How Does Life Insurance Work?

Life insurance can be a very complex topic. There are numerous types of policies on the market today, and each has its own set of features, benefits, and other characteristics. Some life insurance policies provide only a set amount of death benefit, while others can be highly tax advantaged long term savings vehicles.

Understanding how life insurance works – as well as why life insurance is needed as an overall part of financial planning – can make this topic much easier. In addition, knowing how the benefits of life insurance can help a policy holder’s loved ones to avoid financial hardship can help to truly pinpoint where this important financial product fits into one’s financial life, and their overall lifestyle objectives as well.

Analyzing the Many Potential Life Insurance Needs

Everybody’s needs are different. This is one reason why there are so many types of life insurance products that are available today. What does not work for one person’s situation may be the perfect solution for another.

While many people understand that they need life insurance, it may not be clear just exactly how much coverage is appropriate. When determining the right amount of coverage, there are many criteria that should be factored in. These should include the cost of a funeral – including burial and headstone expenses – as well as any unmet medical costs, estate taxes, and possible costs of probate.

Related: Insurance Basics: How Insurance Works

It’s Not Personal, It’s Business

Many people think that life insurance is only used for the needs of individuals in protecting their families and other loved ones. However, life insurance is not just for individual needs. It can also solve many types of business liquidity needs as well.

Life insurance can play a major role in the financial stability of a business. For example, it can protect a company against the unexpected loss of an owner or key person. It can also help to keep a business running until a replacement is found or the business can be sold.

Because businesses can be structured in a variety of ways, there are different life insurance solutions that can be put into place in order to protect them. In addition, life insurance can also be used as a form of executive deferred compensation.

Businesses can avoid many possible negative financial consequences from the loss of key people by using life insurance. Therefore, this important product should be a primary component of every business’s planning process.

The Working Parts of Life Insurance

There are several components that are involved in life insurance. Some of these pieces will be dependent upon the type of life insurance policy that is being determined. The main types of life insurance include:

  • Term – Term life insurance is oftentimes referred to as being “pure” insurance. This is because, in return for a premium payment, term life insurance pays out a death benefit to a named beneficiary if the insured individual should pass away while the policy is in force. This type of coverage does not include any type of cash value or investment build-up within the policy. Therefore, term life insurance simply insures against the loss of a policy holder’s life if the individual dies within the stated “term,” or time period, that the policy is active.
  • Whole Life – Unlike term life insurance, whole life policies can cover an insured for the “whole” of his or her life. This means that there is no set time period in which the policy will expire, and – provided that premiums are paid – the plan will remain in-force. In addition, whole life insurance also includes a cash value component. Here, a portion of the premium payment will go into a savings portion, where the funds can grow on a tax deferred basis. Should the policy holder need cash, he or she can access some or all of the policy’s cash value through a policy loan.
  • Universal Life – Universal life insurance also provides a savings component, along with a death benefit. Yet, while the cash value growth in a whole life insurance policy is guaranteed, the interest rate on the savings portion of a universal life insurance policy can fluctuate. In addition, policy holders who own universal life insurance also have more flexibility with regard to their premium payment.

Prior to purchasing a life insurance policy, it is important to have a good understanding of the goals and needs that the policy should cover. This will help to pin down which type of policy – as well as how much coverage – will best fit the specific situation.


Susan Wright holds a BA from Michigan State University and an MBA from St. Louis University. Having over 20 years of working experience in the insurance and financial services industry, she has trained more than 10,000 financial services representatives. Susan has had licenses in real estate, insurance, and NASD Securities, and she has earned nine industry professional designations, including CLU, ChFC, RHU, REBC, CSA, CLTC, CCFC, CSS, and ADPA. Read more about her on Google+

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