Life Insurance 101 Part One
By Harry J. Lew
Windows computer or Mac? iPhone or Android? Domestic or foreign car? So many decisions in life revolve around “great debates.” The problem is, what starts out as debates over facts eventually deteriorate into battles over emotions, biases and entire belief systems . . . over “religion,” if you will. This makes it hard for people new to the debate to figure out what the true points of difference are and how to best decide for themselves.
Term life vs. whole life insurance is a perfect case in point. The former has its adherents, especially those who preach the benefits of “buying term and investing the difference.” The latter has its supporters, too, who promote the many additional benefits that various forms of whole or permanent life insurance offer. Yes, many agents are able to straddle both camps, recommending the appropriate solution for specific client needs. But sadly, there’s often too much smoke around this argument and not enough enlightenment. Which means too many agents are locked into one solution over the other despite their client needing something else.
Where do you stand in this debate—pro-term, pro whole life, or “it depends”?
Best we can tell, the only way to decide is to be fact-driven—know the facts about each product type, pure facts stripped of bias. Then know the facts about your clients. Finally, apply the appropriate product that fits the client fact pattern before you. Not only is this a much easier decision to make than arguing over “religion,” it’s more defensible in terms of justifying your decision in future E&O disputes.
To that end, in this article, we will briefly describe the key facts about term life insurance: what it is, what it isn’t, what are its main features, what are the advantages and disadvantages of recommending it and under what situations and for what types of prospects should you recommend its purchase. In Part 2 of this series, we’ll do the same for whole or permanent life insurance. Ready?
What Is Term Life?
Term is a form of life insurance that pays a death benefit if the client (insured) dies within a certain period of time. The period (or term) varies based on the client’s preferences. It can range from as little as one year to as long as 30 years. Most life insurers offer a range of possible terms: one year (also called annual renewable term), five years, 10 years, 20 years or 30 years. Within the term, clients pay the same premium (price) each year, either in one sum or periodically (monthly, quarterly, annually). At the end of the term, the life insurance protection ends unless the insured decides to renew it. If so, the person will now be older and have a greater risk of dying, which merits paying a higher premium. The person can also elect to convert his term policy to an ordinary whole life policy contract to a certain age.
What Isn’t Term Life?
Term life isn’t a personal wealth builder. In other words, it does not create value unless the insured dies. This is because there’s no mechanism within the policy to accumulate funds and to either withdraw them or borrow against them at a later date. Also, term life is not a guarantee; it’s not meant to protect the insured forever because it, by definition, expires at the end of its term. Finally, term is not a vehicle for estate planning for the same reason. It will become increasingly difficult to keep the policy in place for the long term because of its escalating premiums. However, with an estate planning need, the policy must remain in effect until the insured dies in order to cover estate tax or achieve other estate-related objectives.
What Are Term Life’s Features?
Term life’s features are quite simple. It typically lasts one to 30 years based on the term selected. It provides a guaranteed death benefit. Its premiums can increase periodically or be guaranteed to be level for the duration of the term. In terms of premiums, the costs are typically much lower compared to permanent forms of life insurance. Finally, the amount of coverage (or face amount) typically links to the insured’s income and is determined by applying a pre-defined multiplier. For example, a 40-year-old applicant might be limited to a death benefit of no greater than income x 25 (multiplier). So if the person earns $50,000, the maximum face amount he or she could apply for would be $1.25 million.
What are Term Life’s Advantages?
Term life insurance is generally the best way to get the greatest death benefit for the smallest premium at the time of initial purchase. However, this might not be the case during future terms, since term premiums will increase at each subsequent renewal. At older ages, term life premiums will be much higher than what a client might have paid for a permanent whole life plan at the outset.
Term is also a great vehicle for temporary life insurance needs of limited duration (say, less than 10 years). “As a general rule of thumb, term insurance will tend to be better than cash value insurance at issue ages below age 45,” says Stephan R. Leimberg, author (with Robert J. Doyle, Jr. and Keith A. Buck) of The Tools & Techniques of Life Insurance Planning (2015, The National Underwriter Company). “And worse at older issue ages if the length of the need for protection is between 10 and 15 years.”
A third advantage, says Leimberg, is that younger clients can purchase policies with large face amounts (perhaps even more than they need at that point) at an affordable cost. This assures that they will have enough protection later when their needs increase, even if they become uninsurable, but they still can’t afford a form of permanent life insurance.
A fourth advantage is that there are various flavors of term—level, decreasing and increasing—that can be added as riders to different types of permanent life insurance. This can provide a highly customized solution to clients who want both a savings element and a pure death benefit, but at an affordable price.
Fifth and finally, term life policies are easy to understand, can be cancelled without penalty and can usually be converted to a permanent policy.
What are Term Life’s Disadvantages?
Leimberg explains that term insurance lacks the tax-free automatic savings of permanent life insurance. As mentioned earlier, the premiums increase steadily with each term until they become literally unaffordable at the higher ages. There is generally little in terms of loan values or other living benefits. And most importantly term life will likely not be in existence for the entirety of a person’s life. If the prospect has a permanent need, then term insurance is not a suitable solution.
From clients’ perspective a big disadvantage of term is that they can end up paying a substantial amount in premiums over several decades and get none of it back . . . unless they die, at which point their beneficiary receives the policy’s face amount (death benefit). However, this can be avoided by recommending return-of-premium term, but at a higher price.
Who Is Term Life for?
Leimberg suggests term life insurance is a flexible solution for the right prospect including:
- Anyone who has a temporary need. For example, Leimberg says a parent who has other life insurance needs covered, but wants to make sure a child will have money to complete college, might purchase a five-year nonrenewable term policy. Prospects with a declining mortgage balance might also appreciate a decreasing-term policy whose face amount declines over time, but whose premium remains level.
- Anyone with a long-term need, but for whom cash flow is currently too small to allow for the purchase of a permanent policy. Young parents with children are the classic application, providing the maximum “bang for the buck.”
- Someone who has stronger savings opportunities outside an insurance policy than inside . . . in other words, someone who has “opportunities that will pay a higher tax-free or after-tax yield with the same level of safety as the insurance policy.” This is the classic “buy term and invest the difference approach.” But Leimberg adds that it’s not just a matter of comparing the two yields. Agents and prospects should also consider other permanent life insurance features such as creditor protection, a minimum rate guarantee, disability waiver of premium, loan features and a number of other nonforfeiture and settlement options.
- Business owners who are trying to fund a buy-sell agreement with cross-purchase arrangements. Here, Leimberg says the need for a younger owner to buy life insurance on the older owner might prove unaffordable without using term life or some combination of term and permanent.
In short, here’s the bottom line on term life insurance. The product isn’t inherently good or bad. It becomes so only when matched to a client. This is why it’s crucial to understand the facts underlying term life insurance and the family and financial circumstances surrounding the prospect. Only then can you match the right product type to the client situation. If people have a big, temporary need for death protection, term life insurance is generally an appropriate solution.
Watch for Part 2 of this series, when we’ll go through the same exercise for permanent life insurance.