The two principal characteristics of term insurance are: the insured must die for any benefits to be paid and, by definition, the contract expires at the end of the term. Stated more specifically, a term life insurance policy promises to pay a death benefit to a beneficiary only if the insured dies during a specified term.
The contract makes no promise to pay anything if the insured lives beyond the specified term. Generally, no cash values are payable under a term life insurance contract. If the insured survives the specified term, the contract expires and provides no payment of any kind to the policyowner.
1) When should term life be sold?
In general, some type of life insurance is indicated when a person needs or wants to provide an immediate estate upon his or her death. This need or desire typically stems from one or more of the following reasons:
A. Providing income for dependent family members until they become self-supporting after the head of household dies.
B. Liquidating consumer or business debts, or to create a fund, enabling the surviving family members to do the same when the head of household dies.
C. Providing large amounts of cash at death for children’s college expenses or other capital needs.
D. Providing cash for federal estate and state inheritance taxes, funeral expenses, and administration costs.
E. Providing funds for the continuation of a business through a buy-sell agreement.
F. Indemnifying a business for the loss of a key employee.
G. Helping recruit, retain, or retire one or more key employees through a salary continuation plan, and finance the company’s obligations to the dependents of a deceased key employee under that plan.
H. Funding bequests of capital to children, grandchildren, or others without the erosion often caused by probate costs, inheritance taxes, income taxes, federal estate taxes, transfer fees, or the generation-skipping tax.
I. Funding charitable bequests.
J. Preserving confidentiality of financial affairs. Life insurance proceeds payable to someone other than the deceased’s estate are not part of the probate estate and are not a matter of public record. It is not unusual for a beneficiary to be a lover, illegitimate child, faithful domestic servant, or have some other type of relationship with the insured that he or she may not want to be publicly acknowledged.
K. Assuring nearly instant access to cash for surviving dependents. Life insurance proceeds are generally paid to beneficiaries within days of the claim. There is no delay, as might be the case with other types of assets, because of the intervention of state or other governmental bodies due to settlement of tax issues, or because of claims by the decedent’s creditors.
L. Directing family assets to family members in a way that minimizes state, local, and federal taxes.
Generally, term insurance is not the most effective type of life insurance for all of these death benefit needs. However, term insurance may serve the insured’s needs in many circumstances. Because term insurance is not just one product, but rather many variations on a general theme different types of term insurance are indicated for different types of needs.
Keep in mind, term insurance, more than any other type of insurance, is pure death protection with little or no ancillary or lifetime benefits. Therefore, the two overriding considerations in the use of term insurance, regardless of the specific application, are:
- Will death protection alone meet the need?
- Will the coverage last as long as the need?
In short, with term — as with any other decision about the appropriate type of coverage — the product must match the problem.
2) Who are the prime prospects for term life?
A. When the need for life insurance is temporary – For example, assuming a parent has adequate income to pay college expenses on a pay-as-you-go basis and adequate life insurance for other purposes, the parent might use term insurance to assure payment of a child’s college education expenses in the event of the parent’s death during the child’s college years. For this type of need, a five-year nonrenewable term policy might offer the best cost/benefit relationship. Similarly, decreasing term policies are often used to pay off the mortgage on the family’s principal residence in the event of the breadwinner’s death.
B. When the need is long-term but cash flow is currently insufficient to buy the needed coverage using higher premium ordinary whole life – Parents in younger families often have major long-term support obligations for their young children and spouses, have committed expenses that already strain the family’s budget and, therefore, simply cannot afford the premiums necessary to buy the amount of coverage they need to protect their families using ordinary whole life insurance.
Term insurance, especially at the younger ages, provides the greatest possible coverage for the lowest premium outlay. In these circumstances, one-year or five-year renewable and convertible term insurance is generally recommended. As the family breadwinner moves into his or her higher earning years and can afford the higher premium outlay, it is often advisable to convert to ordinary whole life insurance. Upon conversion there will be a one-time premium increase. But premiums will remain level from then on.
C. When the policyholder has better investment opportunities outside the insurance policy than inside the policy – If the policyholder has investment opportunities that will pay a higher tax-free or after-tax yield with the same level of safety as the insurance policy, it may be better to buy renewable term insurance and to invest the early years’ premium savings outside the insurance contract. However, they should not base this “buy-term-and-invest-the-difference” choice solely on differentials in potential yields inside and outside the policy. The cash value policy may offer many features not available on the outside investment including: (a) creditor protection; (b) a minimum rate guarantee; (c) waiver of premium in the event of disability; (d) loan provisions; and (e) a host of flexible nonforfeiture and settlement options.
D. To guarantee a savings fund – Many parents set up a savings program for their children’s college educations well before their children start college. A decreasing term policy is often a perfect vehicle to assure the necessary savings fund if the parent dies before completing the funding. One can use term insurance to assure an adequate savings fund in many other similar types of applications.
E. For liquidity in the event of death – One major life insurance application is to provide estate liquidity and to pay estate and inheritance taxes. Because of the ages typically involved, term insurance applications for estate planning and estate liquidity purposes are rather limited.
However, the need for liquidity may stem from temporary special or extenuating circumstances not directly associated with payment of death taxes. New business startups are a case in point. The cash flow needs of starting a new family business preclude the higher premiums of cash value policies until the business passes a critical break-even point or attains minimum profitability. Similarly, it is not uncommon for a successful small business owner to tie up virtually all of his or her assets in the business. This general lack of liquidity becomes even more severe when the business is expanding and engaging in capital improvement projects, such as building a new warehouse or plant, or starting new projects, such as developing and marketing a new product line. If the business owner should die while the expansion project is in process, it might jeopardize not only the expansion project, but also the entire business.
Although liquidity in the event of death will always be a problem (which might best be solved using a whole life policy), one can often best hedge the temporary added liquidity risk during these expansion periods using a term policy. Similar logic may apply in dealing with any potential liquidity squeeze. Instances would include an executive who has received sizable bonuses of restricted stock in his or her company, an investor who has committed a significant portion of his or her portfolio to a temporarily illiquid position, and a real estate developer who is in the process of subdividing and developing a large tract of land.
F. For business purposes – Term insurance may be the most suitable form of insurance for business purposes in many circumstances. For example, one problem of funding buy-sell agreements with a cross-purchase arrangement when the ages of the business owners are disparate is the relatively high premium cost that the younger business owner must pay for coverage on the older owner. Initially, at least, term insurance or some combination of term insurance and ordinary life insurance may provide an affordable alternative.
Similarly, often term insurance may be the most affordable alternative when insuring key employees, especially when these employees are engaged in special projects where their expertise is critical to the successful completion of the particular task or project.
G. When insureds desire additional death benefits in conjunction with other permanent forms of life insurance or packages of policies – Insurers often package level, increasing, or decreasing term riders with permanent forms of life insurance to create a combination of death benefits and living benefits that fit a person’s particular needs and resources. For instance, a person can use a participating whole life policy combined with a decreasing term rider when that person cannot afford the premiums necessary to fully insure using whole life insurance alone. One can design the package so that the policyowner uses dividends on the whole life to buy paid-up additions that replace the term insurance as its face amount declines over time.
Family policies are another example. The family package policy consists generally of some level of ordinary whole life insurance on the principal breadwinner, half that amount in term insurance on the spouse, and about half that amount again of term insurance on each of the children. It is less expensive for the insurance company to cover several persons in one policy than to issue separate policies for each person. The savings help to reduce the overall cost of the coverage to the family.
H. To assure coverage in the event of unemployment or loss of employer-provided coverage – Renewable and convertible term insurance provides a relatively low cost method to cover the contingency of continuing protection in the event of unemployment or discontinuation of employer-provided coverage.
3) What are the advantages of term life?
A. Term insurance allows a person to acquire the greatest death benefit for the lowest premium outlay when the policy is first issued. However, this does not mean that term insurance is necessarily the least expensive form of insurance over the full duration of needed coverage. Because term premiums increase at each renewal, at the later ages the premium cost will far exceed the level premium that would have been charged for an ordinary whole life policy issued at the same age as the original term policy.
B. Term insurance is the best alternative for temporary life insurance needs. Usually term insurance is the best alternative if protection is needed for less than 10 years. Conversely, some form of cash value life insurance will generally be the best alternative if protection must continue for 15 or more years. If the duration of the needed protection is between 10 and 15 years, the best alternative depends upon the facts and circumstances of the case. As a general rule of thumb, term insurance will tend to be better than cash value insurance at issue ages below age 45, and worse at older issue ages if the length of the need for protection is between 10 and 15 years.
C. Younger persons may acquire substantial face amounts of coverage at relatively low immediate cost, perhaps more than their immediate needs, and thereby guarantee that they will have the necessary level of coverage when their needs and family obligations later increase, even if they are then uninsurable.
D. The conversion feature of renewable and convertible term allows policyholders to enjoy higher death protection than they could otherwise afford and later allows them to lock-in their premiums and build cash values when their ability to pay premiums increases.
E. Various types of term insurance—level, decreasing, and increasing—can be combined as riders with other types of permanent insurance to create a package that meets a person’s special death protection, savings, and affordability needs.
F. Life insurance proceeds are not part of the probate estate, unless the estate is named as the beneficiary of the policy. Therefore, the proceeds can be paid to the beneficiary without any delay caused by administration of the estate.
G. There is no public record of the death benefit amount or to whom the death benefit is payable (if paid to someone other than the deceased’s estate).
H. The death benefit proceeds are generally not subject to federal income taxes.
I. The death benefit proceeds are often exempt from state inheritance taxes.
J. Life insurance policies can be used as collateral or security for personal loans. Although lenders generally prefer permanent types of policies because of the cash values, a term policy is often sufficient if the borrower is a good credit risk and the loan is very likely to be repaid unless he or she dies.
4) What are the disadvantages of term life?
A. Term insurance has no tax-free, automatic savings feature as permanent coverage does.
B. The premiums increase until payment becomes prohibitive at later ages. This is one of the main reasons for the purchase of whole life insurance because coverage is useless if it cannot be held until the date it is needed most.
C. Term insurance generally has little or no loan values and little or no living benefits.
D. Term insurance only provides coverage for the term of the contract, not for the insured’s entire life. In other words the term coverage may expire before the need does. A person may become uninsurable at a later age when the need for insurance still exists.
E. Life insurance of any kind is generally not available to persons in extremely poor health. However, persons in moderately poor health can often obtain insurance at substandard rates (a reference to the insured person’s health, not to the quality or strength of the insurance company), which means higher premiums. It is easier to find ordinary whole life policies than term policies for persons who fall into the substandard rating categories.
5) What fees or other acquisition costs are involved?
Life insurance generally is sold on a specified price basis. Life insurance companies are free to set their premiums according to their own marketing strategies and classifications. The premium set by the insurance company includes a loading (a specified part of each premium payment). Typically, loading will cover such things as: (1) commission payments to agents; (2) premium taxes payable to the state government; (3) operating expenses of the insurance company, such as rent or mortgage payments and salaries; (4) federal income taxes; and (5) other applicable expenses, such as claims handling and policy change services.
The bulk of an insurance company’s expenses are incurred when they issue the policy. It may take an insurance company five to nine years, or even longer, to recover all of its front-end costs. The state premium tax applicable to all life insurance premium payments is an ongoing expense. The average level of this tax is about 2 percent of each premium payment.
The aggregate commission payable to the selling agent on term insurance policies is generally less than on cash value policies. This is due to two factors. First, initial premiums for term insurance policies are lower than for permanent forms of life insurance. Therefore, even if the commission rates were equal, the amount paid would be lower. Second, the commission rate on term policies generally is lower than the commission rate on permanent forms of insurance. Whereas the total commission on a permanent policy typically is equal to about one year’s premium with about 55 percent to 80 percent generally being paid in the first year, commission rates on term insurance policies tend to run about 40 percent to 60 percent of the first year’s premium, and about 5 to 8 percent of each successive premium.
Some life insurance companies sell no-load life insurance policies. That is, they do not pay a commission to the selling agent. However, the premiums charged by these companies tend to be as high as those charged by companies that pay commissions to agents. Although there are no commission costs on these no-load policies, these companies apparently tend to incur, in the aggregate, about the same level of direct mail and other marketing costs to sell their policies as other companies pay in commissions to agents to market their policies.
6) How do I select the best type of term life insurance?
In contrast with permanent cash value types of insurance, the term insurance policy with the lowest premium among all identical term insurance policies generally is the least expensive policy. This would seem to indicate that prospective insureds can buy term insurance as a commodity with the lowest price being the indicator of the best policy among insurers of acceptable quality and financial strength.
Comparing Term Policies
One must check all of the policy provisions to see if the policies provide identical benefits. In most cases, the policies available from different companies will not be identical. Therefore, the one needs to weigh the slight differences in the policy provisions against the differences in the premiums.
Here are some factors to consider:
A. In the case of renewable term policies, check the policy illustration for the schedule of future renewal premiums. A policy with the lowest initial premiums may have higher renewal premiums than other policies.
B. Check the age to which coverage may be continued without evidence of insurability. A policy with a lower premium may discontinue the automatic renewal right before other higher premium policies.
C. Check the grace period provision to see if the policy remains in effect for 31 days after the expiration of the term of the policy. A policy that does not provide the grace period may leave the client uninsured if he or she happens to be late with a renewal premium.
D. Check the age to which a convertible policy may be converted to ordinary whole life at attained age without evidence of insurability. It may be worth some additional premium dollars to guarantee this conversion right for additional years.
E. Check whether the incontestability and suicide clauses of the conversion policy will be modified to provide that the two-year qualifying periods will run from the issue date of the term policy if the term policy is converted to whole life.
F. Check whether the conversion clause permits the client to convert the policy to an ordinary whole life policy with the waiver of premium rider without evidence of insurability. If it does, check whether there are any limitations due to preexisting conditions.
The right to include the waiver of premium rider in the converted policy can be an important feature, particularly if the conversion to a policy with a waiver of premium rider can be made even if the insured is already disabled. Also, in those policies that permit conversion to a policy with a waiver of premium rider, check to see if there is a minimum age to convert (such as age 55) if the insured individual is already disabled. In general, it is worth it to pay higher premiums to acquire a policy with more liberal rules regarding conversion to an ordinary whole life policy with the waiver of premium rider.
G. Even if a company offers a very attractive and competitive term policy, it does not mean that the permanent policies into which the policyowner may convert the term policy are equally attractive and competitive compared to other companies’ permanent policies. Consequently, if the possibility of conversion is an important consideration in an evaluation of term policies, one must look beyond the features of the term policy alone and into the relative attractiveness and competitiveness of the permanent policies into which the term could be converted as compared to other companies’ products.
7) How do I read the ledger statement of a life policy?
Policy illustrations or ledger statements are typically presented to potential purchasers to describe the financial aspects of the policy being considered under various assumptions regarding credited interest rates, dividend payments, and premium payment plans. The illustration at the end of this page shows a sample ledger statement for yearly renewable and convertible reissue term. Although the market for yearly renewable and convertible term has diminished in recent years in favor of 5-year 10-year, or longer term policies, the basics of how a policy of any term works is probably best presented by the workings of the foundational original yearly-renewable term policy. Each of the numbers in the ledger corresponds to the following notes (click or tap images at the end of the page to enlarge view):
1. The death benefit is level, in this case, $100,000.
2. The plan of term insurance is yearly renewable to age 95.
3. The gender is male, and the issue age is 45.
4. The insurability status (e.g., smoker or nonsmoker), or rated (extra charge because the insured is a higher risk for medical or occupational reasons). The preferred risk for this life insurance company refers to a nonsmoker, nonrated policyholder—the company’s best insurability category.
5. The face amount of life insurance is $100,000.
6. The ledger statement shows values at the beginning of each year, rather than at the end of each year.
7. The gross premium charged (not taking dividends into consideration) on a non-reissue basis.
8. The projected dividend payable at the end of the prior year (i.e., at the beginning of the following year). In this case, the first projected dividend is to be paid at the beginning of year 6.
9. The net annual premium (gross premium charged on a non-reissue basis taking projected dividends into consideration).
10. A column showing premiums on a reissue basis for the first reissue period. Each successive column shows reissue premiums at subsequent reissue dates.
11. At the beginning of year 5, the insured may apply for reissue rates. If the insured satisfies the underwriting requirements of the insurance company (just as though applying for new insurance), the premium for year 5 will be $286, not $568. If underwriting requirements are not met, the net projected premiums in column 9 will apply.
12. At the beginning of year 9, those who qualified for reissue rates at the beginning of year 5 apply again. If their application is denied, their year 9 premium will be $738, and then the non-reissue rates (column 9) apply. If they qualify for reissue rates, their premium in year 9 will be $378.
13. The net projected premium in year 10 is $902 for those who did not qualify for reissue.
14. The premium is $378 in year 9 for those who did qualify for reissue.
15. At the beginning of year 13, those who qualified for reissue rates at the beginning of year 9 apply again. If denied, their premium in year 13 will be $900, and then the non-reissue rates (column 9) apply. If they qualify for reissue rates, their premium in year 13 will be $498.
16. The net projected premium is $1,154 in year 14 for those who do not qualify for reissue.
17. The premium is $498 in year 13 for those who do qualify for reissue.
18. At the beginning of year 17, those who qualified for reissue rates at the beginning of year 13 apply again. If denied, their year 17 premium will be $1,164; and then the non-reissue rates (column 9) apply. If they qualify for reissue rates, their premium in year 17 will be $700.
19. The net projected premium in year 18 for those who do not qualify for reissue is $1,610.
20. The premium is $700 in year 17 for those who do qualify for reissue.
21. At the beginning of year 21, those who qualified for reissue rates at the beginning of year 17 apply again. If they are denied, their year 21 premium will be $1,665, and then the non-reissue rates (column 9) apply. If they qualify for reissue rates, their premium in year 21 will be $1,034.
22. The net projected premium in year 22 for those who do not qualify for reissue is $2,339.
23. The premium is $1,034 in year 21 for those who do qualify for reissue.
24. At the beginning of year 25, those who qualified for reissue rates at the beginning of year 21 apply again. If they are denied, their year 25 premium will be $2,380, and then the non-reissue rates (column 9) apply. If they qualify for reissue rates, their premium in year 25 will be $1,580.
25. The net projected premium in year 26 for those who do not qualify for reissue is $3,049.
26. The premium is $1,580 in year 25 for those who do qualify for reissue.
27. The premium in year 29 for those who do qualify for reissue rates at the beginning of year 25. In year 29, the insured is beyond age 69; therefore, reissue rates no longer are available.
28. The net projected premium in year 29 (based on the life expectancy for a 45-year-old male) for those who do not qualify for reissue is $4,067. For those still alive after age 74, who want to have their insurance continue in force, the net projected premiums in column 9 will apply.
29. This is a summary page.
30. The total gross non-reissue premiums for the years shown without adjustment for dividends. These sums do not adjust for the time value or opportunity cost of money.
31. The total projected dividends for the years shown. Projected dividends are not guaranteed. These sums do not adjust for the time value or opportunity cost of money.
32. The total net projected premiums on a non-reissue basis (gross premium minus projected dividends) for the years shown. The sums do not adjust for the time value or opportunity cost of money.
33. The total premiums on a reissue basis. These sums do not adjust for the time value or opportunity cost of money.
34. The interest-adjusted indexes for the years are shown on a non-reissue basis.
35. A statement about the renewability as term insurance and convertibility to a non-term plan.
36. A description of the reissue rules.
37. The dividend statement explaining that dividends are not guaranteed.
38. A statement explaining that dividends are related to the company’s investment experience, and that illustrations with higher or lower assumed dividend interest rates are available.
39. A statement about summary values which are based on the end of the year, not the beginning of the year.
40. A statement explaining that the illustrated values are only applicable if the insured meets the company’s underwriting standards.