Term Coverage – Net Protection
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 may guarantee coverage at fixed premiums for the lifetime of the covered individual.
Background
Term insurance is not generally used for estate planning needs or charitable giving strategies but for pure income replacement needs for an individual. Many permanent life insurance products also build a predetermined cash value over the life of the contract, available for later withdrawal by the client under specific conditions. However, on most cash value policies like Whole Life insurance, the only way to receive the cash value is to cash out the policy.
The beneficiaries receive the face value of the insurance but NEVER the cash value with Whole Life policies. Financial Advisers generally advise buying term life insurance and investing the difference elsewhere to those who still qualify to contribute to other tax-deferred investment growth such as IRA’s or 401k’s.
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 expect 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, and 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.
Uses
Because term life insurance is a pure death benefit, its primary use is to provide coverage of financial responsibilities, for the insured. Such responsibilities may include, but are not limited to, consumer debt, dependent care, college education for dependents, funeral costs, and mortgages. Term life insurance is very often chosen in favor of permanent life insurance because it is usually much less expensive (depending on the length of the term).
Many Financial Advisors or other experts commonly recommend term life insurance as a means to cover potential expenses until such time that there are sufficient funds available from savings to protect those whom the insurance coverage was intended to protect. 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 their dependents.
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 assumed 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.
Payout Likelihood and Cost Differential
Both term insurance and permanent insurance use exactly the same mortality tables for calculating the cost of insurance, and a death benefit which is income tax free, as long as the policy is in force and premiums are current; however, the premiums are substantially different.
The reason the costs are substantially different is:
A. Term insurance may expire without paying out, while permanent programs that are kept in force must always pay out eventually.
B. Permanent insurance has built in cash accumulation vehicles of varying natures, depending on the type of insurance, making the premiums more expensive by nature.
Simply put, Term insurance is just that, good for a specified term, and premiums charged to the insured represent risk only. While on the flip side of the coin, Permanent insurance is permanent in nature, covering the insured for the duration of their life so long as premium obligations are met. Moreover, permanent Insurance is made up not only of a risk protection element, but also a savings/investment element meant to build cash value.