The Basics of Life Insurance Part I: Term Insurance

The simplest form of life insurance is called Term Insurance.  Term takes it's name from the notion that it is purchased simply for a term (period of time), after which is it no longer renewable.  Not that long ago the general rule was term products were renewable to age 75 and that was it.  More recently this has been reviewed and some companies are offering term products that can be renewed past this date.  This is also governed by state insurance law so you should check on this for your specific state.  

Buy it, it's Cheap!

Term is pretty well known for it's extreme cheapness (or perhaps we should say attractive pricing) especially for younger people who likely have the greatest need for life insurance. Here's a breakdown on the three types of term insurance that you'll most frequently run into:

Annually (Yearly) Renewable Term

Annually (or yearly) Renewable Term–commonly appropriately called ART or YRT–is priced differently each year and is guaranteed renewable up to a certain age (formerly age 75, now it depends a little bit more).  Pricing follows a schedule that is stipulated by the insurance company at issue and sometimes has a current and guaranteed (which is higher) pricing schedule.

Each year, as the insured gets old (and intuitively as they probability of dying increases) YRT gets slightly more expensive.  In early years (say 20's or 30's) this is often a negligible increase (maybe a dollar or two per monthly premium).  Some companies have products that have a none guaranteed pricing schedule that keeps the price the same for a couple of years, and then it increases at certain intervals (again, emphasis on non guaranteed as this is more for marketing purposes, and will only hold true for maybe the first 10-15 policy years, if that long).

As you age, however, the probability of your dying begins to increase exponentially and the price of your YRT policy follows suit.  Once you start to enter your mid 50's, your formerly cheap term policy begins to get relatively expensive.  As you move on into your 60's and 70's pricing begins to get what many consider cost prohibitive and they cancel the policy.

 Level Term

Understanding that people like consistency and the ability to budget, the life insurance industry in its infinite resourcefulness devised a product that would be a tad more budget friends, and give term insurance a whole new applicability of the world “term.”  Enter level term life insurance.  This time, instead of having a gradually increasing premium, the policy has a guaranteed level period typically coming in either 10, 15, 20, or 30 years.  There are some other slight variations (like a 5 or 25 year term) but this is less common.  Also, it might be interesting to note that 30 year level term has been disappearing more and more over the past few years.

The idea for pricing looks something like this: the insurance company charges you a premium that is more expensive than what it would have charged you on a YRT policy for the first several years of the level period.  Than it undercharges you for the last few years of the policy.  Now, here's the biggy: come the end of the level term, the insurance policy realizes a substantial increase in required premium to renew the policy (if renewable at all, some insurance companies won't allow you to renew a level term contract past the level term, but this is extremely rare).

Not too surprisingly 10 year level term is less expensive than 20 year level term.  There's two basic reasons for this:

  1. The shorter the level period, the sooner the insurance company can increase the rate, so they're willing to charge less.
  2. The insurance company knows that in most cases you will lapse the policy if still alive after the level term period is up because you'll likely be able to purchase a new policy for less premium.  So the shorter the term period, shorter period of time they'll be on the hook for your death benefit.

Reducing Term

The third and final form of term insurance is commonly not referred to as life insurance at all.  It's known as reducing term insurance and it's used primarily to ensure that certain obligations are still met in the event of someone's death.  A great example would be mortgage protection insurance that is commonly offered by mortgage companies.  Let's say you sign a mortgage for $150,000 to buy a house.  Reducing term insurance would begin with a death benefit of $150,000 to satisfy the loan in the event you died.  The following year, principal payments reduce the loan balance to say $148,500 beginning in year two.  Now the reducing term policy death benefit is $148,500.

The key gripe about this product is that the premium remains the same throughout the life of this policy.  So, even though you'll receive less death benefit in later years (you won't actually, the bank will) you pay the same premium.   For this reason, it's common to be given the suggestion to purchase individual term life insurance (usually level term for the length of your mortgage) to ensure that you mortgage is paid off if you're going to worry about purchasing life insurance to pay off a loan (some people don't necessarily target in on specifics like this but that's a topic for another day).

What About Cash?

Depending on your age, you may be familiar with the notion of taking cash from a life insurance policy (which was a lot more prevalent before the stock market exploded and the Baby-Boomers decided they all wanted to be investors)  and wondering how that plays into all this.  The simple answer is it doesn't.  Term insurance has no cash value.  You pay premiums, if you die the insurance company pays a death benefit to your beneficiary(ies) and if you don't then the insurance company got to collect some premiums while you slept sound at night knowing that if the unfortunate happened to you someone would receive money needed to carry on without you.

Depending on how the premiums gets paid, some companies may reflect the “unearned” portion of your premium as cash value simply because if you die they would return this to you (e.g. you pay your premium annually every January, so the insurance company would take your premium and break it up into twelfths and show a declining cash value throughout the year until the end of December when all the premium would have been used).  If you had this sort of arrangement and died in January right after paying your premium, the insurance company would have to return 11/12 of your premium regardless of whether or not they reflected that unused portion as cash value or not, so if your policy doesn't reflect this, don't worry too much about it.

That's it for now, join us next time when we discuss the original form of permanent insurance, Whole Life Insurance.


Leave a Reply

  • RSS RSS

  • Archives

  • Categories