Term Life Insurance: The Basics

What is Term?

Term life insurance is life insurance that you pay for over a fixed time period (or term). When you buy term insurance you specify the time frame, usually 5, 10, 15 or 30 years, but the term can vary. Each month for the term of the policy, you pay a monthly payment. This payment is fixed for the full term of the policy. As long as you make your payment, your policy remains in force. At the end of the policy term, the policy expires. Many term policies have provisions that allow you to renew the policy for a new term, but there are drawbacks to renewing, which will be discussed later.

Why Buy It?

The reasons to buy term life insurance are few, but compelling.

  • It’s cheap! A traditional whole life policy with a death benefit of $100,000 for a healthy 25 year old male can cost around $65/month. Term life insurance for the same individual could run somewhere around $10-$15/month. The difference in cost widens as the death benefit grows. As a general rule, term insurance can cost 50-70% less than permanent types of life insurance. This cost difference can be invested in your retirement account to grow at the market rate (10-12%). In the long run, the cost difference can provide hundred of thousands of dollars in retirement income.
  • It terminates. This may not seem like a good thing, but it really is. Think about it, if life insurance proceeds are intended to supplement your family’s income after you die, then what need have you of life insurance when you are 60 or 70 years old? Hopefully by then, your kids are independent and your retirement is secured by the funds you have saved all your working life. Your spouse can subsist off your retirement savings (else you would not be retired!). So why should your family need an extra hundreds of thousands of dollars should you die? The benefit of term insurance is that after the term is expired, you don’t have to pay for it any more. If you get a long term on the policy, then by the time the term elapses you should not need any life insurance at all. You will be self-insured. Permanent types of life insurance (contrary to what your agent might tell you) require payment to be made on them until the day you die. That payment may not come out of your pocket, but it will come out of the savings you have accumulated within the policy (more on permanent types of life insurance in future posts). Those costs hurt, and (with some types of permanent insurance) they can continue to rise as you age.
  • The cost is fixed. The premium for term insurance is fixed when the policy is issued. The premium does not change over the course of the term of the policy. This is good because it makes the costs of the insurance predictable.

Pricing Factors

There are a few factors which contribute to the premium cost of a term insurance policy.

  • Death Benefit. The higher the death benefit, the higher the premium.
  • Your Health. The better health you are in, the lower your premium. Remember that this premium is fixed at the time you purchase the policy, so the better health you are in when you buy the policy, the longer you can take advantage of your health. Age is a large factor when your health is considered. The younger you are, the cheaper the policy will be. This is one reason to buy insurance as soon as possible.
  • The Term. The downside to buying early is that you generally have to stretch out the term longer. The longer the term, the higher the premium. So there is a bit of a trade-off between your age and the term of the policy. The younger you are when you buy the policy, the longer the term of the policy you will need to get. However, in most cases, the higher cost for the longer term is less than the savings for youth.
  • Your Lifestyle. In most cases, your lifestyle will have no effect on your life insurance premiums, but if you engage in activities that are dangerous and potentially fatal (such as sky diving or other extreme sports), your premium can increase dramatically. Lifestyle choices that affect your health, such as smoking, are also factored in when the insurer looks at your overall health.

Drawbacks

  • Prone to Lapse. If you fail to make a premium payment, then a term insurance may lapse. Insurance agents will tell you (when they are trying to convince you to buy a costly policy) that a low percentage of term policies ever pay out the death benefit. This, according to them, is explained through the following scenario: the insured is sick/injured in the hospital for a couple months and the family, in their grief, neglects to make their premium payment and the policy lapses right before the insured dies. This argument is very misleading, and a prime example of first-rate sales techniques. First off, grace periods are typical with life insurance policies. These grace periods are usually about 30 days. (Reference) If you miss a payment for any reason, you have 30 days to make the payment before the policy lapses. If you make the payment, then your policy maintains it’s validity, and if the insured dies, the death benefit will be paid out. This argument plays on your emotions and your ties to your loved ones to convince you to buy a policy that could possibly quadruple the agent’s commission. Don’t fall for it. If the insured is sick for more than two months, the beneficiaries will have plenty of time to make sure all of their affairs are in order (including making sure that insurance premiums are paid). I think the primary reason that few term insurance policies pay out the death benefit is because the insured survives the term of the policy. Remember that term policies can sometimes be as short as 6 months or a year. If the insured does not die during the term, then the policy will not pay out the benefit. I think you can see how short-term policies can scew the percentage of term policies that pay out. Regardless, if you outlive the term of your policy, does that mean that you lose? If you live a long life and outlive the term on the policy, does that mean you made a bad decision? No! You win! You got cheap insurance for as long as you needed it, and you got to live long enough to enjoy the benefits of the cost savings! That is the best outcome that could be hoped for.
  • No Forced Savings. One of the benefits of permanent insurance is that it forces you to save money. Every month you get a bill from the insurance company that says you must pay your premium. Part of that premium goes into savings to earn interest. With a term policy, you are solely responsible to make sure you are investing your cost savings. This takes willpower and effort, but it will pay out better in the long run.

My Recommendation

I recommend that most people should get a term insurance policy, and invest the difference in cost. Get the policy while you are young (twenties preferably) and get a long term (20-30 years); the goal is to have the policy last until your savings are sufficient that your family will not need additional funds upon your death. If, and ONLY IF, you invest the cost savings and establish a healthy savings habit, you should have plenty of money after 30 years that you can be self insured. At that point, let the policy close out, and enjoy not having any insurance payments for the rest of your life. If you would rather have the safety of knowing that the insurance company will require you to make savings deposits, then you probably should look at some form of permanent insurance.

Posted on 13 Jan 2009