How Life Insurance Works

Types of Life Insurance

The most basic type of life insurance is term life insurance. Term life insurance policies cover the policyholder for a set number of years, anywhere from 1 to 30. For younger, healthy people, term life insurance is the least expensive option. You pay relatively low rates for a fixed number of years with a high level of coverage.

Something to consider if you choose term life is that the premium is only fixed for the length of the policy. If the policy expires and you want to renew, you'll pay a higher premium because you're older now, and maybe less healthy. Term life policies have no cash value of their own. They don't accrue interest and you can't borrow money against them. Basically, they're "pure" insurance products. If you don't die, you can't collect.

All of the other types of life insurance fall under the heading of permanent life insurance. As the name implies, the policy is good from the day you buy it until the day you die, no matter when you die. Permanent life policies can either have a fixed or flexible premium.

The biggest difference between term and permanent life policies is that permanent policies include a cash value component. This means that the insurance company invests your premium payments to build up cash reserves in your account. The advantage of permanent life is that you aren't taxed on investment earnings until you cash in the policy, and you can borrow from your cash reserves tax-free. The disadvantage is that premiums are much higher than term life policies and investment performance can be volatile.

There are several different types of permanent life policies:

Whole Life is the most basic permanent life insurance policy with a fixed premium. It has a savings component that earns cash value, but the policyholder has no control over how or where the money is invested.
Universal Life allows the policyholder to shift funds between the insurance and savings components of the policy, even using savings to make premium payments. Premium rates are also flexible.
Variable Life gives the policyholder control over where his or her savings are invested (stocks, bonds, mutual funds, etc.). The rate of return on investments not only affects the cash value of the policy, but increases or decreases the amount of the final death benefit. Premiums with this policy are fixed.
Universal Variable Life combines the flexibility of universal life with the investment control of variable life. Premiums are flexible and the amount of the final death benefit and cash value depend on the performance of investments.

So how much life insurance do you really need? And for how long do you need it? Find out in the next section.

How Life Insurance Companies Make Money

At first, it doesn't make any sense. How can a life insurance company make money if I pay $1,000 a year for 60 years ($60,000), and after I die they pay my wife $500,000? Don't worry about the insurance companies. They've done their math.

First of all, insurance companies know that relatively few people actually cash in on their life insurance policies. Even people who sign up for permanent life insurance often decide to cancel the policy later in life. If you cancel a policy, you're only entitled to the cash value component of the policy minus a steep early termination fee.

Most importantly, insurance companies don't simply stick your premium payments in the bank. They invest all of that money in stocks, bonds and other interest-bearing accounts. When the markets plummet, insurance companies take a hit, but with billions of dollars in earnings each quarter, they're doing just fine [source: Seeking Alpha].