When discussing Life Insurance with clients, we are often asked “so how do I know if I should be buying a Term insurance policy, or if I should consider a Cash Value type of policy (Universal Life and Whole Life policies)?”
While there are numerous reasons why a person may choose a Term policy over a Cash Value type of policy or vice versa, we like to answer this question by explaining that people who buy Term insurance are typically looking to protect a financial obligation or a future anticipated financial obligation, and once that financial obligation no longer exists they will no longer need this life insurance coverage. The idea here is that once the financial obligation has been met, the insured will not renew their life insurance policy.
Cash Value type insurance policies (Whole Life, Universal Life) are typically purchased when an insured wants to be sure that the death benefit is available when he or she dies regardless of his/her age at the time of death. These types of insurance policies are very popular for paying estate taxes when the insured dies, but they require more premium dollars to maintain than Term Insurance policies assuming the same death benefit.
Term insurance is most often purchased when the insured recognizes that should they die during a certain time period, the insurance will be used to satisfy a time-sensitive financial obligation. On Term insurance policies, there is no Cash Value or Accumulation Value – all the premium paid goes to pay for the cost of insurance for that year. It is most typically offered as either Annual Renewable Term or Level Term.
With an Annual Renewable Term policy, the amount of the death benefit stays level for the life of the policy but the annual premium goes up every year. The reason the premium goes up every year is due to the fact that statistically speaking, every year you are more likely to die than in the previous year – actuary tables and common sense show that the older you are, the more likely you are to die. The premium on an Annual Renewable Term policy increases every year for this same reason.
With a Level Term policy, the premium stays level for the entire stated term of the policy – so for example, the premium on a 30 Year Level Term policy will remain the same for a period of 30 years. After the 30thyear (provided you are not too old), the carrier will likely offer you the opportunity to renew the policy for one year periods thereafter, as an Annual Renewable Term policy. This means that the insurance premium offered for year 31 will be higher (often significantly) and it will continue to increase every year thereafter up until the insured either dies, or until the insured reaches an age where the policy will no longer be renewed by the issuing carrier.
It depends on your budgeting preference. All things being equal, the first year’s premium on an Annual Renewable term policy will be lower than the first years premium on a Level Term policy – but the renewal premium on an Annual Renewable Term policy will be higher in year 30 than the premium on a 30 year Level Term policy in year 30.
The simplified explanation for this is that the level annual premium provided by a Level Term policy is merely an average of the premiums that would otherwise be charged for an Annual Term policy over the same 30 year period. So, some people purchase a Level Term policy because they like the fact that the premium does not change over the term period, which makes annual budgeting for the premium expenditure much easier to manage. Other people prefer to purchase an Annual Renewable Term policy precisely because the premium is lower in the earlier years of the policy, which often coincides with their lower income earning years – as a person ages, they anticipate making a higher annual income and/or having more savings to afford the higher premiums charged in those later years.
Let’s use the following example to see how Term Insurance can be the right product to purchase. Let’s assume Bill and Mary Jones, young newlyweds, are about to have their first child and they decide that they want to buy a house so that they can raise their child in a stable community environment. Bill’s annual income is four times that of Mary’s, and Mary wants to stop working when they have their baby so that she can dedicate her time and efforts to raising the child. They hope to be able to pay for the cost of the college education for their child. Bill wants to be sure that should he suddenly die before their child is out of college and on his/her own, Mary would have enough money to pay off the outstanding balance on the mortgage, to raise the child in their home, to pay for ongoing living expenses, to pay for the child’s college education, and finally so that Mary has enough money to maintain her current standard of living for the rest of her life. Given this scenario, Bill will need to calculate how much money Mary and the child will need (either by working with a financial planner or utilizing one of the many online resources available) in order to accomplish all this should Bill die before the child is grown and on his/her own. Once this figure has been calculated, Bill will purchase a Term Life insurance policy with a death benefit adequate to meet these financial goals.
If a Level Term policy is purchased, Bill would want a policy that provides term period that will get him through the bulk of the years of the above mentioned financial obligations. A trusted life insurance agent can help Bill decide whether he wants an Annual Renewable Term insurance, or Level Term Insurance based on his budgeting preference – remember, Annual Renewable Term insurance premiums are less expensive at first but will increase each year, while Level Term Insurance will offer the stability of the same payment each year for the entire term. Either way, once Bill’s financial goals (paying off the mortgage, sending his child to college, and saving enough for himself and Mary to retire) have been met, and providing that Bill is still alive, there is no longer a need for this life insurance so Bill will no longer renew his life insurance policy.
As you can see, understanding the types of life insurance can be complicated – if you are interested in purchasing life insurance, you should speak with a life insurance agent so you can be sure that the type of policy you purchase will meet your financial goals.