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What is Term Life Insurance and How Does it Work?

Insurance Basics for Medical Professionals

By Jeffrey H. Rattiner, CPA, CFP®, MBA

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After determining the need for insurance and the amount to purchase, the doctor-client and financial planner’s next task is to match those needs to the client’s objectives to determine what type of policy the client should purchase. The life insurance industry features more products today than ever before. One reason for this change is that, clearly, the insurance industry has expanded its product base to become more competitive. Another reason is that clients’ needs are constantly changing and the insurance companies must keep up with those needs or run the risk of having funds withdrawn from their companies. New and different types of life insurance products are here to stay. Since life insurance represents a significant part of a client’s risk-management program, planners have to be versed in the specifics of the varied product base.

Term Insurance

Term insurance provides protection against financial loss resulting from death during a specified time. Term insurance is often characterized as providing “pure” protection because it pays only death benefits and does not contain any cash value features. Coverage stops at the end of the policy period. Term insurance comes in two forms: nonrenewable term and annual renewable term.

Nonrenewable Term Insurance

Nonrenewable term insurance offers the client the poorest quality because the insured has to requalify or prove evidence of insurability for coverage every year. As a result, its cost is the lowest since the insurance company annually re-underwrites the individual applying for coverage. This allows the insurance company to be selective and avoid adverse risks.

Risk Management, Liability Insurance, and Asset Protection Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™8

Annual Renewable Term Insurance

Annual renewable term insurance is a quality term product. Under this type of term insurance, the policyholder may continue coverage on an annual basis. The rates are higher than nonrenewable term since the insurance company must continue to renew the policy at the insured’s option. The premiums generally increase as the policy matures, and the policy offers no flexibility. Coverage automatically stops if the premiums are not paid.

Conversion Provisions

Term insurance may offer a conversion provision that allows the insured to convert the term policy into a cash value policy without evidence of insurability, providing the insured with a guaranteed hedge against future un-insurability. The insured can convert the policy to a whole life policy at a later date. This can be done in one of two ways:

1. The insured can go back to the original policy date of issue and pay premiums on the basis of the younger age. All back premiums, including interest, must be paid to date.

2. The insured can pay premiums at the attained age (or at the age of the insured at the time of conversion).

Advantages of term insurance policies include a lower initial cost, allowing dollars to be invested elsewhere, and pure death protection. Disadvantages include the lack of permanence, the absence of a savings element, the expiration of the policy after a specified period, and a periodic increase in cost. The increasing premium structure of term insurance results from the decreased life expectancies of an individual’s later years.

Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

Assessment

Term insurance is most appropriate for young couples who have children or who otherwise may need a large amount of insurance. It is also appropriate for people who do not want to invest in a cash value insurance vehicle, who cannot afford the higher premiums of cash surrender policies, whose insurance needs will decrease over time, or who have temporary needs. Term insurance consists of mortality charges and policy expense. Because term insurance is quite expensive at the older ages, an alternative product was developed.

Conclusion

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2 Responses

  1. Term Insurance Under Fire

    Jeff – Many financial advisors sell term life insurance to their clients. But, as terms get shorter and renewal rates trend upwards, clients may be better off buying whole life instead.

    Any thoughts?

    Gregory

    Like

  2. More on Term Insurance

    The stage in life when most adults have the most need for life insurance is when they are parents and their children are young. Unfortunately, this is often a time when financial resources are already stretched. Unlike health insurance and house payments, life insurance can easily be regarded as optional rather than a priority.

    To fully appreciate the value of life insurance, it may help to think of it in a different way. Its major function for young parents is as “income insurance.” At this stage of life, it is not an investment. Like homeowners and auto insurance, it is an expense for essential coverage that you hope never to have to use. Its purpose is to provide for the family, if one parent should die, by replacing that person’s paycheck.

    How much life insurance is necessary? The short answer is “as much as you can reasonably afford, and more than you probably think you need.”

    I recommend that parents of young children have a minimum of $500,000 to $1,000,000. Coverage for a stay-at-home parent is just as important as it is for a primary breadwinner. This may seem ridiculously high until you start looking at how much it costs to raise a child as a single parent. Just the basic costs of food, housing, health insurance, and daycare can be daunting. If you add in expenses like sports, music lessons, orthodontia, or college tuition, $500,000 doesn’t seem like such a huge sum.

    What makes this level of coverage affordable for young parents is term life insurance. Term insurance, as its name implies, is a policy taken out for a specific length of time, commonly 10 to 20 to 30 years. It pays the beneficiary the face amount upon the death of the insured, with no investment component or accumulated cash value. Because it is insurance only, it offers the most income replacement for the lowest cost.

    If you are in good health, term insurance is relatively inexpensive. For a 33-year-old non-smoker, for example, a $500,000 policy would cost a woman around $30 a month for a 20-year term or around $45 a month for a 30-year term. A man would pay around $36 a month for 20 years or $60 a month for 30 years. The longer the term of the policy, the higher the premium.

    If you’re in your 30’s, the ending date of a 20-year term life insurance policy may seem far into the future. Once a policy is in place, it’s easy to disregard it except as one more regular expense. It can be a rude awakening, then, to reach your mid-50’s and get a notice from the insurance company that your policy is expiring.

    The biggest risk with such a situation is that you aren’t able to renew the policy because you have become uninsurable. To minimize this risk, it’s wise to purchase the longest term policy that you can afford. It’s also a good idea to review your life insurance needs every few years so you can make timely decisions about whether you need to renew or extend your term insurance.

    It’s helpful, as well, to be clear about the purpose served by term insurance. In most cases, the focus is to provide for minor children, not to provide income for a spouse after the children are grown.

    Ideally, by this stage in life, a widowed spouse will not need a large life insurance policy to produce income. Instead, with the money the couple has saved through buying low-cost term insurance, they have been able to fully fund their retirement plans.

    Rick Kahler CFP® MS

    Like

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