A Basic Overview of Term Insurance
Today, I’d like to say a few words about term insurance.
In order to understand term insurance, it can be helpful to frame the discussion in terms of what it’s contrasted against.
In the main, there are two different kinds of insurance for life insurance products: permanent[1] and temporary.
There are a couple of other options in between, but, here, I’m just focusing on the temporary kind of insurance. And, in a word, that’s term.
So, just briefly stated, temporary insurance is term insurance. This is opposed to permanent insurance – the gold standard for which is basically whole life.[2]
Term is sometimes referred to as “pure insurance” or “pure protection.” What’s referred to, here, is the idea that term insurance does not have a savings component. There is no “cash value” associated with term insurance.
Permanent insurance, on the other hand, has a savings component that is referred to as its “cash value.”
What is cash “value”?
I’ll try to answer that question, first, by offering an analogy.
Analogy: Renting Vs. Buying
Think about the difference between renting a home or an apartment and buying a house.
When you rent, you’re not building up any equity in the property. Instead, you are paying a landlord and what you are getting in return for your payment is a roof over your head. Or, to put it differently, you are purely paying for someplace to live.
Renting is purely providing you with a dwelling.
When you buy a property – or, at least, when you pay toward a mortgage in order to become the owner of the property, eventually — you are building “equity” in that property.
“Equity,” simply stated is the difference between what you owe on a property and what it’s worth.
The difference between term insurance and whole life insurance is not precisely the same, but it but it’s pretty close in this respect. Cash value is akin to equity.
When you are paying premiums into a term policy, you are not building up any cash value. It’s like renting.
When you pay premiums into a whole life policy, you are building cash value – and cash value is something like the equity you build in real property that you may buy.
Now, it’s a little different, in the sense that the equity in a property is going to be the money that you would basically get in the event that you liquidated the asset and after you discharge whatever debt you have on that asset.
For example, let’s say that you buy a $250,000 house. Pretend that you put 20% down on it. So, your putting $50,000 down and financing $200,000. We would say that you have built an immediate $50,000 worth of equity in the house.[3] (And this only increases with time, assuming that you make your mortgage payments.)
After you make your down payment (and after you close on the property!), your real estate has got $50,000 worth of equity built into it. And what that means is that if you go to sell that house, assuming the property’s value is at least the same as it was when you bought it, $50,000 to extract from the house.
To put it slightly differently, you sell the house for $250,000. Simplifying things, the buyer gives you $250,000. You took out a loan for $200,000. So, out of the $250,000, you take $200,000 of that money to pay off your loan.
And what are you left with?
$50,000.
You literally got back the $50,000 that you put “down.”
Now, understand: In real life you would have closing costs and taxes and lots of things. Ordinarily, you would never go through the rigmarole of buying a house, putting $50,000 down, and getting a mortgage loan only to go and sell the thing immediately.
This is just a mental exercise.
In theory, a piece of real property can function like a savings vehicle – or even, in some markets and areas, as an investment vehicle.
You might be saying: That’s a well and good. But…
What’s This Got to Do with Life Insurance?
Well, there is something called a “single-premium whole-life policy.” You literally plop one infusion of cash into the thing. It’s got one premium payment to make and then you’re finished paying for it.
Let’s say that, at the age of 65, you put $50,000 into a policy of this kind. At that age, and if you’re in pretty good health, your $50,000 might buy you $100,000 worth of coverage right off the bat. And you have no other premiums due.
But, besides the $100,000 worth of death benefit that you have, you also have your $50,000 in cash – just sitting in the policy.
If you went to cash that policy out, you could – in principle – get your $50,000 back. You’d get it back pretty much the same way you get your down payment back: by liquidating the asset you put the money into.
Now, in real estate, that means you sell your property. In life insurance, it means you surrender your policy.
Similar caveats apply to life insurance as to real estate. Just as you wouldn’t normally buy property only to immediately sell it for the same price you bought it for, you wouldn’t normally plop cash into a life policy only to surrender it immediately. In both cases, doing this is very likely to result in a loss of money for you.
But these are just thought experiments.
If whole life is like buying a property, and cash value is like equity, then term insurance is like renting.
There isn’t any sort of equity or cash value that you build up in the property.
Is the Lack of Cash Value Bad?
Not necessarily; it depends!
There are many conditions under which a person would be advised to rent instead of to buy. Maybe you only expect to live in a particular area for a few months, for instance.
Likewise, there are many conditions and circumstances in which a person might be advised to purchase term insurance.
Different Kinds of Term Insurance
There are different kinds of term insurance.
First of all, and most basically, there’s going to be a difference in term insurance with respect to the length of the term.
The “term” is the period of time that the policy is in force. So, some “terms” might be 10 years, 15 years, 20 years, and so on.
Secondly, there’s also a difference of whether or not the death benefit remains level.
Let’s say you buy a $1,000,000 term policy. If the term is “level,” that means that the death benefit remains at $1,000,000 for the duration of the term. If it’s a 20-year $1,000,000 level term policy, then at year 1 it would pay out $1,000,000 and at year 10 it would pay exactly the say amount (assuming premiums are paid and it’s in force).
In contrast to the above kind of “level term,” there are policies where the death benefit can decrease or increase over time.
If the policy gets smaller over time, this is called “decreasing term.” If it gets larger, it’s called “increasing term.”
Thirdly, some term policies are convertible.
We already noted the difference between term insurance and, say, whole-life insurance. Well, sometimes, people can switch between the two types.
Going from term to whole life can be done a number of ways.
Number one, a person could simply buy a new whole-life policy and effectively replace his or her term policy with it. (That is, just buy a new, permanent policy and let the term lapse.) You’ll have to reapply and re-underwrite.
Number two, a person could exercise his or her conversion option, if one exists.
Some term policies allow insured parties to basically take some or all of their term coverage and “turn it into” whole life. Usually, this is accomplished by readjusting the premium to correspond to the insured’s age at the time of conversion. But this option does not usually require additional underwriting.[4]
It’s sometimes said the only life insurance policy that matters, is the one that is in force on the day that you die. So, if you know there’s a low likelihood of the term policy paying, then you might think that converting some (or all) into something permanent will guarantee that you will have some protection in force at the time of your death..
Fourthly, there is a question of renewability.
As we stated, term policies are temporary policies. Let’s suppose that right now you purchase a 10-year level term policy. 11 years from now, the term will have concluded.
The question of renewability is basically this: At the end of year 10, do you have the option of buying additional time?
The question needs a bit of clarification.
At the end of year 10, there is of course nothing stopping you from trying to apply for and purchase another policy. This would require that you go back through the underwriting process so that the insurance company can reassess your health and insurability.
But what we’re thinking of with renewability is this: Can you basically extend your original 10-year policy for a longer period of time without getting underwritten again?
If the answer is “yes,” then your policy is renewable. If the answer is “no,” then it isn’t.
Some statistics suggest that fewer than 2% of term policies actually pay out. In part, this is because people outlive their term.
Think about it. Maybe you get a 10-year term, 15-, 20-, 30-year term, whatever. Your term policy covers you for 10 years, 15 years, 20 years, 30 years.
Let’s say that you are 30 years old when you take out a 30-year term. Well, in 30 years you’ll be 60.
Of course, anything can happen. But… Do you really think that you’ll die before you turn 60?
Suppose you make it to 60. Congratulations! You didn’t die!
But, since you’ve outlived your term, your policy won’t pay out. Ordinarily, that policy would just terminate.
If it’s renewable, however, you can “reup” the thing for another term. (Maybe not another 30 years. But maybe for another 10 or 15.)
Here’s another example.
Consider a person who is 20 years and old buys a 20-year term policy.
Well, that term policies going to expire by that person’s age 40. If his or her policy is renewable, that means that at his or her age 40 that individual will receive an offer to extend the term, let’s say, for another 20 years.
If he or she has renewable term, then that renewability is guaranteed on the basis of the original underwriting. This means that the individual at age 40 is guaranteed to be able to continue his or her policy.
However, it’s not to be continued at the same premium rate that was assessed when they were aged 20. The premium rate will be reassessed to their new insurance age 40.
But they don’t have to go back through underwriting to renew that term. All they do is start paying the new premium, and they’re good to go.
Can this be a great feature?
You bet. Particularly, if you are less healthy than you were at 20.
In some cases, maybe a person has gotten into health “kick” in their 30s. Maybe they’re healthier. Maybe it would be an opportune time to re-rate the person or have them apply for a different policy to try to get a better ort “preferred” rate.
But in the case of many people, as they age their health is declines. It can be somewhat comforting to have a policy with the renewability privileges baked into them so that there doesn’t have to be another health assessment, paramedical or anything like that when renewability comes up.
Depending on the table you consult, life expectancy for the average male is somewhere between the mid-70s and the mid-80s. The average female is predicted to live a bit longer: often this is predicted to be somewhere between low- and upper-80s.
Actuarially and statistically, term-life companies are betting that that 30-year-old will outlive his or her policy.[5]
Is not renewing – or, similarly, is non-renewability – necessarily a bad thing?
Again… it depends! What do you need the life-insurance policy to do?
Possible uses of Term-Life Policies
What would a person want these various policies for?
Term has many important uses.
Decreasing term, for example, might be used to keep pace mortgage balance. So (and I’m just making up the numbers), maybe you owe $200,000 on your mortgage. You have a 30-year loan. And you’re paying $1,000 per month. The amount you owe therefore will go down by about $12,000 each year.
Let’s say that you take out a $200,000 30-year, decreasing-term policy. As you pay down your mortgage (and build up your equity!), your coverage also goes down.
If you tragically died in the first year, your survivors would receive $200,000 – enough to pay off the mortgage. If you died halfway through, maybe you’d get $100,000.
This is okay in this application because the further along you get, the more you’ve paid down your mortgage. For this example, you won’t need $200,000 in 15 or 30 years because – theoretically – your mortgage will be paid down, or paid off.
Level term might be used for income replacement.
So, for example, a person who is let’s say 30 years old makes $100,000 a year over the next 30 or 40 years. That person would be expected to bring in about three or four million dollars – abstracting away from cost-of-living increases, inflation, raises, and a lot of other stuff.
The rough math is simple. You just multiply the yearly income – in this case, $100,000 – by the number of years you expect to work (assuming a retirement at age 70, to keep round numbers).
So… a hundred thousand times 30 years equals 3 million. A hundred thousand times 40 years yields four million.
It may be that level term policies are used to cover (some of) that.
Put a big asterisk on those numbers, because there are number of different calculations that can be used to try to ascertain insurance and income-replacement need. The only reason I am doing it in this clumsy way, presently, is to give you a fix on the numbers involved and to get you used to thinking along these lines.
In another place, I will go into the various methods – and completing schools of thought – surrounding these kinds of calculations. So, don’t get upset if I haven’t used your favored approach.
Let’s round things out.
Increasing term might also be used for income replacement, but perhaps with a twist.
Perhaps we know that this 30-year-old is on track in his or her job to receive substantial increases in pay over the next five or 10 years. It may be that increasing term policy is able to keep pace with these raises without the person having to re-underwrite for a certain additional coverage every time there is a bump in salary.
As always, there are complications.
Decreasing term could also be used for income replacement. This is because, on the face of it, the amount of term that’s necessary will go down as the years advance since the person in question will have fewer working years remaining. But, this is just an overview. I’ll go into more detail in later posts.
Miscellaneous Uses
Another term-insurance use worth mentioning is that of student-loan or other debt payoff.
Let’s say that a young person takes out a student loan. If that young person were, tragically, to die before the loan was paid off – and it’s an “unforgivable” loan – then perhaps the parental cosigners (if applicable) are going to be on the hook for that bill.
Some people like having some kind of policy that is keeping pace with the student loan payoff, so that in the unforeseen and unfortunate circumstance of the child’s death, the student loan can be discharged.
Similar things can be said for vehicle loans and other sorts of personal loan.
Term policy can also sometimes be used for something called “pension maximization.”
That will be a complex topic that lies well beyond the scope of what I can get into, here.
Annual-Renewable Term (ART)
There is another special kind of term that is called annual-renewable term.
Annual-renewable term is term that has to be renewed every single year.
Yearly, the insured has the option to re-up the policy. But, with annual renewable term, every year the policy gets a little bit more expensive.
With, say, level term, expenses are averaged over the life of the term. So, compared to ART, a level term policy may be more expensive year one, but less expensive by year 10.
To put it another way, the ART policy will start out less expensive, but get more expensive over time. Premiums for a level term will start out more expensive, but will often end up being comparatively less expensive.
ART might be used when the coverage need is very short-lived.
Or, it may be used in situations where the coverage amount is unavailable in other forms of term.
Or, again, it might be used when there isn’t sufficient budget available for a different sort of policy.
Return-of-Premium (ROP) Term
There is also return-of-premium term.
This is usually a term policy conjoined with some sort of “rider” (that is, a policy “extra”) that provides that if the insured dies after the term completes, then there will be a refund of some or all premiums that were paid into the policy.
This kind of a rider is usually fairly expensive to add on. What’s the benefit?
Well, recollect that fewer than 2% of term policies ever pay out. (According to some Google-able stats, anyway.)
So, for some people, it’s worth the extra money to guarantee themselves a “refund” at the conclusion of the term.
Other ‘Extras’
There are other riders that can be available on term policies.
Sometimes there are “disability waivers” that provide premiums to be paid or waived in the event that the insured is disabled and unable to work.
Sometimes “child,” “family,” or “spouse” riders provide additional, low-cost coverage for other family members.
There can be “non-family” riders for business partners.
Some companies off “accidental death,” “dismemberment,” or “double-indemnity” riders that increase payouts under certain scenarios.
There are “guaranteed-purchase” riders than can enable a person to obtain more coverage later on, without having to be re-underwritten.
And there are certain “accelerated-death-benefit” riders that give access to death proceeds ahead of death in order to pay for chronic illness, long-term care, or terminal illness.
What riders are available will depend on the insurance company in question.
You might think of riders like options packages on a car.
When you buy a car, you can customize it to your preferences by adding features and options – at additional cost – that don’t come standard on the “base models.”
Termination of Coverage
Of course, it is possible for a term policy to terminate prior to the conclusion of its contractual term. This might occur, for instance, in the event that premiums are not paid are scheduled.
But, generally speaking, if the premiums are paid, term policies will go from whatever date the contract is issued until such time as the term concludes.
Pros of Term
Term insurance of term gives you a lot of insurance bang for your buck. You get a high amount of death benefit for a comparatively low amount of premium.
Another positive is that term policies have a lot of versatility. There’s a number of things that can be done with them.
As we have just seen, they can be used for income replacement and for the discharging of various loans.
Finally, term policies have no cash value.
Now, I’m going to list this as both a pro and con. And that might seem somewhat contradictory.
But what I’m trying to underscore in virtue of doing that is to say that there are competing philosophies for how to calculate death benefits and for how to use insurance in your financial plan.
One perspective, popularized by such individuals as Suze Orman and Dave Ramsey, has it that you want to have term so that you have more money to invest in the market.
Think about it this way. You have particular whole-life policy, let’s say paying a death benefit of $500,000. A term policy with the same death benefit is going to have a comparatively lower premium.
The Orman-Ramsey idea is that you would purchase the term policy and then invest the difference between the whole-life premium and the term premium.
The reason for this advice is that Orman and Ramsey think you can get a lot higher return on your money by investing in the market.
So, on this point of view, you could consider the lack of cash value in a term policy to be a positive thing. That would be on the assumption that you share the perspective (or are persuaded by the advice) of people like Susie Orman and Dave Ramsey.
Cons
On the other hand, as has been stated, fewer than 2% of term policies are often said to pay out. This may be because the policies may lapse due to lack of premium payment or because the person outlives the term. Other figures suggest it might be as low as 1% of terms that pay out.
In any case, this is a negative from the standpoint of final expenses. Burial, crematory, and funeral expenses will occur at death. (Duh!)
If there is a 90+% chance your term won’t be in force when you die, then you should probably have another plan for how you will pay these.
You could prepay or use funds from a retirement account or whatever. But you have to realize that the money probably won’t be coming from your term insurance.
Additionally, some legacy planning and other types of estate planning (e.g., trust-funding) are going to depend upon a policy being in force when you die.
With its high likelihood of lapsing, term is not ideal for this application.
And, as I said, not everyone shares the Orman-Ramsey point of view about investing in the market.
This is too big of a topic to tackle, presently. But suffice it to say there are planners who advise the incorporation of life insurance into financial planning – whether estate planning, final-expense planning, legacy planning, retirement planning, what have you.
Conclusion
Whether term is right for you or not is going to depend on many things.
It will depend on your goals. Your needs. Your health and insurability. Your overall financial situation. And much else besides.
If you need a funeral policy, then you want one that has a high probability of being in place when you reach your life expectancy. And this probably won’t be term.
On the other hand, if you need to replace your income or pay down a mortgage or student-loan debt, then term might be just the right thing.
Every “pro” could be a con for certain applications. And various “cons” might be pros after all from another point of view. Whether a thing is a positive or negative depends in part on what the term is being used to do.
A knowledgeable advisor should be able to help you navigate through these waters.
I cannot give you direct advice, but I can simply say that my sketch of what term involves has been for general informational or entertainment purposes only. If you require more in-depth consultation, please consult with a professional in your area.
I hope that this has been somewhat helpful for you!
Notes:
[1] There is an immediate difficulty in the sense that “permanent” is usually defined as the “totality of one’s life.” However, this has to be sharpened up a bit, since if a person dies during his or her term, term insurance would also have – in that case – covered a person for the “totality of his or her life.” What is really in view is a person’s life expectancy, as calculated actuarially and represented on a mortality table.
[2] When I say “gold standard,” I mean with respect to its permanence. Another sort of life insurance product, universal life, is also capable of being “permanent.” But whole life is guaranteed to be permanent, if the premiums are paid as scheduled.
[3] But, in putting “$50,000 down,” it’s not so much that you are spending $50,000, as you are simply transferring $50,000 from some cash position – presumably taking cash from some vehicle, like a certificate of deposit (CD), checking account, savings account, money market, etc. – and you are moving that cash into your real estate.
No, really… you can think of it as if you’re property becomes a kind of savings account. How safe it is – or how much of a return you get – depends on the housing market, and, as it’s often said, the location, location, location (!) of the property that you buy. But I digress.
[4] Unless, that is, you want more whole-life coverage than you had in term. If you’re wanting a higher death benefit, then you’ll probably have to get re-underwritten.
[5] Policies can also lapse (e.g., for non-payment of premium) before their terms conclude.