Life Insurance
Term Life Insurance does not have to be complicated. For many people, a Term policy can be understood as a contract between an individual and an insurance company that states that IF the insured person dies while the policy is in force, THEN the insurance company will pay a certain amount of money to the beneficiaries of the policy. I will use a simple example, then build on it for a better understanding.
I buy a Term Life policy on myself; I am the Insured. I name my wife as the sole beneficiary – 100%. If I die while the policy is in-force, then the insurance company will pay my wife the Death Benefit.
As in the above example, there are three separate roles identified in every Life insurance contract besides the insurance carrier.
- OWNER(s) – the person(s) or entity who owns the contract and is responsible for paying the premiums. The owner is also the one who designates the beneficiaries.
- INSURED – the person whose life is being insured. The death benefit is triggered upon the demise of the insured, not the demise of the owner.
- BENEFICIARY(IES) – the person(s) or entity to whom the death benefit is paid after the insurance carrier receives proof of the insured’s death. There are two main classifications for beneficiaries: Primary and Secondary (sometimes called “Contingent”) beneficiaries. The Primary beneficiary(ies) will receive the death benefit in the percentage designated. However, if the primary beneficiary has predeceased or dies simultaneously with the insured, then the death benefit will be paid to the Secondary / Contingent beneficiary(ies).
Note that the Owner and the Insured are often the same person. This is the case in the example of above: “I buy a Term policy on myself.” Sometimes, the Owner may also be the Beneficiary. E.g., a corporation buys (and owns) a policy on a key employee (the Insured) and designates itself (the corporation) as the Beneficiary of the Death Benefit. However, the Insured and the Beneficiary should never be the same person.
Also note that the Owner and Beneficiary roles can be filled by an individual, or more than one person (Joint ownership), or it can be an entity like a corporation or a trust. However, the Insured will never be an entity on a Life Insurance policy. The insured must have a life. There are policies that will have two-insured people, but never an entity.
Here are some terms and definitions that you need to be familiar with:
- Policy – A contract between the Owner and the Insurance Company.
- Premium – The money paid to the insurance company by the owner to keep a policy in-force.
- In-force – A status that indicates that the contract is enforceable or “active”.
- Death Benefit – the amount of money that is paid by the Insurance company to the Beneficiary upon the death of the Insured.
- Face Amount – the amount of insurance money that is being purchased for the life of the insured. Often, the Face Amount and the Death Benefit are one-and-the-same value. However, sometimes the Death Benefit may be more or less than the Face Amount depending on several factors. Here is one simple example where the Death Benefit is not equal to the Face Amount: Let’s say that the Face Amount is $100,000, but the owner of the policy takes a loan from the policy of $10,000 and before the loan is paid back the insured dies. In this case, the Death Benefit will be $90,000 instead of the Face amount because of the outstanding loan value. This is not likely to happen on a Term policy, but could apply in other situations.
- Term – Term is the duration of time that one’s premium amount is constant. If I buy a 5-year Term policy, my premiums will not change for the first 5 years of the policy. A 30-year Term policy means one’s premiums will remain the same for 30 years. Don’t mix it up. The Term is not how long the policy is in-force, nor is it the length of time for which you are obligated to pay premiums. It simply specifies that the insurance company cannot raise premiums on that contract during that Term.
Let’s clarify with another example. I shop around and buy a 30-year Term policy with a $250,000 Death Benefit for $65 per month. I pay 13 months of premiums totaling $845, but then I win the state lottery mega jackpot. I then ask myself, “Why should I continue to pay for this measly quarter of a million-dollar policy when I’m about to receive $300 million from the lottery?” So, I immediately discontinue my payments to the Life Insurance company and the company immediately discontinues my coverage. You see, as the owner I am not required to keep the policy in-force or to continue to pay the premiums for the number of years specified by the Term. There is no penalty for cancelling the policy, and I am not obligated to continue to pay premiums. Of course, if I don’t pay the premiums, the Life Insurance Company is not required to keep the policy in-force. And if the policy is not in-force at the time of the insured’s death, there is no Death Benefit. (One could also make the case that someone with $300 million dollars should not have a problem paying $65 per month. I can see it either way.)
What happens after the Term is up? With many contracts, the contract doesn’t automatically end, nor does the coverage. What happens is – the premium amount changes dramatically. The premiums are no longer limited to the constant amount that was established years ago when the policy was created. Therefore, the premiums typically skyrocket to levels that are usually not affordable. So, most people let the policy lapse by simply not paying the higher premium amount. The insurance carriers expect this to happen.
A place for a Term Life Policy
Term Policies play a special role. They allow a person to insure themselves or another person for a specific timeframe that matches a particular duration of risk. A common example is to match a 30-year Term policy to a 30-year mortgage.
Example: If I finance a house on a 30-year mortgage, I may want to buy a 30-year Term Life policy so that if I die during that 30-year period, a death benefit is paid to the beneficiaries enabling them to pay off the mortgage and keep the house. If I pay off the mortgage early, say in 20 years, then I can easily drop the 30-Year Term Life coverage by discontinuing the premiums since the house is already paid for.
Here is another example that centers around a particular stage of life – a couple with young children. Josh and Heather recently had their fourth and last child (so they hope). They decide that financially speaking, the most vulnerable years they have as a family are when the children are minors. If Josh were to die while the kids are still young, that would be financially devastating to Heather, or if Heather were to die, the same is true for Josh – financial devastation. Moreover, they conclude that if either of them dies after the kids are grown and out of the house, the surviving spouse would be able to manage without as much of a Death Benefit being left to them since they would not have little ones or teenagers to support. Therefore, they opt to buy a 25-year Term policy on each other to cover the timeframe when the loss of a parent / spouse would be especially impactful. Their youngest child will be 25 years old when the Term ends, so they should be through college and on their way toward independence. Moreover, if Josh and Heather both died together in a automobile accident or plane crash, the guardians of their children would need money to provide support, but this would not be the case after 25 years.
One other distinguishing feature worth mentioning about a Term Life policy is that there is no savings or cash value being accumulated within the policy. When the contract ends or is broken, it’s “You go your way; I’ll go mine” says the company. Another way of saying this is, once the policy lapses for any reason, the company owes the owner, insured and beneficiary nothing; there is no monetary value to be taken from the contract. This can be hard for people to swallow is, but it’s fact. All the premiums paid to the company, belong to the company and nothing is paid back to the payee.
There is one exception to this: a Return of Premium (ROP) rider. If the Term policy has a Return of Premium rider, then there may be a refund of some amount available when the policy is ended. Typically, if the policy is kept and paid for through the end of the Term, then 100% of the premiums are refunded. If the policy is cancelled or lapses prior to the end of the Term, usually there is some form of prorated refund that can be collected by the owner. The details of such a rider will determine the rules. ROP provisions may seem like a policy with cash value, but in technical terms, it is not the same. And yes, the ROP rider increases the premiums by a substantial amount compared to Term policies without ROP.
