What is Term Life Insurance?

Information about Term Life Insurance

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Term life insurance is the original form of life insurance and is considered to be pure insurance protection because it builds no cash value. This is in contrast to permanent life insurance such as whole life, universal life, and variable universal life.

Term life insurance provides coverage for a limited period of time, the relevant term. After that period, the insured can drop the policy or pay annually increasing premiums to continue the coverage. If the insured dies during the term, the death benefit will be paid to the beneficiary. Term insurance is often the most inexpensive way to purchase a substantial death benefit on a coverage amount per premium dollar basis.

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, an earthquake or 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.

Usage

Because term insurance is a pure death benefit, its primary use is to provide for covering financial responsibilities of the insured. Such responsibilities may include, but are not limited to, consumer debt, dependent care, college education for dependents, funeral costs, and mortgages.

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.

This issue is frequently overcome by a feature in some policies called guaranteed reinsurability included on some programs, 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 unviable 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 is the same, and 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. Typically this clause is invoked only if the health of the insured deteriorates significantly during the term.

Payout Likelihood and Cost Difference

Both term insurance and permanent insurance use the exact 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 that term programs may expire without paying out, while permanent programs must always pay out eventually. Insurance industry studies show that it is very unlikely that the death benefit will ever be paid on a term insurance policy. 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. The low payout percentage is a combination of there being a low likelihood (in the aggregate) of a random, healthy person dying within a short period of time. Because of the low likelihood of an insurer having to pay a death benefit, term insurance seems better when considered in terms of coverage per premium dollar basis - by a factor of up to 10.