Term Life Insurance
Life insurance can be broadly classified as either term insurance or cash-value life insurance. Term insurance provides protection for only a limited time, and has no cash value, whereas cash-value life insurance usually covers longer terms, up to a lifetime, and builds a cash value for the policy owner.
Term insurance is the cheapest life insurance policy available. It covers a specific time period, and is usually purchased to cover the financial needs of children and surviving spouse until the children are grown. Term insurance can be bought for 1, 5, 10, or 20 years, and is renewable without needing to provide evidence of insurability, but the renewal price increases as the insured ages, as does the chance of death. However, term life insurance varies as to renewals and premium levels, including the following:
- annual renewable term, which is renewed each year at an increasing premium, but without regard to the insured's health
- convertible term is convertible to another type of life insurance policy — whole life, universal life, variable life, or an endowment policy — without having to prove insurability
- level term maintains the same death benefit and premium level for the entire term of the policy, which can be 5, 10, 15, 20, or 30 years
- decreasing term, where the death benefit decreases over the term, but the premium remains the same
- re-entry term life insurance provides a guaranteed term premium for the initial premium but allows the insured to requalify after a 5- or 10-year period, by undergoing a physical health examination to confirm that the insured continues to be healthy; otherwise, the rates are still guaranteed, but will be higher than re-entry rates.
Some insurers have an age limit for renewing term insurance to limit adverse selection. People in good health will frequently drop life insurance, but people in poor health will renew even at greatly increased prices. However, some insurers allow the renewal of term insurance at any age.
Most term insurance policies are convertible to a cash-value policy, if desired. To convert the policy, the amount that must be paid is determined by either the attained-age method or the original-age method. The attained-age method bases the insurance premiums on the age of the insured at the time of conversion. The original-age method bases the premiums on the age of the insured when the term insurance was first acquired. However, the insured must pay the insurer more money, equal to the difference between what would have been collected had the insured selected the cash-value policy initially over what was collected. Because of the cost of converting a policy based on the original-age method, most insurers either don't offer the original-age method or require conversion within 5 years of buying term insurance.
Types of Term Insurance
Term insurance policies vary widely, but the most common types are classified according to the terms covered, the amount of coverage and premiums, or how they change over time.
Yearly renewable term insurance covers 1 year, and is both renewable every year up to a certain age limit and convertible to a cash-value policy, without the need to provide evidence of insurability. The premiums increase every year.
There is also term insurance for 5, 10, 15, or 20 years or longer, that can be renewed. Premiums remain the same during the period, but increase with each renewal.
There is also a term-to-age 65 policy which covers the insured to age 65, with level premium throughout the term. The policy holder pays a higher premium at the start of the policy than he would for a shorter term policy. This builds up an extra cash reserve used to keep premiums level until the policy expiration. The insured can convert the policy to a cash-value policy before reaching a certain age, specified in the policy.
The need for term insurance usually declines as mortgages are paid down and children grow up and leave home. So money can be saved with decreasing term life insurance that provides a level premium over the term while the face value of the policy declines. Often, the insured may not even have to pay premiums for the final years of the term.
Increasing term life insurance is available for those who wish to provide a hedge against inflation, especially for parents with children who will be attending college. The face value of the policy, as well as premiums, increases over time at a stipulated rate.
An insured in good health can keep premiums down by purchasing a reentry term insurance. The insured must periodically provide evidence of good health and insurability to qualify for the lower premiums.
Benefits of Term Insurance
The main benefit of term insurance is its low cost. Because term insurance is the simplest type of policy, it is the easiest to sell. It was the earliest policy type sold over the Internet, with much more competition among insurers, which drives down prices.
Term insurance is also a natural policy for temporary life insurance needs. Many people don't need life insurance once they attain sufficient financial reserves to cover the loss of a life. The opportunity cost of buying term insurance, or cash-value policies, may be higher than simply investing the money, or even paying off debt, if the family has little income that is not likely to increase substantially. Paying off debt will also lead to a better standard of living.
However, if you want a cash-value policy, but simply can't afford it right now, then convertible term insurance can guarantee your insurability later when you can afford it.
Drawbacks to Term Insurance
The main drawbacks to term insurance are the increasing premiums with age, it cannot easily be changed to accommodate new needs, such as a new child, and it does not develop any cash value.
Increasing premiums and lack of cash value are not necessarily drawbacks. Since term insurance is cheap, the money saved could be invested for greater income that could more than cover the increasing premiums. When you buy a level-premium whole life policy, you pay more for the policy in the early years than would be required for term insurance, and this money is used later to offset the increased premiums that would otherwise be required to insure your life in later years. So buying term insurance while investing the savings may be a better use of your money and provide greater flexibility.