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 now 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 say an earthquake or fire. Whether or not these event will occur is uncertain, and if the policy holder discontinues coverage because they have sold the car or home the insurance company will not refund the premium. This is a pure risk protection.
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[edit] Usage
Because term insurance is a pure death benefit its primary use is generally 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, and mortgages.
[edit] 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.
Since 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 experienced with some of these policies is requirining proof of insurability to renew. 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.
[edit] 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. This clause is typically only invoked if the health of the insured deteriorates significantly during the term.
[edit] Term Life Insurance with Return of Premium (ROP)
Another form of insurance currently being marketed is called Term Life Insurance with Return of Premium (ROP). Though it is called Term Life insurance this type of policy has more in common with forms of Permanent life insurance than true Term with a Pure Death benefit.
These policies offer a partial or complete return of premiums in a lump sum if the insured is still alive at the end of the guaranteed level period, usually 15, 20 or 30 years. If the insured dies during the term, the death benefit is paid as with traditional term life insurance without a return of premium. The premiums are higher for ROP products, because the policyowner receives the premiums paid over the term back. How this works is that the extra premiums are set aside in a savings vehicle designed to accumulate to an amount of money equal to the premium paid in at the end of the term. The amount is then returned as a refund of premium. This functions is virtually identical to the cash accumulation feature on most permanent life insurance products, and provides a less substantial return than other investment vehicles.
Like Permanent products some ROP products also allow loans on a percentage of premiums paid up to that point after a designated number of years have passed. ROP products are more attractive to healthier people who believe they will live past the term and and receive the large sum ROP to apply toward future expenses, such as college, wedding or house downpayment expenses.
[edit] 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.[citation needed] 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.
[edit] Conversion Privileges
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.
