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How Term Life Insurance Works

As the word “term” implies, Term Life Insurance provides coverage for a certain term, or period of time.  Like automobile insurance, home owner’s insurance or health insurance, premiums for Term Life Insurance coverage have to be renewed periodically, or the coverage will expire. Therefore, Term Insurance contracts are not classified as permanent insurance.

It is a fact that 100% of all people will die. But Term Life Insurance is based on the odds that the insured will, or won’t die, within a certain time period.  With the help of actuarial science, the insurance company statistically determines how many people will most probably die within a given time period.  Furthermore, these actuarial statistics cover any given number of occupational and lifestyle habits, health issues, age or genetic factors which may, or may not, increase or decrease the life span of those applying for life insurance coverage.  For this reason, the initial cost of Term is typically lower than permanent life insurance coverage because it is based on a specific time period, not an entire life time.

Annual Renewable Term Life Insurance

Term Insurance is sold as annual renewable term or level term.  Annual renewable Term premiums are lowest when the insured is young, and there are no health, lifestyle or occupational risks.  Each year the annual renewable Term policies are contractually guaranteed to become renewable, but the premium paid for that renewed contract will increase.  This increase is designed to offsets the risk the insurance company is taking in offering the renewed coverage without requiring any further underwriting or examination.

Over time, annual renewable Term will become the most expensive life insurance that you can own.  That is one reason the majority of Term policies never pay out a death benefit.  According to a Penn State University study, 99% of all term policies never pay a death benefit.  Term coverage is either not renewed or it is converted to permanent coverage instead.

Buying Term and investing the difference has become a marketing theme to sell more Life Insurance. But David Babbel, Ph.D., the former senior financial economist in the Financial Sector Development Department of the World Banks, notes, “People don’t buy Term life insurance and invest the difference.  They rent Term Insurance, lapse it, and spend the difference.”

Level Term Life Insurance

Capitalizing on the “buy Term, invest the difference” philosophy, life insurance companies designed level Term Life Insurance.  Level Term contracts are renewable but the period of time between renewing is pushed out several years into the future instead of having to be renewed annually.  The renewable period on a level Term  policy might be 10, 15, 20 or even 30 years out from the time the contract is first initiated.

As a means of protecting their risk on these level Term contracts, the life insurance companies initially charge more for premiums of level insurance, versus annual renewable Insurance policies. However, that level premium is guaranteed for the entire level premiums period, not just for one year.

Once the level premium period has run out in 10, 15, 20, or 30 years, the cost to renew that Term policy will increase to match what the cost of an annual renewable Term policy would have attained over that same time period. Furthermore, the premium will never be level again but will continue to increase at the same rate that an annual renewable Term policy increases each year.

Buy Term, Invest the Difference

As mentioned above, this phrase has become the marketing mantra for those who don’t believe life insurance has any purpose after retirement.

(see our article on retirement strategy)

But investments made with “the difference” have not provided the yields needed for the investors.  Consequently, the Social Security Administration reports that 90% of seniors, age 60-89, are dependent on Social Security for income today.  And according to the Federal Reserve Notes, only 50% of families, where the head of household is 55 or older, have three months of expenses saved.[i]

Buying Term and investing the difference is not working for the majority of American families.  And the reason is that the ever-increasing cost of Term coverage makes it a poor tool to safeguard the wealth that is created over a lifetime. However, Term Insurance is a great way to cover liabilities should a life be cut short.

Who Should Own Term Life Insurance?

Due to the lower premiums available for young healthy adults, Term Life Insurance is a good fit for those who need to protect their income, providing for those who are dependent on them.  The cost of Term can easily fit into any size budget, but is especially beneficial for those who anticipate a higher income in the future.  It is also a great financial tool for young professionals who need to protect their higher incomes with affordable coverage until they are established and can move on to permanent life insurance coverage.

In other words, the purpose of Term Life Insurance is to cover the income of the insured.  If that income is lost due to the death of the insured, the tax-free death benefit will replace that income and allow the dependents of the insured to continue the lifestyle that they would have had had the insured lived.

Another purpose for owning Term Insurance is to cover a temporary liability like a mortgage or business loan.  Banks will often require a life insurance policy as collateral for such loans and Term is the least expensive way to provide that collateral.

Finally, Term Life Insurance is frequently used to ensure that permanent life insurance can be purchased in the future. Permanent Whole Life Insurance is a major asset that provides a way to transfer wealth tax-free. It does this while also generating high cash values. Policy owners can use the cash values to overcome the interest costs they will face throughout the insured’s lifetime.  Purchasing convertible Term Life Insurance, locks in the insurability of a person until they can affordably and comfortably convert to a permanent insurance policy. Purchasing convertible Term Life Insurance is a practical way to plan for the future.

Term insurance never builds equity, and so it is often referred to as “rented life insurance.”  There are types of term insurance that can build cash values, but this cash value is nothing more than premiums that have been paid for the term insurance.  Over time, the cost of issuing a Term policy is overcome by the insurance company’s investment of those premiums paid.

Some companies offer to pay this cash value of the policy to the policy owner if the Term policy is surrendered during the time period where there is cash value associated with the policy.  This surrendered cash value is typically limited to a certain age of the insured and if not surrendered at that time, then the cash value is used to offset the ever-increasing cost of the Term Life Insurance.

In a nutshell, here are the points you need to remember about Term Life Insurance:

Benefits of Owning Term Life Insurance

  • Typically, lower initial cost
  • Useful for temporary life insurance needs
  • Inexpensive collateral for certain types of loans
  • Can be used to ensure future insurability of the insured, if the policy is convertible

Downside of Owning Term Life Insurance

  • No equity developed
  • Not a solution for lifelong coverage
  • The ever-increasing cost for coverage makes it unsustainable

If you, or someone you know, is interested in purchasing life insurance, please contact our office.

[i] https://www.federalreserve.gov/econres/notes/feds-notes/assessing-families-liquid-savings-using-the-survey-of-consumer-finances-20181119.htm