary greatly, depending on how quickly all the correct paperwork is submitted, but expect anywhere from a week to a month or more for payout. 

What does life insurance cover? 

Paying your premiums guarantees that you’ll receive a death benefit as long as a policy is in place. There may, however, be a few exceptions. Regardless, the primary purpose of life insurance policies is to protect loved ones and beneficiaries in the event of the insured’s death. 

What does life insurance usually not cover? 

Your life insurance policy guarantees that your beneficiaries receive a death benefit; however, there are some rare exceptions in which a death benefit may not be paid out. You may not receive a death benefit in the event of:  

• Death while committing a crime generally within the first two years of owning a policy  

• Death by suicide generally within the first year or two of owning a policy 

• Misrepresentation of information on a life insurance form (like not disclosing drinking/drug use or a condition as part of family medical history)  

How much life insurance should you purchase?  

You may have heard general rules that say you should get enough life insurance to match your salary for 10 years, but how much life insurance you should purchase really depends on your needs. In addition to the immediate costs your family would have to cover without you, do you want to cover future goals like paying for your kids’ college or their future weddings? Are you trying to leave a legacy behind for extended family? This life insurance calculator can help you get started determining how much life insurance makes sense for your situation. 

How to find the right life insurance for your needs 

The death benefit of life insurance is critical to your financial plan. Not only does it help protect your family financially, but with permanent life insurance, you’re getting additional benefits while you’re alive that can help you with other financial goals throughout your life, from helping pay for a  to retirement. A Northwestern Mutual advisor can help you look at the big picture to select a life insurance policy that works well with other elements of your financial plan. They’ll assess what you’ve got, walk you through the many life insurance options Northwestern Mutual has to offer and make recommendations to help you reach your financial goals.  

*Depending on the performance of the underlying investment options, the accumulated value available for loans and withdrawals may be more or less than the total premiums paid. 

Dividends are not guaranteed. Utilizing the cash value through policy loans, surrenders, or cash withdrawals will reduce the death benefit and may necessitate greater outlay than anticipated and/or result in an unexpected taxable event.