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
