Term life insurance
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Term life insurance is a type of life insurance that is temporary, as it covers only a specific period of time, the relevant term. It can be considered pure insurance because it builds no cash value. This is in contrast to permanent life insurance such as whole life, universal life, and variable universal life.
Term insurance is the cheapest way, in the short run, to buy a given amount of insurance death benefit on a coverage per premium dollar basis.
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Annual Renewable Term
The simplest form of term life insurance is for a term of one year. The death benefit would be paid by the insurance company if the insured died during the one year term and no benefit is paid if the insured dies one day after the last day of the one year term. The premium paid is then just the expected probability of the insured dying in that one year plus a cost and profit component for the insurer. Since the likelihood of dying in the next year is low for anyone that the insurer would accept for the coverage, purchasing one year of coverage is not generally done, nor cost effective. A variant that is commonly purchased is annual renewable term (ART). In this form, the premium is paid for one year of coverage, but the policy is guaranteed to be able to be continued each year for a given period of years. This period varies from 10 to 20 years, or until age 95 sometimes. In this form the premium is slightly higher than for a single years coverage, but is much more likely for the insured to have the benefit paid.
Level Term
Much more common than annual renewable term insurance is insurance where the premium is the same for a given period of years. The most common periods being 10, 15, 20, and 30 years. In this form, the premium paid each year is the same, and is the cost of each year's annual renewable term rates averaged over the term, with a time value of money adjustment made by the insurer. Thus the longer the term the premium is level for, the higher the premium, because the older, more expensive to insure years are averaged into the premium.
Payout likelihood
Insurance industry studies show that it is very unlikely that the death benefit will ever be paid on a term insurance policy. One study placed the percentage as low as 1% of policies paying a benefit. That is the reason term insurance is able to be so inexpensive. The low payout percentage is a combination of there being a low likelihood (in the aggregate) of a random, healthy person dying within a short period of time, combined with some term premiums rising every year so that the insured finally does not continue the policy as they get older (and more likely to die).
Due to this low likelihood of receiving a benefit, but reallizing the death benefit coverage may be very important to achieving the insured's goals, many people are drawn towards permanent life insurance. Permanent life insurance offers coverage for the entire life of the insured and therefore will pay a death benefit as long as premiums are current. Permanent coverage also allows certain tax advantages, including tax deferred growth of cash value and greater likelihood of receiving a death benefit, which is also usually tax free.
Conversion Privileges
Because many people would prefer permanent life insurance, but may not be able to currently afford the higher premiums, many term policies offer a conversion privilege for a certain period of years, for the insured to convert to a permanent policy regardless of health condition at the time of conversion. In this way a person can obtain the necessary coverage for a young family for instance by purchasing the cheaper term insurance, but be able to utilize the tax advantages of a permanent policy as cash flows increase from raises and promotions for example.