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What Is Term Life Insurance And How Does It Work

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Term Life Insurance

Term life insurance or term assurance is life insurance that provides Life Insurance at a fixed cost typically monthly or annual premiums for a limited period of time known as the relevant term for example 5, 10, 20 years or to say age 65; after that period (the term) the life insurance expires.

If further life insurance is required at the end of the term the cost and availability of further life insurance cover is no longer guaranteed. So the policy holder (the life insured) either loses the life insurance cover or if possible obtains further life insurance coverage with different payments (cost) and / or conditions – reflecting for example the increase in age and / or health conditions.

If the life insured dies during the term, the death benefit will be paid to the nominated beneficiaries for example the life insured spouse or children, or perhaps a charity.

Typically term insurance is the least expensive way to purchase a substantial amount of life insurance death benefit per premium dollar basis over a specific term.

Term life insurance can be contrasted to whole life, universal life, and variable universal life, which guarantee coverage at fixed premiums for the lifetime of the covered individual unless the policy owner allows the policy to lapse.

Term insurance is not generally used for estate planning needs or charitable giving strategies but is used for pure income replacement needs for an individual’s beneficiaries. 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 kept up to date and the contract has not expired, and does not provide for a return of premiums at the end of the term (but see Return Of Premium Term Insurance below).

An analogy being building insurance (that includes insurance against fire) for example if the insurance premiums are maintained and the policy is in force at the time of a fire at the insured building. Then the insurance policy will pay out the sum insured (the insurance).

Similarly with life insurance for example if the life insurance premiums are maintained and the policy is in force at the time the life insured dies. Then the insurance policy will pay out the sum insured (the insurance).

When To Consider Term Life Insurance

Because term life insurance is a pure death benefit, its primary use is to provide life insurance covering the financial responsibilities of the life insured or his or her beneficiaries.

For example Life insurance can insure the following consumer debt, dependent care, university education for dependents, funeral costs, and mortgages.

Its important to remember that term insurance provides insurance for a specific term (period of time). Term life insurance is therefore particularly suited to cover a person’s life insurance requirements that end at a particular time for example a mortgage with a term of 20 years or school fees for a new born child covering say 21 years.

If the required term of insurance cover is unknown for example estate planning or the absolute wish to leave a beneficiary a sum insured (a specified amount of money) on death then perhaps Whole Life Insurance or Universal Life Insurance should be considered.

Types Of Term Insurance

Annual Renewable Term Insurance

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 life 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.

Because 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 to renewal experienced with some of these policies is requiring proof of insurability. 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.

As a result some policies offer a feature called guaranteed re-insurability 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 for example 5, 10 years or until the age of 65.

Although initially offering low cost life insurance premiums, as the life insured increases in age the premiums increase with each renewal period, eventually becoming potentially unaffordable.

Level Term Insurance

The most common type of term insurance is level term insurance.

With term life insurance the premium is guaranteed to be the same for a given period of years for example 10, 15, 20, 30 years or to age 65.

With level term insurance the premium paid each year remains the same for the duration of the contract (the term).

The longer the term the higher the fixed premium amount (cost). This is because all other things being equal the old a person is the more likely they are to make a claim.

Some term life policies include an option to convert the term life insurance policy to a Universal Life or Whole Life policy. This option can be useful to a person who acquired the term life policy with a preferred rating class and later is diagnosed with a condition that would make it difficult to qualify for a new term policy. The new policy is issued at the rate class of the original term policy.

Commonly this option is beneficial were a person would like a Universal Life or Whole Life policy but cannot currently afford the premiums, here then they can take out a term life insurance policy and convert to a Universal Life or Whole Life policy at a later date with guaranteed insurability.

Decreasing Term Insurance (DTA)

Decreasing term insurance is often bought to clear a specific debt (typically a repayment mortgage) that is itself reducing in the amount outstanding over time, with the policy paying out in the event of the death of the borrower or his or her partner (here a joint life DTA policy may be beneficial).

The term is usually selected to align with the associated debt or event; for example a DTA can be used for insuring school fees as the child become older there are fewer costs to their education as an 18 years old student may only have 3 years of education left to fund as opposed to a 10 year old with say 11 years.

So DTA is useful if a large sum insured would be required immediately but over time a smaller amount would be acceptable.

How Does DTA Differ From Level Term Insurance?

Unlike level term life insurance cover, the amount of life insurance cover is reduced over the term – typically pro-rata over the term.

As noted, decreasing term policy can be cheaper than level term insurance because the sum insured goes down rather than staying the same throughout the term, reducing the risk of the insurer having to make a big pay-out of a large sum insured.

So Is DTA Right For You?

Decreasing term life insurance is popular with people on a tight budget as the monthly payments are lower than those you would pay with level term cover – here then the choice of DTA is on affordability.

But many people prefer to pay for level term insurance, even though they have for example a repayment mortgage.

The logic is that, if they set a sum insured that matches their mortgage debt but which stays at the same level as the mortgage debt falls, then they will have additional insurance that could be used for other purposes following a claim for example cash for your beneficiaries.

Moreover many people choose a level sum insured (life insurance) that is greater than their mortgage debt, so they know that their beneficiaries will be better taken care in the event of a claim.

In summary, for many people with dependents the difference in the premiums between decreasing and level term insurance is small and so they opt for a level term life insurance policy which would offer a larger sum insurance to be paid out on a life insurance claim over time (the term) to their dependents (beneficiaries).

Return Of Premium Level Term Insurance

This is a type of term life insurance coverage that provides a return of some or all of the premiums paid during the policy term if the insured person outlives the duration of the term of life insurance policy.

For example, if an individual takes out a 10 year return of premium level term life insurance policy and the 10 year term has expired with no death claim, the premiums paid (cost) by the owner of the policy will be returned to the policy owner.

The premiums for a return premium term life plan are usually much higher than for a regular level term life insurance policy but offer the benefit of the return of premiums at the end of the life insurance term were no claim has been made.

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