What is Term Life Insurance?
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 is temporary, as it covers only a specific period of time, the relevant term. If the insured dies during the term, the death benefit will be paid to the beneficiary. Because the term expires the insurer often does not have to pay out making term insurance the most inexpensive way to purchase a substantial death benefit on a coverage per premium dollar basis.
Because term insurance is temporary in nature its primary use is generally to provide for covering temporary financial responsibilities of the insured. Such responsibilites may include but are not limited to consumer debt, dependent care, college education for dependents, 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 just the expected probability of the insured dying in that one year plus a cost and profit component for the insurer. Since the likelihood of dying in the next year is low for anyone that the insurer would accept for the coverage, purchasing one year of coverage is not generally done, nor cost effective. The main problem with this type of coverage is that the insured could acquire a terminal illness within the year, but not 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 purchase a new policy. A variant that 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 accordingly and later becomes financially unviable as the rates for a policy would eventually approach the face amount. In this form the premium is slightly higher than for a single year's coverage, but is much more likely for the insured to have the benefit paid.
Much more common than annual renewable term insurance is insurance where the premium is the same for a given period of years. The most common periods being 10, 15, 20, and 30 years. In this form, the premium paid each year is the same, and is the cost of each year's annual renewable term rates averaged over the term, 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. This would be used if the health of the insured deteriorates significantly during the term.
Term offers coverage will pay a death benefit which is usually income tax free, as long as the policy is in force and premiums are current (Death benefits of both Term and Permanent coverage are usually income tax free).
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. That is the reason term insurance is able to be so 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 this low likelihood of an insurer having to pay a death benefit, term insurance is by far the most inexpensive way to purchase a death benefit on a coverage per premium dollar basis.
Permanent life insurance offers coverage for the entire life of the insured and therefore will pay a death benefit which is usually income tax free, as long as premiums are current or there is enough cash value to cover the premiums in some cases. This high payout likelihood, though, increases the cost per premium dollar substantially. Permanent coverage allows certain tax advantages, including tax deferred growth of cash value. This tax deferred growth is similar to that of a Roth IRA, however, if the policy is canceled any cash value growth above premium payments is taxable.
Some people may need to take advantage of the benefits offered by permanent programs, but may not be able to attain the proper coverage or higher premiums, many term policies offer a conversion privilege for a certain period of years, allowing the insured to convert to a permanent policy regardless of health condition at the time of conversion. In this way a person can obtain the necessary coverage for a young family, for instance by purchasing the inexpensive term insurance, but be able to utilize the benefits of a permanent policy as cash flows increase or as coverage needs decrease.
Conversion generally allows the policy holder to convert a term program to a permanent program with an equal or lesser death benefit without proof of insurability.