Feature Article
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.
Concepts
Theory of Decreasing Responsiblity
Term insurance should be purchased with the Theory of Decreasing responsibility
in mind. This theory assumes that the insured realizes all financial responsibilities
are temporary and insurance should be purchased to offset those responsibilities.
Buy Term Invest the Difference
Buy term and invest the difference is a concept that grants the insured unlimited
flexibility in investing their money and should be used in combinations with
the Theory of Decreasing responsibility.
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 and 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. 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 20 years,
or until age 95 sometimes. In this form the premium is slightly higher than
for a single years coverage, but is much more likely for the insured to have
the benefit paid.
Level Term
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.
Payout likelihood
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, combined with some term premiums rising every year so that the insured finally does not continue the policy as they get older (and more likely to die).
Due to this low likelihood of receiving a benefit, but reallizing the death
benefit coverage may be important to achieving the insured's goals, many people
are drawn towards permanent life insurance. Permanent life insurance offers
coverage for the entire life of the insured and therefore will pay a death
benefit as long as premiums are current. Permanent coverage also allows certain
tax advantages, including tax deferred growth of cash value and greater likelihood
of receiving a death benefit, which is also usually tax free. Though if the
policy is cancelled any cash value growth above premium payments is taxable.
Conversion Privileges
Because people may prefer permanent life insurance, but may not be able to currently afford the 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 cheaper term insurance, but be able to utilize the tax advantages of a permanent policy as cash flows increase.
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