Life Insurance: What It Is, How It Works, and How To Buy a Policy

Amy Fontinelle has more than 15 years of experience covering personal finance, corporate finance and investing.

Anthony Battle is a CERTIFIED FINANCIAL PLANNER™ professional. He earned the Chartered Financial Consultant® designation for advanced financial planning, the Chartered Life Underwriter® designation for advanced insurance specialization, the Accredited Financial Counselor® for Financial Counseling and both the Retirement Income Certified Professional®, and Certified Retirement Counselor designations for advance retirement planning.

Rukshani Lye is an IFCN-certified editor with expertise in fact-checking and source verification across business, finance, education, and real estate. She has over a decade of experience in business management within corporate and nonprofit sectors.

Life Insurance Basics

1. How to Get Life Insurance
2. Life Insurance Guide to Policies & Companies

Term Life Insurance

1. Term Life Insurance
2. Explaining Term Insurance
3. Group Term Life Insurance
4. Best Term Life Insurance

Whole Life Insurance

1. Permanent Life Insurance
2. Cash Value Life Insurance
3. Whole Life Insurance
4. Best Whole Life Insurance
5. Universal Life Insurance
6. Variable Universal Life Insurance (VUL)
7. Indexed Universal Life Insurance

Other Types of Life Insurance

1. Paid-Up Additional Insurance Definition
2. Adjustable Life Insurance
3. Guaranteed Issue Life Insurance
4. Final Expense Insurance
5. Burial Insurance

1. Let Riders Drive Your Coverage
2. Accelerated Benefit Rider
3. Dread Disease Rider
4. Family Income Rider
5. Return-of-Premium Rider
6. Waiver of Premium Rider
7. Long-Term Care Rider

Raising Money From Your Life Insurance

1. Borrowing From Your Policy
2. Cashing in Your Policy
3. Cash Surrender Value
4. Cash Value vs. Surrender Value
5. Life Insurance vs. IRA for Retirement Saving
6. How Policy Payouts Work

Taxation on Life Insurance Policies

1. Taxes on Life Insurance Premiums
2. Life Insurance Policy Loan: Tax Implications
3. What Is a Tax-Free 1035 Exchange?
4. Is Life Insurance Taxable?

What Is Life Insurance?

Understanding how life insurance works and how to shop for a policy can help you find the best coverage to meet your family's needs.

Life insurance is a contract between an insurance company and a policy owner in which the insurer guarantees to pay a sum of money to one or more named beneficiaries when the insured person dies. In exchange, the policyholder pays premiums to the insurer during their lifetime. The best life insurance companies have good financial strength, a low number of customer complaints, high customer satisfaction, several policy types available, optional riders, and easy application processes.

Key Takeaways

• Life insurance is a legally binding contract that promises a death benefit to the policy owner when the insured person dies.
  
• The policyholder must pay a single premium upfront or pay regular premiums over time for the life insurance policy to remain in force,.
• When the insured person dies, the policy’s named beneficiaries will receive the policy’s death benefit.
• Term life insurance policies expire after a certain number of years. Permanent life insurance policies remain active until the insured person dies, stops paying premiums, or surrenders the policy.
• A life insurance policy is only as good as the financial strength of the life insurance company that issues it.

Types of Life Insurance

Many different types of life insurance are available to meet all sorts of consumer needs and preferences. Depending on the short- or long-term needs of the person to be insured (or their family members), the choice of whether to select temporary or permanent life insurance will be a major consideration.

Term life insurance

Term life insurance is designed to last a certain number of years, then end. You choose the term when you take out the policy. Common terms are 10, 20, or 30 years. The best term life insurance policies balance affordability with long-term financial strength.

Level term, the most common type of term insurance currently being sold, pays the same amount of death benefit throughout the policy's term. Other types of term insurance include:

• Decreasing term life insurance is renewable term life insurance with coverage that decreases over the life of the policy at a predetermined rate.
• Convertible term life insurance allows policyholders to convert a term policy to permanent insurance.
• Renewable term life insurance provides a quote for the year the policy is purchased. Premiums increase annually at renewal. These plans usually provide the least expensive term insurance in the first year.
• Term that lasts until a specific age, such as term-to-65.

Many term life insurance policies allow you to renew the contract on an annual basis once the original term ends. However, since the renewal premiums are based on your current age, the cost can rise steeply each year. A better solution for permanent coverage is to convert your term life insurance policy into a permanent policy. This is not an option on all term life policies, so look for a convertible term policy if this feature is important to you.

Permanent Life Insurance

Permanent life insurance is more expensive than term, but it stays in force throughout the insured’s entire life unless the policyholder stops paying the premiums or surrenders the policy. Some policies allow for automatic premium loans when a premium payment is overdue.

• Whole life insurance is one type of permanent life insurance where the premium and death benefit generally remain the same each year. It includes a cash value component, which is similar to a savings account. Cash-value life insurance allows the policyholder to use the cash value for many purposes, such as to take out loans or to pay policy premiums.
  
• Universal life (UL) insurance is another type of permanent life insurance with a cash value component that earns interest. Universal life features flexible premiums. Unlike term and whole life, premiums can be adjusted over time. UL also lets the policyowner choose between level death benefit or increasing death benefit options.
• Indexed universal life (IUL)is a type of universal life insurance that lets the policyholder earn a fixed or equity-indexed rate of return on the cash value component.
• Variable universal life (VUL)insurance allows the policyholder to invest the policy’s cash value in an available separate account. It also has flexible premiums and can be designed with a level or increasing death benefit.

Top-Rated Companies to Compare

When shopping for insurance, you might want to start with our list of the best life insurance companies, some of which are listed below.

Life Insurance Buying Guide

Step 1: Determine How Much You Need

Think about what expenses would need to be covered in the event of your death. Consider things such as mortgage, college tuition, credit cards, and other debts, not to mention funeral expenses. Also, income replacement is a major factor if your spouse or loved ones will need cash flow and are unable to provide it on their own.

There are helpful tools online to calculate the lump sum that can satisfy any potential expenses that would need to be covered.

Step 2: Prepare Your Application

Life insurance applications generally require personal and family medical history and beneficiary information. You may need to take a medical exam and will need to disclose any preexisting medical conditions, history of moving violations, DUIs, and any dangerous hobbies (such as auto racing or skydiving). The following are crucial elements of most life insurance applications:

• Age: This is the most important factor because life expectancy is the biggest determinant of risk for the insurance company.
• Gender: Because women statistically live longer, they generally pay lower rates than males of the same age.
• Smoking: A person who smokes is at risk for many health issues that could shorten life and increase risk-based premiums.
• Health: Medical exams for most policies include screening for health conditions such as heart disease, diabetes, and cancer, plus related medical metrics that can indicate health risks.
• Lifestyle: Dangerous occupations and hobbies can make premiums much more expensive.
• Family medical history: If there is evidence of major disease in your immediate family, your risk of developing certain conditions is much higher.
• Driving record: A history of moving violations or drunk driving can dramatically increase the cost of life insurance premiums.

Standard forms of identification will also be needed before a policy can be written, such as your Social Security card, driver's license, or U.S. passport.

Step 3: Compare Policy Quotes

Once you've assembled all of your necessary information, you can gather multiple life insurance quotes from different providers based on your research. Prices can differ markedly from company to company, so it's important to make the effort to find the best combination of policy, company rating, and premium cost. Because life insurance premiums are something you will likely pay monthly for decades, finding the policy that best fits your needs can save you an enormous amount of money.

Our lineup of the best life insurance companies can give you a jump start on your research. It lists the companies we've found to be the best for different types of needs, based on our research of nearly 100 carriers.

Benefits of Life Insurance

There are many benefits to having life insurance. Below are some of the most important features and protections offered by life insurance policies.

Most people use life insurance to provide money to beneficiaries who would suffer a financial hardship upon the insured’s death. However, for wealthy individuals, the tax advantages of life insurance, including the tax-deferred growth of cash value, tax-free dividends, and tax-free death benefits, can provide additional strategic opportunities.

Avoiding Taxes

The death benefit of a life insurance policy is usually tax-free. It may be subject to estate taxes, but that's why wealthy individuals sometimes buy permanent life insurance within a trust. The trust helps them avoid estate taxes and preserve the value of the estate for their heirs.

Tax avoidance is a law-abiding strategy for minimizing one’s tax liability and should not be confused with tax evasion, which is illegal.

Who Needs Life Insurance?

Life insurance provides financial support to surviving dependents or other beneficiaries after the death of an insured policyholder. Here are some examples of people who may need life insurance:

• Parents with minor children. If a parent dies, the loss of their income or caregiving skills could create a financial hardship. Life insurance can make sure the kids will have the financial resources they need until they can support themselves.
• Parents with special-needs adult children. For children who require lifelong care and who will never be self-sufficient, life insurance can make sure their needs will be met after their parents pass away. The death benefit can be used to fund a special needs trust that a fiduciary will manage for the adult child’s benefit.
• Adults who own property together. Married or not, if the death of one adult might mean that the other could no longer afford loan payments, upkeep, and taxes on the property, life insurance may be a good idea. One example would be an engaged couple who take out a joint mortgage to buy their first house.
• Seniors who want to leave money to adult children who provide their care. Many adult children sacrifice time at work to care for an elderly parent who needs help. This help may also include direct financial support. Life insurance can help reimburse the adult child’s costs when the parent passes away.
• Young adults whose parents incurred private student loan debt or cosigned a loan for them. Young adults without dependents rarely need life insurance, but if a parent will be on the hook for a child’s debt after their death, the child may want to carry enough life insurance to pay off that debt.
• Children or young adults who want to lock in low rates. The younger and healthier you are, the lower your insurance premiums. A 20-something adult might buy a policy even without having dependents if they expect to have them in the future.
• Stay-at-home spouses. Stay-at-home spouses should have life insurance as they contribute significant economic value based on the work they do in the home. According to Salary.com, the economic value of a stay-at-home parent would be equivalent to an annual salary of $184,820.
• Wealthy families who expect to owe estate taxes. Life insurance can provide funds to cover the taxes and keep the full value of the estate intact.
• Families who can’t afford burial and funeral expenses. A small life insurance policy can provide funds to honor a loved one’s passing.
• Businesses with key employees. If the death of a key employee, such as a CEO, would create a severe financial hardship for a firm, that business may have an insurable interest that will allow it to purchase a key person life insurance policy on that employee.
• Married pensioners. Instead of choosing between a pension payout that offers a spousal benefit and one that doesn’t, pensioners can choose to accept their full pension and use some of the money to buy life insurance to benefit their spouse. This strategy is called pension maximization.
• Those with preexisting medical conditions, such as cancer, diabetes, or smoking. Note, however, that some insurers may deny coverage for such individuals or charge very high rates.

Each policy is unique to the insured and insurer. It’s important to review your policy document to understand what risks your policy covers, how much it will pay your beneficiaries, and under what circumstances.

What to Do Before Buying Life Insurance

Research Policy Options and Company Reviews

Because life insurance policies are a major expense and commitment, it's critical to do proper due diligence to make sure the company you choose has a solid track record and financial strength. That stability matters, given that your heirs may not receive the death benefit until many decades into the future. Investopedia has evaluated scores of companies that offer all different types of insurance and rated the best in numerous categories.

Consider How Much Death Benefit You Need

Life insurance can be a prudent financial tool to hedge your bets and provide protection for your loved ones in case you die while the policy is in force. However, there are situations in which it makes less sense—such if you buy too much or insure people whose income doesn't need to be replaced. So it's important to consider several factors before making a decision.

What expenses couldn't be met if you died? If your spouse has a high income and you don't have any children, maybe it's not warranted. It is still essential to consider the impact of your potential death on a spouse and consider how much financial support they would need to grieve without worrying about returning to work before they’re ready. However, if both spouses' income is necessary to maintain a desired lifestyle or meet financial commitments, then both spouses may need separate life insurance coverage.

Know Why You're Buying Life Insurance

If you're buying a policy on another family member's life, it's important to ask: what are you trying to insure? Children and seniors really don't have any meaningful income to replace, but burial expenses may need to be covered in the event of their death. In addition, a parent may want to protect their child’s future insurability by purchasing a moderate-sized policy while they are young. Doing so allows that parent to ensure that their child has a head start towards protecting their financial future. Parents are typically only allowed to purchase life insurance for their children for up to 25% of the in-force policy on their own lives.

Could investing the money that would be paid in premiums for permanent insurance throughout a policy earn a better return over time elsewhere? As a hedge against uncertainty, consistent saving and investing—for example, self-insuring—might make more sense in some cases if a significant income doesn't need to be replaced or if the policy's investment returns on cash value are overly conservative.

How Life Insurance Works

A life insurance policy has two main components—a death benefit and a premium. Term life insurance has both components, while permanent and whole life insurance policies also have a cash value component.

Death Benefit

The death benefit or face value is the amount of money the insurance company guarantees to the beneficiaries identified in the policy when the insured dies. The insured might be a parent and the beneficiaries might be their children, for example. The insured will choose the desired face amount based on the beneficiaries’ estimated future needs. The insurance company will determine whether the purchaser has an insurable interest in the insured's life, The insurer will also decide whether the proposed insured qualifies for the coverage based on the company’s underwriting requirements related to age, health, and any hazardous activities in which the proposed insured participates.

Premium

Premiums are the money the policyholder pays for insurance. The insurer must pay the death benefit when the insured dies if the policyholder pays the premiums as required. Premiums are determined in part by how likely it is that the insurer will have to pay the policy’s death benefit based on the insured’s life expectancy. Factors that influence life expectancy include the insured’s age, gender, medical history, occupational hazards, and high-risk hobbies.

Part of the premium also goes toward the insurance company’s operating expenses. Premiums are higher on policies with larger death benefits, for individuals who are at higher risk, and on permanent policies that accumulate cash value.

Cash Value

The cash value of permanent life insurance serves two purposes. It is a savings account that the policyholder can use during the life of the insured, and the cash accumulates on a tax-deferred basis. Some policies have restrictions on withdrawals depending on how the money is to be used. For example, the policyholder might take out a loan against the policy’s cash value and would pay interest on the loan principal. The policyholder can also use the cash value to pay premiums or purchase additional insurance.

Cash value is a living benefit that remains with the insurance company when the insured dies. Any outstanding loans against the cash value will reduce the policy’s death benefit.

Good to Know

The policy owner and the insured are usually the same person, but sometimes they may be different. For example, a business might buy key person insurance on a crucial employee such as a CEO, or an insured might sell their own policy to a third party for cash in a life settlement.

Life Insurance Riders and Policy Changes

Many insurance companies offer policyholders the option to customize their policies to accommodate their needs. Riders are the most common way policyholders may modify or change their coverage. There are many riders, but availability depends on the provider. The policyholder will typically pay an additional premium for each rider or a fee to exercise the rider, though some policies include certain riders in their base premium.

• The accidental death benefit rider provides additional life insurance coverage in the event the insured’s death is accidental.
• The waiver of premium rider relieves the policyholder of making premium payments if the insured becomes disabled and unable to work.
• The disability income rider pays a monthly income if the policyholder becomes unable to work a certain period of time (usually several months) due to a serious illness or injury.
• Upon diagnosis of terminal illness, the accelerated death benefit rider allows the insured to collect a portion or all of the death benefit while still living.
• The long-term care rider is a type of accelerated death benefit that can be used to pay for nursing-home, assisted-living, or in-home care when the insured requires help with activities of daily living, such as bathing, eating, and using the toilet.
• A guaranteed insurability rider lets the policyholder buy additional insurance at a later date without a medical review.

Borrowing Money

Most permanent life insurance accumulates cash value that the policyholder can borrow against. Technically, you are borrowing money from the insurance company and using your cash value as collateral. Unlike with other types of loans, the policyholder’s credit score is not a factor. Repayment terms can be flexible, and the loan interest goes back into the policyholder’s cash value account. However, if you don't pay them back, policy loans can reduce your death benefit.

Funding Retirement

Policies with a cash value or investment component can provide a source of retirement income. This opportunity can come with high fees and a lower death benefit, so it may only be a good option for individuals who have maxed out other tax-advantaged savings and investment accounts. The pension maximization strategy described earlier is another way life insurance can fund retirement.

It’s prudent to reevaluate your life insurance needs annually or after significant life events, such as divorce, marriage, the birth or adoption of a child, or major purchases such as a house. You may need to update the policy’s beneficiaries, increase your coverage, or even reduce your coverage.

Qualifying for Life Insurance

Insurers evaluate each life insurance applicant on a case-by-case basis. With hundreds of insurers to choose from, almost anyone can find an affordable policy that at least partially meets their needs. In 2023 there were more than 900 life insurance and health companies in the United States, according to the Insurance Information Institute.

On top of that, many life insurance companies sell multiple types and sizes of policies. Some specialize in meeting specific needs, such as policies for people with chronic health conditions. There are also brokers who specialize in life insurance and know what different companies offer. Applicants can work with a broker free of charge to find the insurance they need. This means that almost anyone can get some type of life insurance policy if they look hard enough and are willing to pay a high enough price or accept a perhaps less-than-ideal death benefit.

Insurance is not just for the healthy and wealthy. Since the insurance industry is much broader than many consumers realize, getting life insurance may be possible and affordable even if previous applications have been denied or quotes have been unaffordable. According to industry research firm LIMRA, 51% of Americans had life insurance in 2024, with a fourth of those only carrying insurance purchased through their workplace.

In general, the younger and healthier you are, the easier it will be to qualify for life insurance, while the older and less healthy you are, the harder it will be. Certain lifestyle choices, such as using tobacco or engaging in risky hobbies such as skydiving, also make it harder to qualify or lead to higher rates.

How Does Life Insurance Work?

Life insurance works by providing a death benefit in exchange for paying premiums. One popular type of life insurance—term life insurance—only lasts for a set amount of time, such as 10 or 20 years. Permanent life insurance also features a death benefit but lasts for the life of the policyholder as long as premiums are paid.

Who Needs Life Insurance?

You need life insurance if you need to provide security for a spouse, children, or other family members in the event of your death. Life insurance death benefits can help beneficiaries pay off a mortgage, cover college tuition, or help fund retirement. Permanent life insurance also features a cash value component that builds over time.

What Are the Benefits of Life Insurance?

• Payouts are tax-free. Life insurance death benefits are paid as a lump sum and are not subject to federal income tax because they are not considered income for beneficiaries.
• Dependents don't have to worry about living expenses. Most policy calculators recommend a multiple of your gross income equal to seven to 10 years that can cover major expenses such as mortgages and college tuition without the surviving spouse or children having to take out loans.
• Final expenses can be covered. Funeral expenses can be significant and can be avoided with a burial policy, or with standard term or permanent life policies.
• Policies can supplement retirement savings. Permanent life policies such as whole, universal, and variable life insurance can offer cash value in addition to death benefits, which can augment other savings in retirement.

What Factors Affect Your Life Insurance Premiums?

• Age (life insurance is less expensive)
• Gender (female tends to be less expensive)
• Smoking (smoking increases premiums)
• Health (poor health can raise premiums)
• Lifestyle (risky activities can increase premiums)
• Family medical history (chronic illness in relatives can raise premiums)
• Driving record (good drivers save on premiums)

How Do I Buy Life Insurance?

Once you determine how much coverage you need and what type of policy would best fit your needs, there are several options for purchasing life insurance. You can contact a local insurance agent or broker; look for online marketplaces that offer products from several insurers; or contact the insurance company directly to obtain coverage. Look for a company with a financial stability and a reputation for good customer service.

How Do You Qualify for Life Insurance?

To qualify for life insurance, you need to submit an application. Life insurance is available to almost anyone. However, the cost or premium level can vary greatly based on your age, health, and lifestyle. Some types of life insurance don't require medical information; however, no-exam policies generally have much higher premiums and involve an initial waiting period before the death benefit is available.

Bottom Line

There are many types of life insurance policies available, each offering a variety of features. Understanding how life insurance works helps you choose the best coverage for you and your family. Once you decide what type of insurance you need and how much coverage makes sense for your situation, compare products from top life insurance companies to determine the best fit.