What is life insurance and how does it work?

What is life insurance? Are there benefits to getting this? Is it worth it? Find out important things about it in this article

What is life insurance and how does it work?


By Mark Rosanes

Life insurance plays an important role in providing families with a certain level of financial security after the death of a loved one. With the right policy, this type of coverage can help families pay off loans and debts and meet daily living expenses. 

This financial benefit, however, is just one of the many aspects of life insurance. Like other forms of coverage, it can also be a complex investment with the potential to yield several advantages, depending on how it is managed. 

In this article, Insurance Business examines how this crucial financial tool works in the different regions that we cover, what types of benefits it brings, who needs coverage the most, and when the best time is to purchase one. If you’re an industry professional searching for ways to help life insurance clients find the best policies, this article can serve as a useful guide. Just click the share icon on the top left of the screen.

What is life insurance?

Life insurance is a type of insurance policy that provides a tax-free lump-sum payment to the beneficiaries once the policyholder dies or after a set period. Because of the financial benefit it offers, life insurance has become one of the most popular forms of coverage among consumers. 

Policies remain in-force as long as the policyholder continues to meet premium payments. Some types of plans end after a set term while others provide lifetime coverage and accumulate cash value

How does life insurance work?

Life insurance works almost exactly the same in different regions, although the policy names may vary. Coverage comes in different forms, with each offering different levels of financial protection.

United States & Canada

These North American neighbors operate the same systems when it comes to life insurance, with coverage generally falling into two categories.

1. Term life insurance

As the name suggests, this type of policy covers the policyholder for a set term. It pays out a death benefit if the insured dies within a specified period, meaning they can only access the payment in the years when the plan is active. The most common terms last for 10, 20, or 30 years.

Term life insurance policies come in several variations. These include:

  • Decreasing term life insurance: A renewable policy with coverage decreasing over the policy’s term at an agreed upon rate.
  • Convertible term life insurance: Can be converted into permanent life insurance.
  •  Renewable term life insurance: Premiums increase annually that the policy is in-force, with rates typically the cheapest in the year it was purchased.

2. Permanent life insurance

Unlike term life insurance, a permanent policy does not expire. Coverage comes in two main types, each combining the death benefit with a savings component.

  • Whole life insurance: Offers coverage for the entire lifetime of the insured and the savings can grow at a guaranteed rate.
  • Universal life insurance: Uses different premium structures, with earnings based on how the market performs.

You can read the profiles of the largest life insurance companies in the US and the top life insurers in Canada in our updated rankings. 

United Kingdom

Life insurance policies in the UK also come in two major categories, which work the same way as those in the US and Canada. These are:

1. Term life insurance

This type of policy also runs for a fixed term but only pays out a death benefit if the policyholder dies within this period. Otherwise, the insurance company keeps all the premiums paid. There are three kinds of term life insurance policies:

  • Level term life insurance: Pays out a lump sum if the policyholder dies within the agreed term, with the level of cover remaining the same throughout. 
  • Decreasing term life insurance: The death benefit amount reduces each year. Such policies are designed to be used with repayment mortgages, where the loan balance likewise decreases over time.
  • Increasing term life insurance: The death benefit amount rises throughout the policy’s term to keep up with inflation.

2. Whole-of-life insurance

Similar to permanent life insurance in Canada and the US, this type of policy provides lifetime coverage, with payouts given to the beneficiaries after the policyholder’s death. Because of the level of coverage, whole-of-life policies have more expensive premiums than term insurance. it has been noted with this type of policy that if the policyholder lives longer than expected, they can actually end up paying more than they will get out of the policy. 

UK citizens can also access over-50s plans, which provide coverage for individuals aged between 50 and 85, without requiring them to submit medical information. Premiums are often based on the plan holder’s age and the amount of cover. Rates, however, tend to be higher as there is no way for insurers to predict the planholders’ risk level.  

The sum assured is also usually capped at around £20,000, while waiting periods can last between 12 and 24 months. Additionally, the beneficiaries will not receive a benefit if the policyholder dies due to natural causes during this period, but the premiums they paid will be returned. 


Apart from providing a death benefit, life insurance policies in Australia offer financial protection should the policyholder become seriously ill or disabled. Policies are grouped into six main categories, with the level of coverage summed up in the table below. 

types of life insurance in Australia

Each life insurance plan also comes with built-in features and benefits, which vary from insurer to insurer. The key to finding the right policy is to review the product disclosure statement (PDS). Here are some benefits Australians may want to keep an eye out for when buying life insurance:

  • Terminal illness benefit: Pays out 100% of the death cover in advance if the policyholder is diagnosed with a terminal illness or given less than 12 to 24 months to live. 
  • Funeral advancement benefit: Benefit ranges from $10,000 to 10% of the sum insured but the policyholder’s family must provide a valid death certificate and full claim forms to receive the payout. 
  • Financial advice benefit: Reimburses the cost of financial advisory services up to a specific limit, usually ranging from $2,000 to $5,000. 
  • Future insurability benefit: Allows the policyholder to increase their level of cover without the need to provide additional medical information. 
  • Premium freeze option: Lets the policyholder freeze their premiums, so instead of their stepped premiums increasing each year, their benefit amount decreases instead.
  • Indexation: The level of cover rises by a set percentage between 3% and 5% or the consumer price index (CPI), depending on which is greater, to keep up with inflation.
  • Interim cover: Provides a lump-sum payment should the policyholder die because of an accident during their policy assessment. The benefit is usually the lesser of $1 million or the sum insured at the time of application.

Here’s what the leading life insurance providers in Australia offer in terms of coverage. 

At what age is life insurance worth taking out?

A person’s age and health status are the two biggest factors impacting both their eligibility for and the premium prices of life insurance. Because of this, some industry experts say that the best time to take out this form of coverage is while a person is young and healthy. They add that as people get older, health issues also begin to develop, which can disqualify them from coverage and make premiums more expensive. Others compared the “economic impact” of missing out on buying life insurance while younger to delaying saving for retirement. 

There are those, however, who argue that younger people tend to be faced with more expenses, including mortgage, car loans, student debt, and childcare costs that can benefit them to put off buying coverage. They may also be uncertain of the term duration they need as renewing a policy 10 or 20 years down the road is guaranteed to be more expensive.

The bottom line is, just like in other types of policies, there is no one-size-fits-all life insurance that can cater to every need – and the answer to the question of when the best time is to take out coverage all boils down to a person’s unique situation and preferences.

Who needs life insurance?

While life insurance can play a vital role in providing some level of financial security to a family after a tragic loss, not everyone has a need for this type of coverage. Those who have built up enough wealth and assets to care for their family’s needs after they die can forego purchasing life insurance. However, there are also certain groups of people who experts say will benefit greatly by taking out this form of financial protection. These include:

 who needs life insurance

What are the benefits of life insurance?

Different life insurance policies offer different benefits. Permanent plans in the US, for example, can be used as a financial tool that enables the policyholder to accumulate wealth. Life insurance, however, also provides several practical benefits. These include paying for:

  • Funeral, and cremation or burial costs
  • Medical bills not covered by health insurance
  • Estate settlement costs
  • Outstanding debts, including mortgage, and student and car loans
  • Replacement income
  • Federal or state taxes
  • Inheritance
  • Charitable donations

What does life insurance cover?

A life insurance policy covers almost all types of death, including those due to natural and accidental causes, suicide, and homicide. Most policies, however, include a suicide clause, which voids the coverage if the policyholder commits suicide within a specific period, usually two years after the start of the policy date.

Some life insurance providers may also deny a claim if the policyholder dies while engaging in a high-risk activity such as skydiving, paragliding, off-roading, and scuba diving.

In addition, an insurer may reject a claim based on the circumstances surrounding the death. For instance, if the beneficiary is responsible for or involved in the policyholder’s death.

Does life insurance actually pay out?

Yes, as this is standard practice. Insurance companies are obligated to pay out the premiums to the policyholder’s beneficiaries after they‘ve died – which answers the question “how does life insurance work?” Payment made to a life insurance policy’s beneficiary is known as the death benefit.

If you are named by a life insurance policyholder as the sole beneficiary, life insurance companies aren’t obligated to seek you out and give you the money. Even though the policyholder has passed on, most insurance companies don’t keep tabs on their policyholders this way. The burden falls on you or any other beneficiaries to inform the insurance company of the policyholder’s demise. This is how life insurance works.

To collect the death benefits, you will need to come forward and inform the insurance company that the policyholder has died. In most cases, this must be done within 30 to 60 days from the policyholder’s death.

Making a claim on a life insurance policy requires a few steps, which include:

  • Contacting your insurance provider
  • Getting copies of the death certificate
  • Filling and submitting the appropriate paperwork
  • Specifying the type of payment you wish to receive

There may be some more specific steps involved in making life insurance claims, so make sure to contact the insurance company. Refer to this guide on how to file an insurance claim for some background information on how life insurance works.

How does life insurance pay you?

Life insurance pays you depending on the payment options available and which of them you choose. In some cases, the policyholder may decide how their death benefits pay out.

So how does life insurance work? How do beneficiaries get paid? Here are the most common ways a life insurance company may pay you:

Lump Sum Payment

This is a single, lump sum payment of the death benefit. Upon the insurer’s approval of the amount, you can expect to receive a check or have the money deposited to a bank account.

In cases where the policyholder withdrew a portion or made a loan on the premiums, the lump sum payment will have deductions.


This is a regular payout of an amount of money over a period. This can be a lifetime annuity, where the beneficiary receives a payout for the rest of their life. Another annuity payout is the fixed-period annuity, where the beneficiary receives a regular payment for a specified period, spread over several years or several decades.

Retained Asset Account

The insurance company deposits the money in an account that earns interest. The beneficiary may then withdraw money from it as needed.

A note on how life insurance works for beneficiaries: the amount paid also depends on whether you’re named as a revocable or irrevocable beneficiary.

Revocable beneficiaries can have their share of the benefits increased, reduced or removed completely.

An irrevocable beneficiary cannot be removed or have their share changed in any way without their consent.

How long must you have life insurance before it pays out?

This can vary, as a life insurance policy pays out when the policyholder dies, and for as long as death occurs once the insurance policy is in effect.

Some insurance companies require a minimum amount of coverage (commonly called a “binder”) if an applicant dies before the life insurance policy is issued and in force. This is usually refunded or credited to the first premium payment after the new policyholder is approved.

If you’re the policyholder and you need cash in an emergency, it’s possible to use money from your life insurance policy. Here are some ways:

Getting a Whole Life Insurance policy

Since this policy has a higher premium, this may have a cash component feature. Using this has some caveats. Accessing the cash component can require that your policy has (after some time) accumulated a certain amount that you can borrow.

Giving up on the policy

You can give up on your policy and withdraw its cash value. This is possible if your policy satisfies certain conditions, i.e. the amount is sufficient to justify prematurely giving up on your policy.

Borrowing from your policy

Some insurance companies may allow you to take a loan from the existing cash value. In this case, the loan amount is deducted from the death benefit before the payout.

How much money do you get from life insurance?

This depends on a few factors, but the main thing to consider is how much cash value is already in the policy.

How does life insurance work in this situation? The payout can vary significantly if you’re the sole beneficiary, one among many beneficiaries, a revocable beneficiary, or a policyholder who is cashing out on a life insurance policy. For example, a payout for a sole beneficiary can most certainly be higher than if there were other beneficiaries.

Cashing out and paying taxes and fees

The good news about cashing out a life insurance policy is that you pay no taxes. The same is true if you are a beneficiary.

You only pay taxes when cashing out on your life insurance policy when:

  • The actual amount exceeds the amount of premiums paid – This means that the excess of your premiums when you give up on your policy are considered income and you’ll have to pay the appropriate taxes.
  • You have unpaid loans on your policy – In cases where you take a loan on the cash value of your policy and don’t pay it back, you’ll likewise have to pay the appropriate income taxes on the loan amount, as this will be considered income.

Apart from paying taxes in these instances, remember that you may also have to pay penalty fees. Refer to the policy’s terms and conditions and/or consult your insurance agent for more details on how does life insurance work.

Are you in search of the right life insurance policy? Which features and benefits do you think are essential? Should you take out life insurance while you’re young or should you wait until you’re a bit older? Use the comments section below to share your thoughts.

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