What Is Term Life Insurance
Life insurance is provided by insurance companies to individuals who have a life insurance need. That need exists when the individual’s untimely death would cause significant financial hardship to others. The life insurance contract, or policy, guarantees that benefits lost due to the individual’s death will be replaced by money paid by the insurance company. The money is paid in the form of a death benefit to one or more beneficiaries chosen by the policyowner. The policyowner and the insured may be the same person or different people, but the policyowner must have an insurable interest in the insured. In other words, the policyowner must have a stake in the insured’s protection. The death benefit is a lump sum that can be invested or spent, at the discretion of the recipient(s).
The Logic Behind Life Insurance
Consider a household with a husband, wife and two children. In this family one spouse specializes in earning income, the other specializes in homemaking services; the children spend income and demand homemaking services.
At least three of the four household members have a strong interest in reducing the risk associated with the delivery of income by the breadwinner. Risk is defined as variability of possible outcomes. The sudden death of the breadwinner would reduce household income to zero, placing the survivors in a precarious position. By definition, insurance is the reduction of risk through the assumption of cost. By paying premiums on a life-insurance policy for the breadwinner, the household eliminates the possibility of a total loss of income resulting from the breadwinner’s unexpected death.
Technically, individual life insurance transfers the risk from the household to the insurance company’s shareholders, rather than reducing the degree of risk. The insurance company has a financial interest in reducing risk, however, and many insurance-company activities (research, safety-oriented advertising, etc.) actually do that. The very act of pooling risks is what makes these risk-reduction activities possible.
It is worth noting that even if the homemaker spouse earns no monetary income, the other three household members would almost certainly benefit from life insurance on the homemaker. Homemaking services would have to be purchased or foregone if the homemaker died. Alternatively, the breadwinner spouse would have to invest a substantial sum in finding a new spouse.
Term Life Insurance: Definition and Mechanics
Today, life insurance is sold in numerous forms. The original and most basic form is term life insurance, which provides insurance for a specific time period or term. Individuals purchase term life insurance by paying regular, periodic (usually monthly) premiums to the insurance company. The company invests the premiums in a diversified portfolio of fixed-income instruments and blue-chip stocks. Normally, the death of any one individual cannot be predicted accurately, but statistical techniques used by actuaries can predict the proportion of a large number of randomly chosen individuals who will die at a given age. This enables the insurance company to time its investments so as to raise the funds necessary to pay death benefits.
Term life is the cheapest form of life insurance because its only purpose is protection (as opposed to investment). The policy’s premium is determined by actuaries who calculate the insured’s life expectancy. The invested premiums are designed to be sufficient to accumulate a sum equal to the policy’s death benefit by the statistically-estimated time of the insured’s death. Competition among insurance firms drives premiums down to the minimum level necessary to pay the death benefit and cover the costs of administering the policy. Interestingly, the fraction of term life insurance policies that result in a death-benefit payout is quite small, around 1-2%.
Life Insurance Need Is Not Always Permanent
The underlying basis for term life insurance is that life insurance needs are not permanent. This is true for several reasons. One reason is that the individual may eventually accumulate sufficient wealth to replace his or her lost income with a bequest. Another reason is that the need to replace lost income is not permanent. Children grow up, become educated, take jobs and support themselves. Spouses can support themselves by working. Once retirement is reached, there is no need to replace lost income because there is no earned income to replace. When the insurance need vanishes, there is no reason to carry insurance.
The other forms of life insurance are permanent policies designed to terminate with the death of the policyholder. Moreover, they combine pure protection with a savings plan, which increases the administrative costs of the policy. For these reasons, permanent life insurance is more expensive than term life insurance, at least for younger policyholders in good health. Past their 40’s, as health starts to deteriorate, many policyholders find term life premiums too high to pay.
Debate over the superiority of term life insurance has given rise to a maxim: “Buy term and invest the difference.” Under this strategy, a consumer choosing between term life insurance and a permanent form, such as whole life, select term insurance for any non-permanent insurance need. He or she can then subtract the term premium from the whole-life premium, invest the dollar difference and expect to end up with greater wealth at end of term than if whole life had been purchased. The effectiveness of this approach depends on long-term market performance and national interest rate levels.
Varieties of Term Life Insurance
Term life insurance comes in several varieties. The simplest one is annually renewable term life. The policy term is for one year, at the end of which the insured has the option of renewing the policy for another year. Because the risk of death rises with age, the premium will be higher in the second year than it was originally. In addition, the insured must meet the standards of insurability. He or she must be in sufficiently good health to be insurable. Before initially obtaining insurance, the individual had to supply medical records to the insurance company and pass a physical exam. Annually renewable term life insurance compels the individual to meet insurability standards at each renewal.
The more popular form of term life insurance is level premium term insurance. The insured obtains insurance that is guaranteed for a term of 5, 10, 15, 20 or 30 years. The premium remains constant for this term. Depending on the terms of the policy, the insured may have the option of renewing for a second term (at a higher premium) without having to meet insurability standards. The level premium is higher than annually-renewable coverage for the first few years, but lower thereafter.
Suitable Candidates for Term Life Insurance
Young people are in better health and statistically less likely to die than older people over any given time period. Since young people are less risky to insurance companies, they pay lower insurance rates. As age increases, insurance need decreases. People who accumulate more wealth have less need for death benefits to replace their incomes. Children age, become educated and take jobs; they are no longer dependent on parental income. Young people with non-permanent insurance needs are the best candidates for term life insurance because they pay the lowest rates during the years when they need insurance the most. More broadly, anybody with a temporary insurance need is a candidate for term life insurance. Whole life insurance would be the superior choice when the insured reaches an advanced age, when rising term rates finally exceed those of whole-life or the insured is afraid of not being able to pass the medical in upcoming years.
In the case of permanent insurance need, whole life is probably the better choice because the insured would be left without convenient access to insurance once term insurance coverage expired. Examples of permanent insurance needs include insurance for burial and final expenses, for business success, and for estate planning. Key-person insurance need might be better met with either form of life insurance, depending on its particular circumstances.
Technology and Term Life Insurance
The competitive pressure that holds down premiums for term life insurance has been intensified in recent years by technological innovation. For decades, life insurance was sold by insurance agents representing individual companies. Permanent insurance was more profitable than term insurance for both the company and the agent. Sales depended much less on price competition between companies than on the personal relationship between the insured and the agent. Obtaining comparative prices for term life insurance was a cumbersome and difficult process for life insurance consumers. The advent of the personal computer allowed independent agents to compile data bases on the term life insurance prices of hundreds of companies, thereby elevating price comparison to the leading role in term life insurance sales. This has cut deeply into life-insurance company profits, but it has been a boon to consumers.
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