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What Is Life Insurance & How Does It Work?

By Janet Siroto · February 08, 2022 · 13 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is Life Insurance & How Does It Work?

Life insurance is a type of insurance policy that can provide the policyholder with something almost priceless: the reassurance that loved ones will have the financial support they need after the insured person passes away. More technically, it is a contract between the policyholder and the company providing the insurance coverage.

Whichever way you define it, it’s an important tool that can protect those who depend upon you most if you weren’t here to financially care for them.

Let’s take a closer look at what it’s all about and how it can help give your loved ones a financial safety net…and give you peace of mind.

What Is Life Insurance?

Let’s give you an overview of this important product:

•   Life insurance is a kind of a contract between a policyholder and the company issuing the insurance. Specifically, that policy guarantees that the beneficiaries who are named will receive, upon the death of the insured, a sum of money known as a death benefit.

•   For this kind of coverage, the policyholder pays premiums during their lifetime. They must also disclose details like their health status and some facets of their lifestyle to be insured.

•   Life insurance comes in two main varieties: term insurance, which covers you for a specific time period (or term), and permanent insurance, which covers you for however long you live, even if that’s 110!

Life insurance comes in many different forms and with an array of features, but at its core, it can be thought of as a way of making sure that your loved ones have a financial cushion when you aren’t here. Consider these scenarios:

•   Let’s say you have a non-working spouse: Life insurance will mean they are covered so housing, food, and other expenses are provided for.

•   Perhaps you have toddlers and want to know that, no matter what, their college tuition will be paid.

•   Maybe you have a relative who can’t live independently and you will sleep better at night knowing their care will be taken care of if you weren’t here.

We’ll review the options and specifics in more detail so you have all the info you need to pick the right policy for you. Ready? Here we go!

How Life Insurance Works

Let’s define some of the terms you are likely to hear used when you’re shopping for life insurance. Here’s what they mean and how they function to give you the coverage you’re hoping for:

•   Death Benefit: It’s a scary term, we hear you! But it’s the crux of life insurance policies. This is the lump sum payment that will be paid out at the time of your death to your beneficiaries if you die while covered by a life insurance policy. It can go a long way towards keeping them in good financial shape. Btw, a death benefit is usually not subject to the usual income tax.

•   Beneficiaries: These are the people who receive the death benefit from your life insurance policy. You can name one or more people who you want to be covered. (You can also name trusts and charities.) Beneficiaries usually have plenty of flexibility in how to use the funds. Depending upon the specifics of the financial situation and of policy payout, someone might choose to pay off a mortgage loan, for example, or make monthly payments to stay current.

•   Premium: This is the monthly or yearly payment you make to the life insurance company to pay for your coverage and keep your policy in effect.

•   Cash Value: Permanent life insurance policies have a cash value savings component that grows over time and can be used or borrowed against.

Types of Life Insurance and How They Work

Now, let’s take a look at some of the main types of life insurance you might be interested in: term life versus whole life.

Term Life

As the name suggests, this insurance covers you for a specific term or length of time (think 10, 20, or 30 years, though other lengths are often available). This works well for people who want to know that, say, if anything were to happen to them, their non-working spouse would be able to pay the mortgage for the remaining term. Or if you have children and you want to be sure their educational costs are taken care of if you were to die. Typically, term life insurance is more affordable than permanent life insurance. Worth noting:

•   Regular payments must be made to keep the policy active.

•   Payments on term life insurance policies are typically fixed.

•   If the term ends and you are still alive, that’s great! But you probably don’t get any refund of premium payments.

Permanent Life

This kind of life insurance covers you for your entire life. Whenever you die, your beneficiaries will receive their lump-sum death benefit. What’s more, these policies have a cash value; that is, some of your payments go into a savings vehicle on a tax-deferred basis that you can then tap or borrow against. Because of this extended coverage and the savings function, permanent life insurance is the costlier option, with the price often ranging from five to 15 times that of term life insurance. Permanent life insurance comes in an array of options. Let’s spell out a couple of common ones:

•   Whole Life: These life insurance policies provide a death benefit as well as the cash-value account. The latter may have a guaranteed rate of return, and as it grows, there may be dividends paid that can be put towards your premium payments or reinvested in the cash-value account.

•   Universal Life: This kind of policy gives you more options than whole life. For instance, you can possibly alter your premium payments, and the cash value will accrue in different ways. Its growth might be tied to an indexed fund like the S&P 500; you’ll hear these life insurance policies referred to as an indexed universal life policy. Or you might prefer what is known as a variable universal life policy. These usually have varied investment accounts that you can manage as you like.

Guaranteed Acceptance or Simplified Issue Life Insurance

These are policies that allow the applicant to avoid the medical examination that is usually required for life insurance. (These are brief exams that often involve a blood draw and urine sample, to chart factors like cholesterol that might influence the cost of your policy.) These forms of insurance can be good for people who don’t like doctor’s appointments, who fear learning what these tests might reveal, and also who want to considerably shorten the time it can take for approval of a policy with what’s known as medical underwriting, which can equal a couple of months.

In Guaranteed Acceptance life insurance, as the name implies, you can’t be turned down; your medical status isn’t an issue. However, you will probably be offered a small death benefit (say, $25,000) and rates will be higher than with some other forms of life insurance.

With Simplified Issue life insurance, the applicant may only have to answer a few questions about their health, no exam required. With these kinds of policies, however, the full death benefit may not be paid unless the policy has been held for two years; if the policyholder dies before then, a refund of premiums may be paid out.

Type of insurance

Period of Coverage

Benefits

Downsides

Term Life Insurance For a finite period of time (say, 5-40 years)

•   Affordable

•   Term is tailored to your needs

•   You might outlive the policy’s term

•   When the policy is over, your premium payments aren’t refunded

Permanent Life Insurance For your entire life; your beneficiaries will definitely receive a payment

•   Peace of mind that loved ones are covered

•   Cash value savings account

•   Expensive

Guaranteed- or Simplified-Issue Life Insurance A permanent policy that ensures a small benefit when you die

•   No medical exam needed

•   Easy to apply for

•   Quicker approval

•   Lower coverage amount

•   Expensive

•   Death benefit may not be paid if policyholder dies within a few years of getting the insurance

Which Type of Life Insurance Is Right for Me?

So, now, how do you know what type of policy is best for you? Here’s some food for thought. People often choose term life insurance for one or more of these reasons:

•   Finite timing: They expect to have saved up enough money or paid off debts by the time this policy expires and would therefore not need to have their income replaced. Or perhaps they believe their beneficiaries will be financially independent by the time the policy expires.

•   Affordability: The policy is more affordable and, therefore, easier to fit within their budget.

Whole life policies typically have premiums that are up to 15 times the cost of term life, and some people may prefer to purchase term life — and then personally invest the difference between a term life premium and a whole life one.

That said, there are plenty of people who decide permanent life insurance is right for them. Here are some typical reasons:

•   Long-lasting: This type of insurance is designed to be in force throughout the policy holder’s life, which provides a complete sense of security.

•   Cash component: This insurance type has a cash value component, as well, which serves as a savings vehicle. The policy holder can borrow against the value at a predetermined interest rate.

•   Possibility of “cashing out”: Some people may like having the ability to surrender their whole life policy during their lifetime and receive the cash value of it. Doing so, however, can have tax implications that can be discussed with a tax professional.

How Much Life Insurance Coverage Do You Need?

Everyone’s situation is unique when it comes to getting life insurance. You may have more kids than, say, your brother. He may have a bigger mortgage. One of you may be more concerned about eldercare costs for your parents down the road. There is no one number that says how much coverage is right for either one of you.

But there are helpful formulas that can help you figure out a sensible amount of coverage. One popular option is the DIME formula. The acronym stands for Debts, Income, Mortgage, and Education. Here’s how to use this formula.

Debts

Gather your debt information, from car loans to personal loans, and from student loans to credit card balances. Forecast out for the number of years you want coverage for. In other words, add up everything that’s owed outside of mortgages.

Income

Take the household’s annual income and multiply it by ten (if you are contemplating a 10-year term, that is). This will provide a ballpark estimate of what it would take to replace lost income during that period of time.

If the life insurance policy would be needed to provide financial support for more than ten years (perhaps because there are young children in the household), use a higher multiplier.

Mortgage

Home loans are usually the largest debt of a household, and often have the longest term. As part of calculating the amount of life insurance to take out, include the payoff on mortgages.

Doing so can help to prevent loved ones from taking on the burden of the house payment expenses and/or from potentially being foreclosed upon.

Education

If there are outstanding student loans, they can be incorporated into the life insurance amount. Also consider children who might have future tuition expenses at college, along with their housing costs, textbooks, and so forth.

When adding up debts, income, mortgage, and education (DIME), what is the total dollar amount? This can be a benchmark for the coverage amount of a life insurance policy. If you have any assets, such as a savings account, you can subtract that from the total dollar amount to get a more accurate picture of the possible financial need.

How Much Does Life Insurance Cost?

Life insurance costs will vary tremendously since each person has their own special needs. You might want $300,000 in term life insurance for 20 years and pay one premium. Or maybe you’d prefer $3 million in permanent insurance. Of course, there will be a big difference in those premium payments!

Let’s look at a few scenarios so you have a ballpark idea of costs, but the best way to get prices that reflect your situation is by working with an agent or using a simple online calculator:

•   For a 20-year term policy : For $250,000 of coverage, a 30-year old female would pay $168 a year; a male would pay $192. For $500,000 of coverage, the same woman would pay $252, while a man would pay $300. If we scoot the benefit up to $1 million, the annual cost would be $348 for a woman and $480 for a man.

•   For a 30-year term life policy : For $250,000 of coverage, a 30-year-old female would pay $240 a year; a male would pay $276. For $500,00 of coverage, the numbers would be $336 and $444; for $1 million, the annual premium would be $588 for a woman and $780 for a man.

•   For permanent life insurance, the costs will be higher. One recent quote saw that $500,000 of coverage in a 40-year term policy would cost approximately $700 a year for a 30-year-old man. A $500,000 whole life policy would cost $4,060 per year, or almost 6 times more.

Of course, there are huge variations in the price of policies. As you see from the above numbers, if you get term life insurance for a longer period, you’ll pay more than for a shorter period. Also, the more coverage you buy, the higher the premium.

Now, let’s look at a few of the factors that influence the cost:

•   Age and gender: The older you are, the more expensive a life insurance policy will be, as health issues tend to crop up. Also, since women have a longer life expectancy than men, their rates are usually lower.

•   Your health: Those in excellent health will pay less than those who, say, have high cholesterol or blood pressure and a family history of cancer.

•   Lifestyle: This includes everything from whether or not you smoke, have a history of substance abuse, and have a clean driving record, to factors like whether your job or hobbies are deemed high-risk (for example, flying airplanes, scuba diving).

What is the Process of Buying Life Insurance?

Here’s what to expect from the insurance buying process:

•   Once you decide what kind of policy you want and have an idea of the coverage amount, it’s a good idea to explore your options and get some free quotes. You can talk to a life insurance agent or do your own research online; there are many tools that put the information you want just a click or two away.

•   Expect to be asked questions about your health, your family history, your hobbies, and your lifestyle as you shop and apply. This is an important step in figuring out your risk factors and life expectancy, which is used to set your rates.

•   Once you’ve found a policy and insurer that you like, fill out that carrier’s application as completely as possible. The application will be reviewed as part of what’s called the underwriting process. The carrier will look at the application through the lens of potential risk. In other words, they will review the application to determine how risky it would be to issue a life insurance policy to that particular applicant — and then price it accordingly.

•   For many policies, a medical exam is part of the process. Applicants are asked and should honestly answer about family health history, personal health and lifestyle, prescriptions being taken, surgeries performed, and so forth. A physical exam is often done. This can include a height and weight check, the taking of blood pressure, as well as urine and blood samples.

•   After that, you have completed your application. For policies that involve a medical exam, it can take 6 to 8 weeks to be informed of your approval.

Choosing a Beneficiary

Once your application is approved, an important step will be choosing your beneficiary or beneficiaries. This is the person or people who would receive the death benefit if you pass away while covered by a life insurance policy. A few points to consider:

•   You can name more than one person and determine the percentage of the death benefit each would receive.

•   You can name contingent beneficiaries in case a beneficiary dies before the policyholder does.

•   You don’t have to name a person as a beneficiary. You can also work with a lawyer to set up a trust and have the death benefit used as you determine.

•   It’s wise to review and update your beneficiaries regularly once you have a life insurance policy. A new baby, a divorce, and other events can trigger you to alter your selections (changes can be made at any point).

Can a Beneficiary Make a Claim?

No one wants to think about death, but it’s a fact of life. It’s also the event that a life insurance policy is inextricably linked to; the death benefit is there to support loved ones after the policyholder passes away. So let’s spell out what would actually happen in this situation:

•   Notification of death: The insurer will probably pay claims quickly, usually within a month or in as little as a week, but paperwork must be filed and the beneficiary may have to inform them of the death. The issuer of the policy may not know otherwise.

•   Death certificate: The beneficiary must submit a certified copy of the death certificate, which the insurance company will keep.

•   Make sure you have satisfied all claim requirements: When actually submitting your claim, have all the supporting documentation attached. This can include a claim form and death certificate.

That’s it! Also, here’s a good thing to know: You don’t need a copy of the insurance policy to file a claim, just the name of the insurance company and the fact that you are a beneficiary.

Making Policy Changes

Life insurance often is a part of your life for a very long time, decades and decades. Sometimes, people will want to change some aspects, such as the amount of the death benefit or the company that is providing the policy. Let’s look at how that works:

•   Coverage amount: Let’s say you started with a $500,000 policy, but now, five years into it, want to double the coverage…Can you? The answer to this can vary by the insurance company. Some carriers provide flexibility in their policies that allow a policy holder to change the coverage amount. If considering a particular insurance company and this flexibility is important, ask that question before taking out the policy.

•   Switching providers: Consider changing the policy first. You may be able to save time and money by amending or adding to your current policy instead of replacing it. Also, there can be surrender charges that you need to pay if you give up a permanent policy so you can sign on for a new one elsewhere.

   What’s more, if you are switching policies after a number of years with one insurer, you are older now, and the rates will be higher. Swapping policies may not actually save you money. It’s often best to go through underwriting and get approved for the new policy first, see how the features and prices compare, and then decide whether or not to cancel the original policy and sign up for a new one.

•   New policy waiting periods: If you are thinking of forging ahead with a change, note the waiting period. Most new policies have a waiting period before certain kinds of death benefits become effective. Consider this before replacing your old policy.

Life Insurance Riders

One way to make a change to your life insurance policy involves riders; think of these as add-ons that can help tailor your coverage to your evolving needs. Riders deliver additional benefits; yes, you’ll pay extra, but the amount is usually low because not much underwriting is required.

For instance, if you are the sole provider for your family, you might want to add an Accidental Death Rider, which would increase the amount of the death benefit if a fatal accident occurred. Or maybe you want to explore a Long-Term Care Rider, which would help pay expenses were you in need of nursing home or in-home care. Talk with an agent or explore options online to learn more.

The Takeaway

Life insurance can be a challenging topic to dig into. But take heart: Part of what makes it seem complex is that it’s designed to meet the needs of so many very different people. Whatever the specifics of your situation and lifestyle, there is probably that can give you peace of mind.

By acquainting yourself with the basic concepts, terms, and processes, you’re now ready to go out and find a life insurance policy that will let you know your loved ones will be well-provided for if a worst-case scenario occurred (though we sure hope it doesn’t!).

Making Life Insurance Easier: SoFi and Ladder

SoFi and Ladder have partnered to make affordable term life insurance quotes quick and easy to get – nearly instantly, in fact. Ladder offers competitive rates for policies ranging from $100,000 to $8 million, and they don’t charge any commission fees.

The coverage amount and associated premiums can be conveniently adjusted with no hassle. It’s just a couple of clicks. And, these term insurance policies have payments that will never increase throughout the term. Plus, qualifying applicants don’t need to take a medical exam.

Check out the fast, easy, and reliable term life insurance process with SoFi, powered by Ladder.


Ladder policies are issued in New York by Allianz Life Insurance Company of New York, New York, NY (Policy form # MN-26) and in all other states and DC by Allianz Life Insurance Company of North America, Minneapolis, MN (Policy form # ICC20P-AZ100 and # P-AZ100). Only Allianz Life Insurance Company of New York is authorized to offer life insurance in the state of New York. Coverage and pricing is subject to eligibility and underwriting criteria. SoFi Agency and its affiliates do not guarantee the services of any insurance company. The California license number for SoFi Agency is 0L13077 and for Ladder is OK22568. Ladder, SoFi and SoFi Agency are separate, independent entities and are not responsible for the financial condition, business, or legal obligations of the other. Social Finance, Inc. (SoFi) and Social Finance Life Insurance Agency, LLC (SoFi Agency) do not issue, underwrite insurance or pay claims under LadderLifeTM policies. SoFi is compensated by Ladder for each issued term life policy. SoFi offers customers the opportunity to reach Ladder Insurance Services, LLC to obtain information about estate planning documents such as wills. Social Finance, Inc. (“SoFi”) will be paid a marketing fee by Ladder when customers make a purchase through this link. All services from Ladder Insurance Services, LLC are their own. Once you reach Ladder, SoFi is not involved and has no control over the products or services involved. The Ladder service is limited to documents and does not provide legal advice. Individual circumstances are unique and using documents provided is not a substitute for obtaining legal advice.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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