eli5: What exactly is life insurance? How does it work?


Is it as simple as person x gives money to some company to be spent a certain way after person x dies? How is that any different from a will? etc..

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Life insurance is for people who have other people dependent on them like a spouse and children. You name your beneficiaries and buy a plan where you pay regularly to the life insurance company and in the event of your death, the beneficiaries will receive money to take care of themselves. It’s different from a will because a will is a plan to give things you already own to other people whereas life insurance is to insure that your dependents get additional money from the insurer.

I pay $150 a month. If I die, my spouse gets $3 million. That’s life insurance.

Life insurance works because the life insurance company takes the money, invests it, and makes their money over the period they expect you to keep living.
It’s a complex risk calculation, as you become higher risk you pay more.

Life insurance is a hedge against the policy holder’s death. For instance, let’s say you have a family of 4, with only one parent working. If that parent dies, then they’d be out of luck. So the family takes out a life insurance policy, paying the insurer a small fee periodically. In the event of the policyholder’s death, the insurer pays out some large sum of money as negotiated when the policy was bought. The policy can also be used to settle expenses and debts of the deceased, like paying for the funeral.

Life insurance is like any other insurance policy. You pay premiums with the understanding that when you die, the named beneficiary on the policy will get a payout. The money can be spent however the beneficiary chooses but it’s not uncommon for at least some of it to be used to settle debts the deceased left behind like unpaid credit cards, mortgages, etc.

A will is a legal document you create before you die that states who gets your belongings, money and other articles of your estate after your death. They may stipulate who gets what and how much goes to each party named in the will. They might also have conditions about how assets are distributed like waiting until children reach adulthood before getting their inheritance.

All insurance is designed to offset a *loss*. If my house burns down the insurance replaces my house. If my car crashes insurance gets me another car. What you do with the money is up to you. If my car crashes I don’t *have* to spend the money on a new car, I can just pocket the amount and take the bus. It’s just an agreement give me $X if my *thing* is lost.

Life insurance exists to cover the *loss* of the benefit of the earnings of the deceased.

For example, say I’m the sole breadwinner in my home, I have a spouse and 2 children. My future earnings are going to cover things like paying off my mortgage, getting my kids through college, paying for their weddings etc.

So I’m 30 I probably want a lot of insurance to cover those events (all the years of earnings I’m not getting).

If I’m 80 I probably don’t need much/any insurance because what I’m paying for? The house is paid off, the kids are through school, married, have their own problems, etc.