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What is term life insurance? Here's how it works

At a glance:

  • What is term life insurance and how does it work?

  • Types of term life insurance

  • Factors to consider with term life insurance

  • Summary of what is term life insurance

When we think of insurance, we think of paying a premium at set intervals and getting a certain amount of coverage. When we stop paying the premium, we stop getting the coverage. During this time, we feel safe, knowing that if something bad happens, the risk can be compensated.

The financial health of your family or other loved ones can be protected through life insurance—either term or whole life.

Term life insurance is often provided to employees in the form of group term insurance, but it is also available on the individual level. Although it does not build up a cash value like whole life insurance does, it is an attractive option for many people for a variety of reasons.

What is term life insurance and how does it work?

The primary purpose of life insurance is to provide financial support to your beneficiaries in the event of your death. Every type of life insurance policy has a regular cost (called a premium) based on your life expectancy and the type and amount of your insurance coverage.

Term life insurance is a life insurance policy that provides coverage at a fixed rate of payments for a limited period, called the term. Term is the original form of life insurance.

As insurance, it satisfies claims against what is insured, similar to how auto or health insurance works, as long as premiums are being paid for the period of coverage. If an event (i.e., your death) occurs, a benefit is paid out. If no event occurs, no benefit is paid out. Term life insurance is therefore a pure death benefit.

What term insurance costs

Term life premiums are usually very inexpensive when a person is young and healthy. They increase as you age due to the risk of your death increasing, and many of them expire without paying out, while whole life policies MUST pay out, per the contract, because they have an investment component that builds up cash for you. But as the years go on, term life premiums may total more than the death benefit of the policy.

Term insurance considers the following factors:

  • Length of coverage (term)

  • Face amount (death benefit)

  • Premium

Insurance companies use different combinations of these factors when constructing their policies. And the factors themselves can change. For example, the face amount can stay the same over the life of the policy, or it can decline.

Which is better: Term or whole life insurance?

Term can be contrasted with the other form of life insurance, called permanent (or whole) life.

A permanent life insurance policy covers you for life as long as you make your premium payments. The most traditional form of permanent life insurance is whole life. Once you are approved for the policy, the insurance company cannot cancel the policy, and the cost of your payments will not go up, because it averages insurance costs over your lifetime.

The financial health of your family or other loved ones can be protected through life insurance—either term or whole life. (Photo: Nick Ansell/PA Images via Getty Images)
The financial health of your family or other loved ones can be protected through life insurance—either term or whole life. (Photo: Nick Ansell/PA Images via Getty Images)

This means that over time the policy develops a cash value, which is a reserve the insurer accumulates in the early years so there will be sufficient money in later years to pay the promised death benefit, while keeping the premiums level.

Premiums for whole life policies are at first higher than those for term, but over the long run can end up lower and sometimes much lower.

How term life insurance works

The death benefit from term life insurance goes to the beneficiary on the policy. What happens with that money is up to the beneficiary.

The death benefit can be used for a whole host of financial obligations. In most cases, the beneficiary had been depending on the policyholder's income but no longer is; now the payout can provide a measure of financial security. Common uses for a term life death benefit include:

  • Family and dependent expenses

  • Debts, including mortgages and consumer debts

  • College education

  • Funeral expenses for the policyholder

  • Estate taxes

  • Replacement income from the policyholder

  • An annuity

  • Expenses needed for employment or setting up a business

A person taking out a term life policy usually factors expenses like these into his or her coverage needs. An insurance underwriter then writes a policy for him or her and determines the premiums to be paid for it.

Term life insurance provides coverage at a fixed rate of payments for a limited term. Once the term is up, you no longer have coverage and must reapply for it. However, the premium you once paid is not guaranteed, and you may have to satisfy more stringent conditions in order to qualify for coverage again. This proof of insurability, as it is called, can be a challenge as you get older if you have medical conditions.

If you die

If you die during the term that is covered, your beneficiary will receive a death benefit. If you do not die, no death benefit will be paid at all (unlike with whole life insurance). This fact leads some to liken term life insurance to paying rent as opposed to owning your home.

How payouts work

Proceeds from a term policy may be paid out as a lump sum or as an annuity. An annuity is paid over time in regular payments, either for a specified term or over the beneficiary's lifetime.

Types of term life insurance

Term life insurance policies exist in two main forms: annual renewable term and level term.

Annual renewable term

Annual renewable term covers one year, but is guaranteed to renew each year for a certain number of years. The coverage period varies from 10 to 30 years or up until a certain age, such as 95. The premiums increase each year.

Level term

Another option is level term life insurance. As the name suggests, the premium stays level for a certain number of years. After that term, the premium is likely to rise. The premiums' cost is based on the total cost of each year's rate, plus an inflation adjustment. Because of this, the longer the term of coverage is, the higher the premium.

Most level term policies contain a renewal option. This option, however, may not be guaranteed, and the policyholder may have to offer proof of insurability in order to get renewed. This can happen, for example, if the insured person's health takes a turn for the worse.

Factors to consider with term life insurance

Term life insurance can fit into your financial planning. Here are some things to consider.

Buying term and investing the difference

Cost is one of the attractive features of term life insurance. Because it is so much lower during one's younger years when one has less probability of dying, it can play an indirect part in one's financial planning.

Buying term and investing the difference" is a strategy in which a policyholder sets aside money equal to the difference between a term and a whole life policy. The person then invests this money elsewhere, typically a tax-deferred investment such as an individual retirement account. Over time, he or she builds up enough funds to approximate what would have been provided by a whole life policy.

Proponents of this strategy argue that you can spend less overall and get a return that is equal to or better than what you could get with a whole life policy. However, the burden is on you to be a disciplined saver and knowledgeable investor, and you take the risks upon yourself. With whole life insurance, the investment risk is assumed by the insurance company.

Convertibility

Many term life insurance policies offer the option to convert to a whole life policy. For some, this is a useful option, especially if they first bought the policy with an excellent rating but later suffered a health issue that jeopardized future term life insurability.

In this case, the person could convert to a whole life policy under favorable terms. The conversion is good for a certain number of years or up to a certain age.

Health and proof of insurability

Because term life insurance coverage renews periodically, proof of insurability is a major factor to consider. The odds of your health making you uninsurable increase as you age. What if you became terminally ill during a term of coverage? You may not be insurable when it comes time to renew.

Your health is therefore a factor when considering term life, the more so as you get older. Some policies, however, do offer guaranteed reinsurability that does not require proof of insurability.

For those who fear being uninsurable, other options, such as buying term and investing the difference, may be attractive.

Summary of what is term life insurance

Term life insurance was the original life insurance, being limited to a death benefit payable to a beneficiary. It is a way for your family to get some financial protection if you die. The money they get from a policy can be used for almost any financial need they can think of.

Whether term life insurance is right for you depends upon your financial objectives and how you want to achieve them.

If you are considering life insurance, you should weigh the pros and cons of term life against whole life. One may be more suitable than the other. Be sure to study whole life in some depth so that you can see how it differs from term. Consider all of the factors that we discussed here.

You may also find it helpful to meet with an insurance agent to learn how each type can serve you. You can run through some life scenarios to get a sense of what kind and how much life insurance you need.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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