How Does Life Insurance Work?

Understanding the basics of various financial principles, concepts, and products is paramount to succeeding with your personal finances. With that in mind, today I wanted to focus on helping people understand how does life insurance work.

Life insurance comes in all different shapes and sizes, but regardless of what type of policy you’re looking to get, the process you go about applying and following through on your commitment work the same.

How Does Life Insurance Work?

The following will be a guide to helping you understand how life insurance will work and it involves a few different stages.

Step 1: Determine Your Need

1. Is life insurance necessary?

The first thing you must grasp is whether or not you need life insurance. While I’m not going to go into great depths here, you may need some sort of policy if you’re married, have children, or have a large amount of debt that’s been co-signed for.

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2. How much do you need?

While “rules of thumb” are commonly used when calculating the amount of life insurance you should have, it’s best to talk to a professional and really delve into your personal situation to come up with that figure. If you’d like to do it on your own, then a good place to start is 10 times your annual income. So, if you make $50,000/year, then getting a $500,000 policy would be a good place to start.

In addition to that, you may want to consider how much debt you have and add that to the amount. You should also take into account future desires you may want to be taken care of in the event you’re not around: inheritance to kids or grand kids, paying for your children’s college, helping secure your remaining spouses retirement, etc.

3. What type of policy should you get?

There are two main types of life insurance (temporary and permanent) but this post isn’t about how each of them work. However, of those main types there is (1) term life insurance, (2) whole life insurance, (3) universal life insurance, and (4) variable, and you should take it upon yourself to learn more about how each work.

The final 3 of the 4 mentioned are permanent policies. A permanent policy is sometimes suitable, but it depends on your financial situation and what you’re trying to accomplish. However, if you’re looking for the cheapest life insurance out there then a good place to start is with term insurance.

4. Where should you get your policy?

While there are a trillion life insurance agents out there and tons of different brokers, the thing to determine first is whether or not you should get an individual policy or a group policy.

Many employers offer life insurance policies to their employees. Some may give you a small policy (maybe 1 or 2x’s your salary) as a part of your employment package, whereas others may also give you the opportunity to purchase additional coverage through a group policy. So, should you take advantage of that additional group insurance or should you meet with an insurance agent and get a policy on your own?

Group Policies versus Individual Policies

In the majority of cases that I’ve worked on, it’s most likely that you’re going to get a cheaper rate (assuming you’re healthy) if you get an individual policy that’s manually underwritten. The way life insurance will work is that when you get a group policy, the insurance company looks at the entire workforce and assumes some things such as: average age, general health, and the job functions performed at your employer (as a whole).

With that in mind, if your coworkers are older than you or they’re unhealthy as a whole, then the group life insurance rates will reflect that. Saying that, group life insurance is great for older people or others that may be unable to get a policy on their own.

Regardless of what you choose, I’d encourage you to check out both avenues: find out how much it’s going to cost through your work, then meet with an insurance broker to see what they can offer you.

The final thing to be aware of with group policies is that some of them are not portable. Meaning that when you leave your employer, you’ve lost your insurance policy. Now, all employers’ plans do not work that way and some of them will allow you keep the insurance in place in the event you get terminated or find a job elsewhere.

Take Note: just because an agent quoted you a particular price on an individual policy DOES NOT mean that’s what you’ll get approved for. The quote that they show you is typically an educated guess; your actual premium will not be known until you’ve gone through the underwriting process.

Step 2: Application Process

After you’ve determined everything above, then the second part in understanding how does life insurance work involves the application process. If you’ve determined to opt for a group policy, then you likely won’t have to worry about these next two steps as your group rates has already been determined and your personal health won’t affect that outcome.

1. The application and health screening

If you’ve decided to go with an individual policy, then you should have taken the time to shop life insurance rates on your own (or consult with a broker who can assist you with that). After finding the most affordable rate, then you must apply for the coverage.

The application will go into quite a bit of information (it’s often more detailed with the permanent policies), but it won’t take you too long to fill it all out. After the application has been mailed off (or submitted online), then blood and urine samples will be ordered by the life insurance company.

When that occurs (typically a day or two after you submit your application), you’ll be contacted by the company performing the tests and they’ll schedule a time to meet with you. You’ll generally be able to choose where you want the test to occur – such as having it done in your home or in many cases the person will even go to your work to make it most convenient for you.

2. Manual underwriting

Once the blood/urine tests are complete, all of the data will be sent back to the life insurance company. At that point, there will be a team (or person) assigned to your case and they will go through the underwriting process. This involves scouring your application, possibly contacting your doctor for any information they have on file, confirming what you wrote on your application (family history, etc.), and examining your blood-work and urine results.

Step 3: Accepting and following through on your policy

After you’ve submitted the application, given your blood and urine samples, and the insurance company has gone through the underwriting process, they will come back to you with an offer (sometimes – if you’re in poor health particularly – you’ll get completely denied).

1. Accepting or declining the offer

The offer (or premium – i.e. how much you’ll pay each month/year) is based on your age, gender, and health. Again, this is not applicable if you opt for the group route as your monthly premium has already been determined based on your group. The price will be reflective of the rating that you’ve received. With that, there are 4 main ratings: Preferred Plus, Preferred, Standard Plus, and Standard. If you’re unhealthy, then there are something called Table Ratings (Table 1-8) and it’s possible that you may fall in one of those categories as well.

Hopefully your insurance agent did a good job during the quoting process, because the hope here is that you get approved for what the agent originally quoted you (if not better than what they showed you). If you got approved for the rating you were originally quoted, then great!

If not and you were approved for a much lower rating than you expected (therefore resulting in a higher premium), then you can choose to decline the policy and cancel it.

2. Pay your premiums

Whether you get a group or individual policy, the way life insurance work after you’ve gotten approved is that you must pay your premiums each month (or year…or whatever you decided on when you signed up). Now, if you accidentally miss a payment there is generally a window (maybe 10-30 days) to submit the late payment, but beyond that there’s a chance your policy could be cancelled by the insurance company. This may not be the case for a permanent policy as there may be enough cash value to pay for the premiums.

3. Hopefully you won’t need to use it

If you happened to purchase a 20-year term policy, then I think everybody wants to outlive that time period and have the policy lapse. However, that’s not always the case as there is always a chance you could die prematurely (which is the reason you bought the life insurance), then the process your beneficiary (or beneficiaries) must take is rather simple:

1. Find your life insurance contract or documents (note, you probably should put this in a safe place and inform your beneficiaries of where you keep it).
2. Obtain a death certificate.
3. Contact your insurance carrier and follow their procedures (likely as simple as faxing over the death certificate).
4. Receive the tax-free life insurance death benefit and do as they wish with it.

Understanding how does life insurance work is a fairly easy process (despite the great depth I’ve gone into to explain it). You simply must start by determining your need (how much and what type of policy best suites you), then determine the avenue (group or individual policy), then apply and follow through with paying your premiums.

Readers: what type of life insurance policy do you have? Did you go through your employer or did you opt for an individual policy?

About the Author

By , on Dec 20, 2012
Andy Tenton
Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the publisher of WorkSaveLive.com.

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{20 Comments}

  1. Evan says:

    Great Primer on the topic! Isn’t Variable just a subset of Universal, though?

    • Andy says:

      Hey Evan, thanks for stopping by! They’re certainly closely related, but in my opinion I think there are some advantages to Universal in that you can have your cash value be “indexed” where you partake in stock market gains while having no risk of the stock market downside (very similar to indexed annuities). Whereas variable policies are subject to increases, and decreases, based on the performance of the stock market.

      So, if you’re using life insurance as an investment vehicle (which is a conversation for a different day) then choosing between variable and (indexed) universal comes down to what type of risks you want.

      In any case, the fees in most universal policies are cheaper than variable policies as well.

  2. Both my wife and I have 20 year term policies. The payments are super low and we figure that we will be self insured in 20 year, so at that time we will no longer need life insurance.

  3. We have individual term policies that are very cheap. If you have a family, you have to get insured. There was a single mom in our hometown who was killed in a car accident recently. She left a 7 year old son. There were donation jars in all the gas stations to cover funeral expenses and help care for her son. Broke my heart.

  4. We both have life insurance policies mine which I got just a few years back after coming to Canada. Mrs.CBB has had hers for many years now. They came and did the urine and blood tests and asked if we smoked which we did. We are almost one year smoke free and we can go in to our advisor and prove to them likely with more tests than our rates may go down a bit. Heck anything is better than a kick in the arse I say! Cheers

  5. We each have 20K through our employer but we also bought our own policies because that is definitely not enough. We actually bought 30 year “return of premium” policies. They were dirt cheap- around $25 per month each.

  6. I don’t have life insurance (I don’t see a need) but we’ll buy some when we start trying to reproduce or buy a house, whichever comes first.

    I have a question about changing salaries, though. How easy is it to change the amount you’re insured for and how often should you do it? Presumably if we’re both working we’ll make incrementally more money each year and eventually that will require a significant amount more insurance. And then what if one of us takes a lower-paying job or stops working? Can we reduce the amount of coverage easily?

    • Andy says:

      If you have insurance through your employer, then your coverage will change automatically as they determine base the amount of of your salary. With that said, it’s definitely not easy to do it if you go through an individual policy. You’re pretty much locked in whenever you buy the insurance and the only way to get out of it is to cancel the policy.

      You can choose to add on more insurance once you get a raise, but you’ll be older at that point and therefore the new (additional) policy will be more expensive. You could also choose to cancel your previous policy and then take out a new policy for the full amount (instead of having 2 policies). The problem with that method is now your entire premium will be higher instead of just paying more for the small additional coverage your purchased.

      Ultimately, to get around this, I’d encourage you to bite the bullet upfront and just buy beyond what you need from the start. Adding an extra $100k or $200k to a term policy (knowing you’re young and probably healthy) won’t add too much to your monthly payments and it’ll likely save you some hassle down the road.

  7. Pauline says:

    My opinion may change with time and having a family, but if you have a decent net worth already I don’t think you need life insurance. Insurance companies have to be profitable, meaning most people will lose money by contracting life insurance, so I prefer to auto-insure myself by trying to build wealth.

  8. Jon says:

    Even after reading this post I have to admit I am completely overwhelmed by looking for life insurance.

    I know how important it is, and I feel like my gf and I should get it (technically we’re common-law partner) because we own a house and carry a mortgage, but I am struggling to get my head around it. Is it a good idea just to talk to an insurance broker about it so they can match me up with the right type of insurance, or will I end up paying more by including a 3rd party?

    • Andy says:

      Great question, Jon, and I’m sorry I didn’t make it any easier on you.

      I’d definitely encourage you to find a broker. You can’t go directly to some insurance companies anyhow, and even for the companies that you can go directly to (take State Farm for example) they’re still paying a broker/agent to meet with you. So you lose nothing by meeting with a 3rd party and having them shop rates for you. In-fact, I’d say that you’d probably save money.

      If you’re looking for somebody in your area, I’d encourage you to check out Dave Ramsey’s website and use his endorsed local provider in your area (although…that person will be very biased towards term life insurance – which isn’t a bad thing). It would be a great place to start though.

    • Evan says:

      Most States don’t recognize Common-law marriages; 27 don’t allow it anymore and 13 never had it (according to wikipedia). Notwithstanding, do you own the house together? if so then even without a “title” there is a definite need for insurance

      • Andy says:

        Just to make sure I’m not confused…what does the common law marriage have to do with anything? (Totally not trying to be a jerk…just wanting to clarify that there isn’t something that I should know). If they both own the house (together) it doesn’t matter if they’re married, dating, or didn’t know each other for more than 1 hour. In that case, life insurance would be necessary and the fact that it pays directly to a designated beneficiary also means that the “title” of their relationship wouldn’t matter.

  9. I don’t have any insurance except what’s offered through my employer (1 year’s salary) because I have no children, and no house. This was really interesting though, a very good basic overview.

  10. Debt Roundup says:

    I have some through my employer, but I need to add more on top to satisfy covering my wife and child.

  11. I don’t have life insurance myself (except for a $1000 free loss-leader given to me to try to get me to buy more) since all of my debts are in my own name and from before I got married.
    But I would think that expenses would be a more important number to base your policy on, instead of income. I made $23,000 this year, but aside from my own debt payments, we only spent $8000 of it… and that was mostly on stuff that we probably didn’t need anyway. So a $230k policy wouldn’t last my wife 10 years but nearly to her own retirement.

  12. Good post Andy. I worked in the life insurance industry for five years and was always surprised at how little many people would carry. We have term to cover ourselves as it’s significantly cheaper and don’t view it as an investment product the way some of the permanent policies can be. I always used to have group policies as well, because they worked out to be so cheap…usually a few bucks per month for up to 3 or 4x my salary.

    • Andy says:

      It is pretty mind boggling how cheap the group insurance can be but if you checked elsewhere, how much would a 10-year term policy be for $180k? Probably not much…

      That would give you more coverage as well because the likelihood of you staying with an employer for 10 years is very slim.

  13. AverageJoe says:

    I’m surprised individual policies usually beat term in your experience. In mine, it was about 60/40 the other way…but you’re absolutely right on: most people think group policies will be less expensive, and they’re often more expensive AND with a substandard insurer.

    • Andy says:

      Hey AJ! Did you mean “individual policies usually beat group?” I would say that most of my clients are fairly young which is why I’ve seen that. For any true “adult” (35+) I’d say the group policies tend to be cheaper. It’s still fairly close though which is why I think it’s important that people check both.

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