Understanding Term Life Insurance

This column discusses term life insurance, including what term life insurance is, the several types of term life insurance policies, and some advantages and disadvantages of owning a term life insurance policy.

SEE ALSO:

• 10 Most Common Mistakes to Avoid When Purchasing Life Insurance
• The 5-Year Rule: Keeping Your Life Insurance (FEGLI) After Retirement

What is Term Life Insurance?

A term life insurance policy provides a death benefit to the named beneficiaries of the policyholder through a specified period of time called the “term.” Once the term expires, the policyholder can either renew the life insurance policy for another term life insurance policy, possibly convert the life insurance policy to a permanent (cash value) life insurance policy or allow the life insurance policy to lapse.

How Term Life Insurance Works

When an individual applies for a term life insurance policy, the insurance company (the “insurer”) determines what the individual will pay in insurance premiums based on the following factors:

(1) The face amount of the policy (the payout amount);

(2) the age of the applicant;

(3) the applicant’s gender; and

(4) the applicant’s health.

In some cases, a medical exam may be required. The insurance company may also inquire about the applicant’s driving record, current medications, smoking status, occupation, hobbies, family health history, and other personal information. If the applicant for life insurance is approved by the insurer and the applicant (the “insured”) dies during the term, then the insurer will pay the policy’s face value to the named beneficiaries of the life insurance policy.

The lump sum cash benefit (usually not taxable) may be used by the beneficiaries to settle the insurer’s healthcare and funeral costs, consumer debt, mortgage debt and other expenses. But it is important to understand that the beneficiaries are not required to use the insurance proceeds to settle the insured’s debts after the insured has died.

Different Types of Term Life Insurance

Term life insurance can be broken down into several types. The first breakdown is individual term life insurance versus group term life insurance. With individual term life insurance, an individual has to apply on his or her own (usually working with a licensed life insurance agent or broker) to purchase a term life insurance policy.

The individual has to be approved for the insurance and if approved, the insured has to pay the premiums that the insurer determined. If the insured fails to pay the premium, then the insurer will cancel the insurance. If the insured dies within the term, then the insurer has to pay out the face amount of the life insurance to the named beneficiaries.

Individual term life insurance policies can be purchased in which the policy term can be 10, 15, 20, 25 or 30 years, sometimes 40 years, and can usually be renewed for an additional term. Depending on the life insurance company, it may be possible to convert a term life insurance policy into a permanent (cash value) insurance policy such as a whole life insurance policy.

If the term life insurance policy expires before the insured’s death, then there is no payout. If the insured lives beyond the policy term, then the insured may be able to renew a term policy at expiration. However, the premiums will be recalculated based on the insured’s age at the
time of renewal and the premiums will be higher compared to the premiums when the term policy was bought earlier.

The following is an example of a term life insurance policy:

Peter, age 29, wants to protect his family in the unlikely event of his early death. He buys a 10-year $500,000 term life insurance policy with a premium of $50 per month. If Peter dies within the 10-year term, the insurance company will pay Peter’s beneficiary $500,000. If he dies after the policy has expired, his beneficiary will receive no benefit. If he remains alive and renews the policy after 10 years, the premiums will be higher than his initial policy because the premiums will be based on his current age of 39, rather than age 29.

Individual term life insurance policies are available in several types including

(1) Level term insurance;

(2) Annual renewable term life insurance;

(3) Decreasing term life insurance; and

(4) Return of premium life insurance.

These several types of life insurance will be discussed in a future column.

The advantages of owning a term life insurance policy include:

(1) Cheaper premiums compared to a permanent (cash value) life insurance policy for the same amount of death benefit, especially if purchased when one is young; and

(2) the insured keeps the individual life insurance policy no matter where he or she lives, even if their health deteriorates or they change occupations; and

(3) it is most appropriate for individuals who have a temporary need for life insurance such as family income protection and paying of a large debt such as a mortgage.

The disadvantages to owning an individual term life insurance policy include:

(1) If the insured outlives the term but still has a need for life insurance, then the insured will have to reapply at an older age, most likely resulting in higher premiums. Also, the insured at that point could be uninsurable and not qualify for a new term life insurance policy; and

(2) there is no cash value building up in term life insurance policies.

Another type of term life insurance is group term life insurance. Group term life insurance is a type of temporary life insurance in which one contract is issued to cover multiple individuals. The most common group is a private company or a government (federal, state or local) in which the contract is issued to the employer who then offers coverage to the employees as a fringe benefit. Federal employees have access to a group life insurance policy called the Federal Employees Group Life Insurance (FEGLI) program.

Many employees provide, at no cost to the employees, a base amount of life insurance. There are employers such as the federal government that provide a base amount of life insurance to employees in which the employer and employees share the premium cost. Also, the employer provides supplemental life coverage for employees and for spouses and children. This includes the FEGLI program. Group life insurance is also sold by various associations and professional organizations to their members.

According to the U.S Bureau of Labor Statistics, life insurance is available to 57 percent of private company employees and 83 percent of government employees through the workplace. Group life insurance policies – and this includes the FEGLI program – are generally written as term insurance and offered to employees who meet eligibility requirements, such as being a permanent and not a temporary, employee.

There are several advantages and disadvantages when it comes to group life insurance.

Advantages include:

(1) Guaranteed issue. This means that employees need not go through medical and other underwriting in order to qualify. Any permanent employee when hired can enroll without being denied enrollment due to age, health status, smoker or non-smoker, occupation or family health history; and

(2) premiums are usually lower compared to an individual term life insurance policy.

The disadvantages of group life insurance are:

(1) If an employee leaves the employer, then the employee loses their enrollment in the group life insurance program. If the departed employee needs life insurance at that time after leaving the employer, the departed employee will usually have to pay more in premiums for an individual term life insurance policy; and

(2) many employers do not offer life insurance to their retirees or if they do, the premiums will skyrocket in cost with retirees paying the full cost of the premiums. This includes federal employees in which, if they meet the requirements to carry FEGLI life insurance coverage into retirement their premium cost will increase significantly.

When an employee leaves a job in which they were enrolled in the employer-sponsored group life insurance program, the departing employee may be able to convert their group term life insurance into an individual life insurance policy, usually a whole life insurance policy.

This includes the FEGLI program in which federal employees can convert their Basic Insurance Amount (BIA) (their current SF-50 salary, adjusted slightly upward) to a whole life insurance policy. This is the case whether the employee leaves or remains in federal service. However, the premium cost usually skyrockets when the term insurance is converted to a whole life insurance policy.