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What is 'Term Life Insurance'

A type of life insurance with a limited coverage period. Once that period or "term" is up, it is up to the policy owner to decide whether to renew or to let the coverage end. This type of insurance policy contrasts with permanent life insurance, which is intended to provide life-long protection.

Other characteristics of term insurance include:

  • Low cost
  • No cash value
  • Usually renewable
  • Sometimes convertible to permanent life insurance


BREAKING DOWN 'Term Life Insurance'

Term life insurance policies provide a stated benefit upon the death of the policy owner, provided that the death occurs within a specific time period. However, the policy does not provide any returns beyond the death benefit (the amount of insurance purchased); the policy has no additional cash value, unlike permanent life insurance policies, which have a savings component, increasing the value of the policy and its eventual payout.

Because of this, term life insurance is also known as "pure life insurance": Its only purpose is to insure individuals against the loss of life, and all premiums paid are used to cover the cost of insurance protection.

Characteristics of Term Life Insurance

Premiums for term life insurance are based on a person’s age, health and life expectancy, as determined by the insurer. If the person dies within the specified term, the insurer pays the face value of the policy; if the term expires before death, there is no payout. Policyholders may be able renew a term policy at its expiration, but their premiums will be based on their attained age.

Say, George is 30 years old and wants to protect his family in the unlikely event of his early death. He buys a $500,000 term life insurance policy that charges him $50 a month for the next 10 years. If George is suddenly struck by lightning and dies before the 10-year period is over, the policy will pay George’s wife and children $500,000 as long as he’s kept up the payments. Or, say George pays his premiums every month until he’s 40 and must then decide whether to renew. If he chooses not to, and he’s struck by lightning the day after his policy expires, his family gets nothing.

Since it is for a temporary amount of time, and it pays only a set death benefit, term life is the least expensive type of insurance to buy. A healthy 35-year old (non-smoker) can typically obtain a 20-year level-premium policy with a $250,000 face value, for between $20-$30 per month. Purchasing a comparable whole life policy (a type of permanent life insurance) would more likely cost four figures a month. Because the majority of term life policies never pay a death benefit, insurance companies can offer them much more cheaply than whole life policies (every one of which eventually pays), and still make money.

How Premiums Work

Term life insurance premiums are set based on the age, sex and health of the policyholder, as determined by a medical exam; also included factors such as driving record, medications, smoker or non-smoker status, occupation and family history.

The younger a person is when he takes out a term life policy, the cheaper his premiums. The reason is obvious: A person is statistically less likely to die between the ages of 25 and 35 than between the ages of 50 and 60. For younger ages, term coverage is inexpensive and the premium can be guaranteed not to change for up to 30 years. Once the guaranteed period ends, the policy still remains in force, but changes to a one-year renewable term. The premium is then based on your attained age and increases every year.

Interest rates, the financials of the insurance company and state regulations can also affect premiums. In general, companies often offer better rates at "break point" coverage levels of $100,000, $250,000, $500,000 and $1,000,000.

Types of Term Life Insurance

Level Term or Level-Premium: Level term life insurance provides the insured with coverage for a specified period of time; the term may be one, five, 10, 20 years or longer. The premium is calculated based on the age and health of the insured. The insurer levels out the premium payments by charging more at the beginning of the policy than mortality costs require, so the premium payments are fixed and guaranteed for the duration of coverage.

Yearly Renewable Term: A yearly renewable term (YRT) policy has no specified term and is renewable every year without evidence of insurability. The premiums on a YRT policy start off low and increase each year because they are based on the insured’s attained age. Although there is no specified term with a YRT policy, premiums can become prohibitively expensive for those at later ages, making the policy difficult to maintain.

Decreasing Term: A decreasing term policy features a death benefit that declines each year according to a predetermined schedule. The insured pays a fixed, level premium for the duration to the policy. Decreasing term policies are often used in concert with a mortgage to match the coverage with the declining principal of the loan.

Who Is Term Life Insurance Good For?

A popular time to take out a term life insurance policy, particularly one with a 20-year term, is upon having children. They are usually a good fit for younger people with families, just in case something happens to the primary earner. They are also well-suited to people who know for certain their need for life insurance coverage will be temporary — in other words, they feel their surviving family members will no longer have a need for the extra protection life insurance provides or that they will have accumulated enough liquid assets to self-insure. If you only need insurance for 10 years, then buy term.

As you move through different phases of life – buying a house, starting a family, opening a business, retirement – the amount and kind of life insurance you need also changes. When you're young and need a lot of coverage to replace a loss of income for your dependents, term life insurance often makes the best sense (and in fact has become the default option for most insurance buyers, primarily because it is inexpensive and uncomplicated). As you accumulate assets and need coverage that will last for your lifetime, permanent life insurance may be the better option.

Term vs. Perm: Term Life Insurance Vs. Permanent Insurance

However, the right choice between permanent insurance/cash-value insurance products (whole life, universal life, etc.) and term life insurance also depends in large part on the circumstances and mindset of the policyholder.

In general, term life policies are ideal for people who want a lot of coverage but do not want to pay a lot in premiums each month. Whole life customers pay more in premiums for less coverage, but they have the security of knowing they are covered for life at a set premium, assuming they keep up with their monthly payments.

While many people strongly favor the affordability of term life – relatively low premiums for a higher death benefit – others cannot stomach the idea of paying  premiums every month for 10 or 20 years and then, assuming they are still alive (which is the most likely scenario) having nothing to show for it at the end of the term. It's similar to people preferring to buy their homes rather than renting. They like the fact that home ownership provides tax benefits, builds equity and, at some point, they will own their houses outright. The same is true for permanent life insurance.

Not to mention the fact that term insurance premiums get more expensive as one ages: Those who choose to carry term into their later years may end up paying premiums that are commensurate with the cost of some of the newer permanent products that are now available in the marketplace. If you remain healthy, you may be able to find new coverage at a reasonable cost. However, if you have health or other issues (such as traveling to foreign countries), you may be rated (which increases the premium), or even deemed uninsurable – and stuck with the increasing annual renewable term policy.

Some customers also prefer permanent life insurance because these policies can be used as investment/savings vehicles: A portion of each premium payment is allocated toward building up cash value (one reason why it's higher than a term policy premium), and with many types of policies, the cash value growth is guaranteed. Some plans pay dividends, which can be paid out or kept on deposit within the policy. Over time the cash value growth may be sufficient to pay the premiums on the policy, so, in essence, you own your policy outright. There are also several unique tax benefits, such as tax-deferred cash value growth and tax-free access to the cash portion.

Of course, as many financial advisers point out, the growth rate of a cash value life insurance policy is often paltry compared to other financial instruments, such as mutual funds and exchange-traded funds (ETFs); substantial fees often hinder the rate of return. Hence, the common saying "Buy term and invest the difference."

Still, the return is steady and tax-advantaged. And many products are getting more sophisticated, too, permanent-life supporters say. Some illustrations only use traditional whole life insurance and compare the guaranteed values in those policies against the historical growth of the stock market. But newer, more competitive products, such as an equity indexed universal life policy, may be able to produce much higher returns over time.

Term vs. Perm: Other Factors to Consider

Obviously, there is no-one-size-fits-all answer to the term vs. perm debate; even generalizations are difficult. Proponents of both sides can cite numerous studies and examples based on historical performance that show why their position is the correct one. But other factors to consider include: 

  • Rate of return earned on investments versus permanent policy cash value (and whether consistent investing is feasible for the client).
  • Whether these investments will be in a traditional or Roth IRA or qualified plan and whether there will be any matching contributions in employer-sponsored plans.
  • The type of term policy used and whether it has any riders, such as guaranteed renewable or return of premium.
  • Loan provisions and other features in the permanent policy.
  • When the permanent coverage becomes paid up.
  • Rate of withdrawal of assets at retirement.
  • Lifespan of the investor and spouse.
  • When Social Security will be taken.
  • Whether accelerated benefit riders are purchased and used in either type of policy.
  • Whether policyholders expect to carry a mortgage late in life. 
  •  The policyholder has or intends to have a business which requires insurance coverage.
  • Whether life insurance could play a role in tax-sheltering a sizeable estate.

Convertible Term Life Insurance

To many, convertible term life insurance offers the best of both worlds. This is a term life policy which includes a conversion rider: The rider guarantees you the right to convert an in-force term policy (or one about to expire) to a permanent policy without going through underwriting or proving insurability.

The key features of the rider are: (a) you maintain the original health rating from the term policy upon conversion, even if you later have health issues or become uninsurable, and (b) you decide when and how much of the coverage to convert. The premium for the new permanent policy will be based on your age at the time of conversion. For example, say you purchase $1 million in a 20-year term policy at age 29. At age 39, you decide to convert $250,000, then convert another $250,000 at age 49, and allow the remaining $500,000 of coverage to lapse. The premium for each of the $250,000 policies would be different based on ages 39 and 49.

Of course, overall your premiums increase significantly, since whole life insurance is more expensive than term life insurance. The advantage is the guaranteed approval: You does not have to undergo a medical exam as a new customer would. Any long-term medical conditions developed during the term life period cannot be used to adjust premiums upward. Even if there haven't been major changes in your health, insurance companies continually review underwriting standards as new technology becomes available, and you could suddenly go from a preferred to a lesser rating if you tried to buy a whole new policy.

However, if you wanted to add additional riders to the new policy (e.g., a long-term care rider), the insurance company may require you to go through underwriting again, and only offer you the new policy with additional riders at a lower health rating.

The premium for a term policy with a conversion rider may cost more, but it may be worth the small additional cost to have the option of switching to permanent coverage. The conversion rider should allow you to convert the term coverage to any permanent policy the insurance company offers with no restrictions (i.e., having to convert by a certain age during the first five to 10 years that the term policy is in force, or limiting partial or multiple conversions).

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