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How does life insurance work?

A life insurance policy represents an agreement between you and an insurance company. You agree to pay a certain amount of money each month (or year) for an agreed-upon length of time. In return, the insurance company agrees to pay out an amount of money to a beneficiary of your choosing if you die before reaching the end date of the contract.

If you are still alive at the end of the contract, you may be able to extend or convert your policy. If not, it will simply lapse.

Permanent life insurance policies — like whole life insurance — last your entire life, as long as you pay your premiums on time and in full.

Purchasing life insurance

Buying a life insurance policy typically requires the applicant to answer some questions about their medical history and undergo a basic physical examination. Rates for life insurance policies are determined by a number of factors including age, gender, overall health, tobacco use, lifestyle, policy type and more.

Issuance of the policy may depend upon answers to health questions set forth in the application.

And of course, the amount of life insurance coverage you wish to purchase will factor into the cost of your premiums.

Why buy life insurance?

There are a number of reasons to buy life insurance. Here are 9 of the most common reasons for doing so:

  • Income replacement
    If the insured person is the primary financial earner of the household, the payout from their life insurance policy can help replace their income for a certain number of years and help their spouse and children maintain their standard of living.
  • Mortgage protection
    If one spouse were to die, the surviving spouse may not be able to afford their mortgage payments with their income alone. Life insurance death benefits can help the surviving spouse and any children to continue living in their home.
  • College tuition
    It can take many years to build up a suitable college fund. If a parent were to die before reaching that point, sending any kids to college could become financially difficult. The money from a life insurance policy can help guard against that happening and serve as a college fund backup.
  • Inheritance
    Some individuals choose to use life insurance as a gift to leave behind for a child or grandchild.
  • Final expenses
    A life insurance payout can help the surviving family members cover final expenses and funeral costs.
  • Estate taxes
    Many individuals who are set to leave behind a valuable estate will also have a life insurance policy in place. The money from the life insurance policy may be used to help pay off estate taxes.
  • Business partnerships
    A life insurance policy is often put in place as part of a business partnership in order to execute a buy-sell agreement if one of the partners were to die unexpectedly.
  • Cash value
    Permanent life insurance policies build up a cash value that may be used to help secure a loan. The cash value can be tapped into as needed for help with medical bills or home projects.
  • Domestic assistance
    If a stay-at-home parent were to die unexpectedly, the surviving spouse might be tasked with child care, cooking, cleaning and more, in addition to holding down their regular job. All of these domestic duties carry a financial value that can be paid for with the help of a life insurance payout.

Types of life insurance

There are different types of life insurance for different needs. The traditional types of life insurance include:


Term life insurance is a type of policy that is put into place for a specified length of time, generally between 10 and 30 years (although shorter terms are also available). If the insured individual dies during that time, the policy payout is made to the beneficiaries. If the insured lives past the policy expiration date, the policy lapses or may be extended at an increased rate.


Whole life insurance is a permanent policy that includes level premiums (which remains valid until the insured individual dies, provided all premium payments are up to date). Whole life insurance includes a cash value that can be accessed while the insured is living.


Universal life insurance is similar to whole life insurance but offers some additional flexibility in regard to the premium payments, death benefits and cash value components of the policy.


Variable life insurance allows the insured individual to take advantage of market-based options within the policy such as equities and mutual funds.
How do life insurance companies make money?
If an insurance company collects $10,000 in premiums from a customer but then has to pay out
$250,000 when that person dies, how could the company possibly make any money?

Life insurance companies take the money collected from premiums and invest it, with the hope of turning it into more than what the policy is worth. There are also customers who outlive their policy (or stop paying their premiums), which means the insurance company does not have to pay out any benefits.

An AIG-appointed life insurance agent can tell you more about how life insurance works


Policies issued by American General Life Insurance Company (AGL). Issuing company AGL is responsible for financial obligations of insurance products and is a member of American International Group, Inc. (AIG). Products may not be available in all states and product features may vary by state. ©2018. All rights reserved.

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