Term life insurance
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Term life insurance or term assurance is life insurance which provides coverage at a fixed rate of payments for a limited period of time, the relevant term. After that period expires, coverage at the previous rate of premiums is no longer guaranteed and the client must either forgo coverage or potentially obtain further coverage with different payments or conditions. If the life insured dies during the term, the death benefit will be paid to the beneficiary. Term insurance is the least expensive way to purchase a substantial death benefit on a coverage amount per premium dollar basis over a specific period of time.
Term life insurance is the original form of life insurance and can be contrasted to permanent life insurance such as whole life, universal life, and variable universal life, which guarantee coverage at fixed premiums for the lifetime of the covered individual unless the policy owner allows the policy to lapse. Term insurance is not generally used for estate planning needs or charitable giving strategies but is used for pure income replacement needs for an individual. Term insurance functions in a manner similar to most other types of insurance in that it satisfies claims against what is insured if the premiums are up to date and the contract has not expired, and does not provide for a return of premium dollars if no claims are filed. As an example, auto insurance will satisfy claims against the insured in the event of an accident and a home owner policy will satisfy claims against the home if it is damaged or destroyed by, for example, a fire. Whether or not these events will occur is uncertain. If the policy holder discontinues coverage because he has sold the insured car or home, the insurance company will not refund the premium. This is purely risk protection.
Because term life insurance is a pure death benefit, its primary use is to provide coverage of financial responsibilities for the insured or his or her beneficiaries. Such responsibilities may include, but are not limited to, consumer debt, dependent care, university education for dependents, funeral costs, and mortgages. Term life insurance may be chosen in favor of permanent life insurance because term insurance is usually much less expensive (depending on the length of the term), even if the applicant is an everyday smoker. For example, an individual might choose to obtain a policy whose term expires near his or her retirement age based on the premise that, by the time the individual retires, he or she would have amassed sufficient funds in retirement savings to provide financial security for the claims.
Annual renewable term
The simplest form of term life insurance is for a term of one year. The death benefit would be paid by the insurance company if the insured died during the one year term, while no benefit is paid if the insured dies one day after the last day of the one year term. The premium paid is then based on the expected probability of the insured dying in that one year.
Because the likelihood of dying in the next year is low for anyone that the insurer would accept for the coverage, purchase of only one year of coverage is rare.
One of the main challenges to renewal experienced with some of these policies is requiring proof of insurability. For instance the insured could acquire a terminal illness within the term, but not actually die until after the term expires. Because of the terminal illness, the purchaser would likely be uninsurable after the expiration of the initial term, and would be unable to renew the policy or purchase a new one.
Some policies offer a feature called guaranteed reinsurability that allows the insured to renew without proof of insurability.
A version of term insurance which is commonly purchased is annual renewable term (ART). In this form, the premium is paid for one year of coverage, but the policy is guaranteed to be able to be continued each year for a given period of years. This period varies from 10 to 30 years, or occasionally until age 95. As the insured ages, the premiums increase with each renewal period, eventually becoming financially inviable as the rates for a policy would eventually exceed the cost of a permanent policy. In this form the premium is slightly higher than for a single year's coverage, but the chances of the benefit being paid are much higher.
Level term life insurance
Much more common than annual renewable term insurance is guaranteed level premium term life insurance, where the premium is guaranteed to be the same for a given period of years. The most common terms are 10, 15, 20, and 30 years.
In this form, the premium paid each year remains the same for the duration of the contract. This cost is based on the summed cost of each year's annual renewable term rates, with a time value of money adjustment made by the insurer. Thus, the longer the term the premium is level for, the higher the premium, because the older, more expensive to insure years are averaged into the premium.
Most level term programs include a renewal option and allow the insured to renew for a maximum guaranteed rate if the insured period needs to be extended. It is important to note that the renewal may or may not be guaranteed and the insured should review their contract to see if evidence of insurability is required to renew the policy. Typically this clause is invoked only if the health of the insured deteriorates significantly during the term, and poor health would prevent them from being able to provide proof of insurability.
Most term life policies include an option to convert the term life policy to a Universal Life or Whole Life policy. This option can be useful to a person who acquired the term life policy with a preferred rating class and later is diagnosed with a condition that would make it difficult to qualify for a new term policy. The new policy is issued at the rate class of the original term policy. Note that this right to convert may not extend to the end of the Term Life policy. It may extend a fixed number of years or to a specified age, such as convertible to age 70.
Return Premium Term life insurance
A form of term life insurance coverage that provides a return of some of the premiums paid during the policy term if the insured person outlives the duration of the term life insurance policy.
For example, if you own a 10 year return of premium term life insurance plan and the 10 year term has expired, the premiums paid by the owner of the life insurance policy will be returned less any fees and expenses which the life insurance company retains. Usually, a return premium policy returns a majority of the paid premiums if the insured person outlives the policy term.
The premiums for a return premium term life plan are usually much higher than for a regular level term life insurance policy, since the insurer needs to make money by using your premiums as an interest free loan, rather than as a non-returnable premium.
Payout likelihood and cost difference
Both term insurance and permanent insurance use the same mortality tables for calculating the cost of insurance, and provide a death benefit which is income tax free. However, the premium costs for term insurance are substantially lower than those for permanent insurance.
The reason the costs are substantially lower is that term programs may expire without paying out, while permanent programs must always pay out eventually. To address this, some permanent programs have built in cash accumulation vehicles to force the insured to "self-insure", making the programs many times more expensive.
Other permanent life insurance policies do not have built in cash values. The policy owner may have the option of paying additional premium in the early years of the policy to create a tax deferred cash value. If the insured dies and the policy has a cash value, the cash value is often paid out tax free in addition to the policy face amount.
Insurance industry studies indicate that the probability of filing a death benefit claim under a term insurance policy is low. One study placed the percentage as low as 1% of policies paying a benefit. The low payout likelihood allows term insurance to be relatively inexpensive. Because of the low likelihood of an insurer having to pay a death benefit, term insurance may offer more coverage per premium dollar - by a factor of up to 10.
- Buy term and invest the difference
- Family income benefit insurance
- Life Insurance
- Permanent life insurance
- Theory of Decreasing Responsibility
- Universal life insurance
- Variable universal life insurance
- Whole life insurance
- Term life versus Permanent life insurance, Forbes, 2013