How Life Insurance Works

If you are considering purchasing life insurance, it is essential that you first learn how it works.  Life insurance is a contract between an insurer and a policyholder. The insurer promises to pay a beneficiary, such as a spouse or child, a designated amount of money when the insured person dies or, sometimes, becomes terminally ill.  

Life insurance companies make money by charging a bit more money during payments than they eventually must pay out over the long haul.  Life insurance can still be useful for policyholders, however, because it provides the peace of mind that no financial difficulties will arise as the result of the death of the insured person.

While the policyholder and the insured person are often the same, this is not necessarily the case.  If a man purchases life insurance for himself, he is both the policyholder and the insured person.  If a wife takes out insurance on her husband’s life, she is the policyholder, while he is the insured person.  

The policy owner is always responsible for life insurance payments.  A life insurance contract's face amount is the amount to be paid when the insured person turns a certain age or dies.  Although this face amount is usually slightly different than the actual benefits paid at death.

Term life insurance and permanent life insurance are the two primary kinds of life insurance.  Term life insurance is the "pure" type of life insurance, because it buys protection versus death and only death.  Term life insurance provides insurance for a certain number of years.  

Face amount, premium and length of coverage are the only factors that go into term life insurance.  Different combinations of these factors are sold by insurance companies.  

For example, a company may sell a policy in which the face amount either remains the same or declines.  The most common type of term life insurance is a Level Term policy.  

A Level Term policy has a constant premium for any time longer than a year, usually coming in five-year increments.  These policies are great for long-term planning and often contain an option to renew at the end of the contract.

Permanent life insurance remains intact until the policy pays out.  The only exception is if the policyholder fails to pay a premium or the insurer can prove fraud.  Whole life coverage, universal life coverage, limited pay and endowment are the four types of permanent life insurance.  

Whole life coverage provides guaranteed death benefits and asks for fixed annual premiums.  The major disadvantage of whole life insurance is that the rate of return is thought to be low when compared to other savings options.  

Universal life coverage offers greater flexibility with the payment of premiums and the cash value of the policy can grow.  It was invented to address the disadvantages of whole life insurance.

Limited pay life insurance calls for premium payments over a specified period of time, as opposed to over the life of the contract.  In an endowment policy, the cash value inside the policy matches the face amount of the policy at a specified age.

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