Updated August 22, 2019

How Does Life Insurance Work?

Read more about Life Insurance

How exactly does life insurance work? What does it cover and how does the payout work? Read on to understand how life insurance works before you buy.

What Is Life Insurance?

Life insurance gives families financial protection in the event of premature death. If there is anyone who relies on your income, life insurance is a great way to still provide for them after death.

You pay a monthly premium, and if you die while the policy is still in force, the insurance company will pay the death benefit to your beneficiary.

There are many different types of life insurance. You can read about them in detail here.

A life insurance policy is a unilateral contract. That means that as long as you pay the monthly premiums, the insurance company is committed to uphold the contract. But you're not obligated to pay either. If you stop paying, the policy will just lapse with no death benefit payout.

Some types of life insurance affect eligibility for Medicaid and Medicare later in life, so make sure you plan accordingly if you're planning on using either of them. If so, make sure to check out this article from Elder Law Firm of Steve Bailey to learn when you should think about applying for the programs.

What Does Life Insurance Cover?

Life insurance covers the death of the insured. It covers most cases of death due to accident, illness, or natural death.

Your beneficiary will receive the death benefit when you die. This money can be used for anything.

Just some of the things you can use life insurance to cover include:

  • The loss of your income
  • Your outstanding debts (mortgage, student loans, business debts, etc.)
  • Your children's education funds
  • Child care costs
  • Funeral expenses
  • Outstanding medical bills

What Kind of Deaths Are NOT Covered?

Not all deaths are covered by life insurance. Some instances of death that are not covered may include:

  • Death by suicide. If you commit suicide within 2 years of the policy, the death benefit won't be paid. After the 2 years, deaths from suicide are paid. But there is an important exception.

    If the insured had a history of attempting suicide or mental illness and did not disclose it when applying, it is fraud. The claim would be denied due to fraud. In this case, the beneficiary would only receive a refund of the premiums paid.

  • Murder by the beneficiary. If it is found that the beneficiary was involved in the murder of the insured, the death benefit won't be paid.

  • Death from illegal activity. If you engaged in criminal activity and was killed as a result of that, the death benefit won't be paid. For example, if you're breaking into a home and were killed from that, there will be no payout.

  • Fraud/lying on application. If the insurance company found that you didn't disclose important information on your application, they can deny payment (for example, if you died from lung cancer but you didn't say that you'd been a smoker for years). Or if you died from motorcycle racing, and didn't disclose that hobby.

How Do Life Insurance Companies Make Money?
Life insurance works because of the law of large numbers. Most insured people will not die, so the company won't have to pay out. Insurance companies use Big Data to statistically estimate how many clients will die in a given year. They use the information to set premium rates high enough to ensure they will collect enough money to pay claims.

The insurance company also invests the premiums to earn returns. The assets are mostly invested in corporate bonds, structured securities, and US Government bonds, with some in real estate, home loans, and common stocks.

2-Year Contestability Period

Life insurance policies have a 2-year contestability clause. If you die within the first two years of the policy, the insurance company can contest it. This means the company will investigate to determine if the illness or disease was known and you didn't disclose it.

During these 2 years, if it is found that you misrepresented on the application, several things can happen:

  • If you died within the 2 years, no death benefit is paid to your beneficiary.
  • If the misrepresentation was minor, the company may still pay the death benefit, minus the premium that you should have paid.
  • If you don't die, the insurance company can cancel your policy or raise your premium.

After the policy is two years old, life insurance claims are usually paid without a hassle. Exceptions occur when fraud or foul play is suspected.

It's very important to disclose everything on your life insurance application. This way, you can ensure that the death benefit will be paid out.

How Does Life Insurance Pay Out?

When the insured dies, the beneficiary is paid the death benefit. The beneficiary will first have to file a claim (more on that below). After the claim is processed, the company should pay out within several days.

There are several settlement options. Some ways you can arrange to have the death benefit paid out are:

  • Immediate lump sum: This is the most common payout option. The beneficiary gets one huge check.
  • Income for a set number of years: The death benefit is paid out in installments over a certain period of time. You can choose either monthly or annual installments.
  • At a later date: It's paid at a later time, such as when the beneficiary reaches a certain age. This is a good idea if a child is the beneficiary.

Who Gets the Money?

The death benefit is paid to the beneficiary. More than one primary beneficiary can be named. The death benefit can be divided equally between the beneficiaries, or split so that one gets more than another.

If the primary beneficiary dies before the insured, a contingent beneficiary receives the death benefit.

The beneficiary can also be a trust or a charity.

Beneficiary designations can be changed at any time and should be reviewed when there is a birth, death, marriage, or divorce.

How to File a Claim

When an insured dies, the beneficiary should:

  • Contact the insurance company.

  • The insurance company will ask the beneficiary to complete a claim form and provide a certified copy of the insured's death certificate.

    It usually takes about a week to obtain certified copies of the death certificate from the County Clerk in the county where the insured died.

  • Once the insurance company receives a claim in good order, they send a check to each primary beneficiary for their share. The check includes interest from the date of death until the day the money is sent.

  • This amount is free from probate and not taxed.

"In Good Order" Means:

  • The beneficiary provided all the information required on the claim form,
  • The circumstances of death aren't suspicious, and
  • Death didn't occur during the 2-year contestable period.

If the claim is contestable, it doesn't mean the claim won't be paid. An investigation will be conducted before the company makes its decision. If fraud was not involved and death wasn't from suicide, death claims during the first two policy years are usually paid.

What Happens If You Don't Die?

First of all, it's great that you are still alive! What happens depends on what type of insurance you have.

  • Term Insurance: Term insurance policies last only for a specific period of time. If you don't die while a term life insurance policy is in force, the policy terminates without further value and that's it.

  • Whole Life Insurance: Whole life policies last for your entire life and have a cash value element. If you live to age 100 with a traditional whole life policy, the cash value will equal the death benefit and the company will send it to you as a birthday present on your 100th birthday.

  • Guaranteed Universal Life: Guaranteed Universal Life is the only policy that remains in effect after age 100. Some policies last up to age 121. If you live longer than that, the coverage terminates, usually without value.

If Everyone Else Dies

If everyone you love dies before you, first, I'm very sorry. Second, before you cancel your policy, figure out if you qualify for a life settlement.

In a life settlement, you sell your policy to a company for more than the cash value. Convertible term policies can qualify for life settlements. The worse your health is, the more money you may be able to earn by selling your policy as a life settlement.

Bottom Line

Life insurance is a great tool to manage financial risks to your loved ones if you're no longer here to take care of them. Make sure you take the time to understand how it works and what is covered before you buy.

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