Term life insurance is the simplest form of life insurance. It provides a death benefit if you die during a specified term period. If you survive the term period and do not renew or convert the policy, the life insurance coverage expires with no value.
While term life insurance is the simplest type of life insurance, yearly renewable term life insurance is the simplest term life insurance plan.
Yearly renewable term life insurance, often referred to simply as YRT or ART, provides life insurance coverage for one year only. At the end of that year, coverage ends. However, because the policy is renewable, you can extend the coverage at the end of each year for an additional year until the maximum age for renewability is reached.
CONVERTIBLE AND RENEWABLE
Any term life insurance policy might contain a provision that permits you to renew the coverage for an additional period (normally at a higher premium) or to convert the term insurance coverage to permanent life insurance. Both conversion to a permanent policy and renewal of the term insurance can be done whether or not you continue to be healthy or not. In simpler terms, you can renew the term insurance coverage or convert it to permanent life insurance even if you are on your deathbed.
Because the term policy premiums are based on the likelihood of death at your age during the term period, premiums generally increase as you get older. At issue, term life insurance premiums are generally much lower than the premiums for otherwise identical permanent life insurance, but term life insurance premiums can increase significantly as you get older. For this reason, term insurance might not be an economical option if your life insurance need is for more than a few years. Also, term life insurance policies generally do not contain any provision for cash value.
SUITABILITY OF TERM INSURANCE
Term insurance can be a good alternative when your life insurance need is of short duration or your short of cash but still have an insurance need. An example of this is a father who is still in medical school and has a family to care for while he is finishing his degree. He has a limited income right now, so he cannot afford a large premium. The purchase of a term life insurance policy that enables him to convert to a permanent policy a few years later could be an attractive option in this situation.
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TYPES OF TERM LIFE INSURANCE
Term life insurance policies normally offer additional features with respect to premium costs, renewability, and the ability to change the policy’s coverage into other kinds of coverage. Term life insurance can be:
- level term life insurance
- decreasing term life insurance
- increasing term life insurance
LEVEL TERM LIFE INSURANCE
Under level term life insurance, the face amount (death benefit) stays the same for the entire length of the term period. The premium remains level for a specified term, often five or ten years, although the term can be as short as one year or as long as 40 or more years. At the end of this period, you have the option of renewing the policy for an additional term at a higher premium. Some insurers also offer a multi-year level term insurance policy that, at the end of the term period, may be renewed each year for one additional year. Sometimes, you also has the option of converting the policy to a permanent type of insurance.
The conversion provision generally allows the policy to be changed to any whole life or universal life insurance plan issued by the company at the time of conversion, without proving how healthy you are. In many states, level term plans can be renewed only to age 85. You can start with term insurance and later convert to whole life when you need and can afford permanent protection.
DECREASING TERM LIFE INSURANCE
Decreasing term life insurance is especially useful when the amount of money needed at death diminishes over time. For example, you own a $10,000, ten-year, reducing term policy, the protection starts at $10,000 and reduces over the ten-year period; at the end of the ten-year period, coverage ceases.
The coverage reduces by the same amount each year (the case under straight line decreasing term life insurance), or it reduces more slowly in the early years of the coverage and more quickly towards the end of the term period. This latter type of coverage reduction is often found in decreasing term insurance designed specifically to cover a home mortgage. Decreasing term life insurance offers fixed, level premiums and decreasing insurance coverage as the years go by; it can be used at your death to pay off the loan on a car, to redeem a home mortgage, or for many other purposes.
Besides repaying a mortgage, several other needs normally diminish over time, such as the need to provide funds for dependent children. For each year you survive and provide a dependent’s support, one less year’s funds are usually needed at your death. The child’s financial independence normally ends the need for life insurance proceeds. Thus, the need to support dependent children who will ultimately become independent can be met logically with decreasing term life insurance.
Normally, decreasing term life insurance is not renewable, although a minority of companies allow a decreasing term policy to be converted to a permanent policy. Usually the amount that can be converted is determined by the amount of current death benefit remaining under the decreasing term insurance, rather than the original death benefit amount. Decreasing term insurance is not as commonly sold today as it was in the past.
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INCREASING TERM LIFE INSURANCE
Increasing term life insurance is normally offered only as a rider on another (permanent) life insurance policy rather than as a policy itself. When used in that way, the basic idea behind increasing term life insurance is that in the event of your death, while the increasing term coverage is in effect, the beneficiaries receive the entire face amount on the basic policy plus a return of the premiums paid, or the cash value of the permanent life insurance policy (i.e., an amount equal to the increasing term coverage). In essence, it is the death benefit equivalent to owning a level face amount policy plus an account equal to the cash value of the basic policy.
Increasing term riders typically do not extend for more than 20 years. Premiums generally increase as the coverage provided by the increasing term rider increases and as you become older.
RENEWABILITY AND CONVERTIBILITY FEATURES
Because term life insurance coverage, by definition, exists only for a specified time (the term period), insurers provide two methods by which the coverage can be provided beyond the specified time. Although these optional methods involve a cost, it is small in comparison with the benefits provided. These two features are known as renewability and convertibility.
Renewable Term Life Insurance
A renewable term life insurance policy gives you the option to extend the term coverage—to renew it, in other words—at the end of the term period without being required to show how healthy you are. Although renewable term life insurance coverage has historically given the right to renew the coverage for an additional period equal to the original term period, many insurers now offer a different renewal feature. Under this newer renewal feature, a renewable term life insurance a policy that has reached the end of the initial term period may renew for successive one-year term periods. Thus, a ten-year renewable term life insurance policy may be able to renew at the end of each ten-year period for additional ten-year periods or for successive one-year periods, depending on the policy’s renewal provisions. Renewable term life insurance policies may be renewed, regardless of your health, until the renewability period expires. The premiums for the renewed coverage reflect your current age at the time of each renewal.
Some companies offer a renewable level term life insurance policy known as re-entry term, which offers two renewal rates at the end of the term period:
- The higher premium rate is guaranteed not to exceed a maximum rate shown in the policy, and you can renew the coverage at this premium rate, even though you might be unhealthy at the time.
- The second premium rate is lower but requires you to prove how healthy you are in order to renew the coverage at the lower premium rate.
If you choose to renew existing term insurance coverage when the current term period expires, the term insurance premium normally increases, reflecting you’re older than at the beginning of the prior term period. With respect to long-term use of term life insurance, this continually-increasing premium is its principal disadvantage.
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Convertible Term Life Insurance
If you own convertible term life insurance you can avoid the regular premium increases associated with term life insurance by exercising your right to exchange the term life insurance coverage to permanent life insurance coverage. This right to exchange the term life insurance coverage for a permanent life insurance policy is known as a conversion right. A conversion right can be included in term life insurance, whether issued as a policy or as a rider.
Although some insurers limit conversion from term life insurance policies only to whole life insurance, many insurers simply require that the conversion be to any type of permanent life insurance the insurer offers. Your right to convert term insurance to permanent insurance only gives the right to exchange the term insurance for permanent insurance in the insurance company that wrote the original term insurance.
Two Conversion Options
If you wish to exercise the right to convert your existing term life insurance, you generally have two options:
- an attained age term conversion
- an original date term conversion
In an attained age term conversion, you simply exchange your existing term life insurance coverage for permanent life insurance coverage at your age at the time of the conversion. For example, if a 25-year-old purchased term insurance and kept it for 15 years before exercising an attained age conversion, his or her issue age under the permanent life insurance policy issued on conversion is 40. He or she would, of course, pay premiums based on that age 40; furthermore, the permanent life insurance policy initially has little or no cash value.
To illustrate an attained age term conversion, suppose that a 25-year-old man purchased $100,000 of annually renewable term (ART) life insurance and kept it in force until he reached age 40. The ART annual premium at his age 25 was $140. His ART renewal premium at age 40 would have been $371. Instead of paying the increasing premiums each year, he chooses to convert his coverage to whole life insurance. In an attained age term conversion, his annual premium for the $100,000 of whole life insurance will be based on his current age of 40 and will be about $1,560, depending on the insurer.
If he had chosen to convert his term coverage through an original date term conversion, the financial aspect of the transaction would have been quite different. Instead of being issued a whole life conversion policy having an issue age of 40 and an annual premium of $1,560, the whole life policy issued on conversion would have an issue age of 25 (the age at which he purchased the term insurance) and an annual premium of $800.
The obvious question at this point is, “Why wouldn’t everyone choose an original date term conversion?” The answer is that you are required to make a payment—often a substantial one—to the insurer in the case of an original date term conversion. The purpose of the payment is to put the insurer in the same financial position it would have been in if the whole life insurance policy had actually been issued when he was age 25.
Your payment to the insurance company is usually the larger of the difference:
- in reserves between the policies being exchanged
- in the premiums paid for the term insurance compared to the premiums that would have been paid under the whole life insurance, plus interest less dividends
Because the policy reserves are approximately equal to the cash value, the difference in reserves is approximately the difference between the whole life insurance policy’s cash value and the term life insurance policy’s cash value (which is usually zero). In the case of the original date term conversion, the $100,000 whole life insurance policy issued at age 25 would have had a guaranteed cash value of $13,400 at age 40, and the term policy would have no cash value.
So, under the first option listed above, he is required to pay $13,400 for the privilege of having an original date term conversion. By making that payment, however, the whole life insurance policy issued under the original date term conversion has a guaranteed cash value of $13,400!
Insurers vary significantly with respect to the period of time during which you can convert term life insurance to a permanent life insurance policy. As a general rule, a specific maximum age is stipulated in the convertible term insurance policy, indicating the conversion can occur anytime before you reach age 65, 70, or 85. Some older policies require much earlier conversion, such as during the first two years of the term policy, or up to three or five years before the policy’s original term ends.
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TERM LIFE INSURANCE PREMIUMS
Term life insurance is generally affordable coverage that pays a death benefit only if you die during the term period. Initially, its premiums are less than for otherwise identical permanent life insurance issued at the same time. Over time, however, the premiums for term insurance can become much greater than for a comparable amount of permanent life insurance issued at the same time
Premiums Increase with Age
The feature that often attracts you to term insurance is its lower premiums–lower at least initially when compared to permanent types of coverage that may be issued. It is commonly used when you need temporary protection or cannot afford the premium for permanent forms of life insurance in the amount needed. Because term life insurance premium costs increase regularly as you age, often increasing every year or every few years, its biggest weakness is its lack of affordability when you are older.
To get an understanding of the rapidly increasing term life insurance premiums that apply as you get older, let’s look at some representative guaranteed ART premiums at various ages for a $100,000 life insurance policy. Actual premiums may be higher or lower.
ART Premium at Various Ages
Although term life insurance rates may vary significantly from one insurer to another, by looking at these ART life insurance premiums, it is easy to see why term insurance generally is an inappropriate choice to meet your long-term life insurance needs. In fact, it is just this lack of long-term affordability of term life insurance that gave birth to the level premium whole life insurance plan.
THE LEVEL PREMIUM LIFE INSURANCE PLAN
The mere fact that term life insurance coverage becomes increasingly unaffordable as you reach the age at which you’re more likely to die, and the fact that this coverage may eventually become prohibitively expensive, demonstrates its inappropriateness as a solution for lifetime insurance needs. A need for affordable life insurance that continues for a lifetime is more appropriately met by a level premium plan.
The level premium plan is relatively simple. By charging level premiums that are higher than required to meet mortality expenses in the early years of coverage and by earning compound interest on those excess premiums, the insurer is able to accumulate a sufficient reserve to pay the premium deficit between the higher mortality expenses in the later years and the relatively low level premium amount that you continue to pay.
To see the level premium plan in operation, let’s compare the premiums for annually renewable term life insurance coverage with the premiums for a term life insurance policy to age 65. The graph below shows the difference in premiums between $100,000 of life insurance purchased as one-year term insurance and held for 30 years with an otherwise identical term-to-age-65 policy issued at age 35.
Difference in Premiums Between Annually Renewable Term and Term-to-Age-65 Policies
The annual level premium for the $100,000 term-to-age-65 policy is $246. The first-year premium for a $100,000 one-year term insurance policy issued to the same person is $152; the additional $94 in premium charged for the term-to-age-65 in that first year is accumulated at interest to help pay the premiums due after the tenth year. That is the cross-over year, at which time the one-year term insurance premiums at $254 are greater than the annual premiums for the term-to-age-65 policy. In the second year, the one-year term insurance annual premium increases to $156, leaving only $90 to be added to the reserve fund. At the end of 30 years, the reserve fund held for the term-to-age-65 policy would be exhausted, because it was used to pay for the additional mortality, and the coverage ends.
A somewhat similar approach is used in the case of a life insurance policy providing coverage for a 35 year old’s whole life is shown in graph below. Using the same one-year term premiums, the annual renewal premium for a $100,000 one-year term insurance policy exceeds the premium for a whole life insurance policy issued to a 35-year-old insured at the insured’s age 65. During the earlier period when the one-year term insurance premium (approximately representing the actual mortality cost) was less than the whole life insurance premiums, the difference was compounded at interest to produce the premium reserve.
After age 65 in this graph, the built-up reserve was sufficient to pay the difference in the premiums as the one-year term insurance cost exceeded the level annual whole life insurance premium. In the case of whole life insurance, however, the reserve, an amount that approximates the policy’s cash value, is not depleted. Rather, it continues to build so that the policy endows for its face amount at the age at which everyone is deemed to have died. Under life insurance policies issued before 2009, the 1980 CSO mortality table used assumes everyone dies by age 100. Life insurance policies issued on and after January 1, 2009, must use the 2001 CSO mortality table that assumes everyone dies by age 120.
Sample Comparison of ART and Whole Life Policy Premiums