Thursday, May 12, 2011

Understanding Term Insurance

Term insurance is the most basic form of life insurance and, therefore, the easiest to understand. At its simplest level, term insurance provides life insurance for a defined period (usually a one-, five-, or ten-year term). For that insurance, you pay a monthly, quarterly, annual, or semiannual premium that remains constant during the specified term.

But that’s pretty much the only constant. I can’t even say that the death benefit remains the same for the entire term of the policy because various options are available, such as decreasing term insurance and increasing term insurance, in which the death benefit changes each year (rarely more than 20 percent above or below the original policy amount). These two products are distinguished from level term insurance, in which the death benefit remains the same for a specified period.

Term insurance provides a benefit for others if you die during the specified period. Term insurance is not an investment — you receive no benefits other than the security of knowing that if you die, the insurance proceeds go to your beneficiaries.

Exploring Options in Term Insurance

Although term insurance is no more than a policy for a defined period, it comes in many different forms, and you have various options when choosing a policy. The options you must consider are discussed in the following sections.

Renewable term

The primary purpose of life insurance is so that your beneficiaries receive a benefit if you die. If you buy life insurance, not only do you want your policy to remain in effect during the specific period you designated, but you also want to be able to keep buying the insurance until you decide to stop — not when the company decides that you’ve become too great a risk.

Most term life policies are renewable — but your premium may not be the same for the renewed period. (I discuss premiums in Chapter 9.) After each term (the one-, five-, or tenyear period that you specified) ends, the amount you pay per year for the next term will increase.

A policy may be renewable only for a limited time (ten years, for example). So when shopping for a policy, be sure to check for how long it is renewable.

Without renewability, the insurance company can decide that it no longer wants to insure you when the term of your policy ends. Renewable term insurance insures that you can still buy life insurance regardless of the condition of your health later; after you qualify the first time, you don’t have to take any additional medical exams to maintain your policy. And because you become a bigger health risk as you age, not passing a medical exam is the danger of not purchasing a renewable policy.

Renewable doesn’t mean that you can change the face amount of your policy. If you decide that you want more insurance, the company will likely require that you pass a new medical exam to qualify.

Age limits

Many term insurance policies have an age limit (specified in your contract) after which the company won’t allow you to renew your policy. This age can range from as low as 60 years old to 85, 90, or even older. Obviously, at the upper age ranges most people are extremely high risks, so the price of coverage would be so high that it wouldn’t pay for you to purchase coverage. But certainly 60 or 70 isn’t very old, and many people at that age want continued coverage.

When looking at term insurance policies, make sure you give consideration to any age limits imposed in the policy.

Convertible term

If you purchase a convertible policy, you are allowed to convert to a different type of policy without having to pass another medical exam. Again, because your health is more likely to deteriorate as you age, this feature may be important if you think that you may want to keep buying life insurance later in life.

Most people don’t continue to insure themselves after they reach retirement age, usually because they no longer have anyone dependent upon them, but there are exceptions. For example, take a look at a family of four in which the father is 56, the mother is 43, and the two children are both under 10. The younger child won’t start college for another 15 years, and the parents want to make sure the children have sufficient money even if the father dies. These parents may want to keep insuring the father after he reaches the age of 70, the
age at which his policy specifies that he can no longer renew his term insurance policy. To them, therefore, convertibility is an important option.

Another reason you may want to be able to convert your term insurance is if your family has a history of heart disease, cancer, or other serious illness. If your family history makes you more likely to become sick later in life, you may want to ensure that you don’t have to pass a medical exam later, even after term insurance is not available. Because buying life insurance is, basically, eliminating as much risk as possible, many people think that this provision is an important one.

A third reason to keep the convertible option has to do with the price of term policies versus cash-value policies. Term policies generally cost considerably less than other types of life insurance because the others also build value while paying for the insurance. Convertibility may be important to you if you’re on a limited budget but want a cash-value policy. You know that you can convert later, when you have greater financial strength.

Keeping the option to convert means that your policy will likely cost you more. Consider the following questions regarding convertibility:
  • To what can you convert your policy? Whole life? Universal life? Either one? Any product the company offers later on?
  • When can you convert? Some policies specify how many years you have to convert. Obviously, more time to decide gives you more options when you need them. Of course, the additional flexibility likely means a higher premium throughout the life of the term policy.
  • When you do decide to convert, will the new premium be based on your age when you convert? Or will the company require you to make a lump sum payment to “catch up,” as though you had purchased the cash value policy to begin with?
Decreasing term

For most term insurance policies, the death benefit remains constant and the premium increases over time. With a decreasing term life policy, the opposite is true: After the specified term, the face value of the policy decreases, while the amount you pay each year or month remains the same. In that way, the insurance company effectively increases its premium, which it must do because, as you age, you’re at a greater risk for death. So the same premium purchases an increasingly lower amount of insurance.
For many people, decreasing term life insurance allows them to be insured to the maximum when they most need it (when their beneficiaries are most dependent on them) but to be insured for lower amounts as their beneficiaries need less. Because the premiums remain locked in, budgeting is simple — you always pay the same amount.

Mortgage insurance is an example of decreasing term insurance. When you buy mortgage insurance, you’re making sure that your home mortgage gets paid off if you die. But of course, while you’re alive, you’re paying off your mortgage principal, so the balance keeps declining.

Re-entry term

Renewable term insurance may have a provision called reentry, which means that the insurance company can ask you to undergo a medical exam before it will renew your policy after the term expires. If your health isn’t good and the reentry clause permits it, the company can cancel your insurance. In return, you can purchase renewed insurance at a reduced rate — basically, the rate a person who just passed an exam would pay.

The gamble here is that you will remain healthy. Then again, if the re-entry clause doesn’t permit the company to cancel your insurance but does allow it to charge you higher premiums, you’re gambling on money, not your health. Some re-entry policies spell out the maximum premium that can be charged. If you’re gambling, you ought to know how much you’re gambling on.

When purchasing re-entry term insurance, make sure that you keep the right to renew your insurance even if you don’t pass a medical exam. Although may have to pay higher premiums, at least the company won’t be able to cancel your policy.

Employee benefits

Many companies offer term life insurance policies to their employees as a fringe benefit. The amount often ranges from the equivalent of your annual salary to triple your annual salary. The employer usually pays the entire premium.

Only the cost of the first $50,000 in life insurance is tax-free. Any premium an employer pays on your behalf for an insurance policy over $50,000 is additional income that you must claim on your tax return. In addition, this benefit is available to you only while you are employed with the company. When you leave, you lose the protection. If having that insurance was part of your estate planning, you now have to reevaluate your position.

Comparing Term Insurance Policies

If you decide that term insurance is for you, the next step is to get quotes from at least three insurance companies and compare them. To help you, I’ve provided a worksheet for you to fill out. Step 2 of the worksheet asks you to find out the rating of the insurance company.

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