Term life insurance is, when judged by the annual premiums, the most affordable kind of life insurance by far. But why is it so much less money than whole life insurance and other forms of permanent life insurance? Is the coverage less valuable? Will the insurance coverage still pay out, and be there when you need it? Is it somehow more risky to use term life insurance instead of other kinds of life insurance?
You don’t need to worry. Term life insurance provides the exact same insurance protection that other kinds of life insurance do, for a much lower price. It does this by working in a very different way than other forms of life insurance. How does it work? The answer to these questions and more is detailed below.
Term Vs. Permanent Life Insurance- A Shorter Coverage Period
While term life insurance provides the exact same amount of life insurance protection as other kinds of policies, it does not provide coverage for the same period of time. Permanent life insurance provides coverage lasting a lifetime. Whole life insurance and other forms of permanent life insurance such as variable universal life insurance and universal life insurance are guaranteed to pay beneficiaries a death benefit as long as premium payments are made in sufficient amounts.
Term life insurance only lasts for a specific number of years. Term life insurance is temporary. Like it’s name implies, term life insurance is meant to provide coverage only for a specific term, or length of time.
A common length of term life insurance coverage is 20 years, different options exist though. If the insured person passes away during the 20 years of coverage (which begins approximately when the first payment is made and ends 20 years from that date) the claim is paid out in full. The amount of death benefit paid out from a term life insurance policy will always be equal to the face amount of the policy.
If the insured person passes away anytime after the coverage period ends, the policy pays nothing. Coverage only lasts for the term of the policy. Because many people will outlive the end of the protection period, the odds of a life insurance company actually having to pay a claim on a term life insurance policy is relatively small compared to a whole life insurance policy (which theoretically has a 100% chance of a claim being paid). Because the odds of a claim are small, the coverage can be priced much cheaper than permanent life insurance.
No Cash Value
Term life insurance has no cash value. When the coverage ends, the policy expires worthless, and the life insurance company keeps all of the premiums that were paid to them (except in a special product called a return of premium term life insurance policy). Contrast that to a whole life insurance, which has guaranteed cash values build over time. That cash value belongs to the policy owner, unless a death claim is filed. If a claim is filed the life insurance company keeps the cash value and pays out the face value of the policy to the beneficiary.
Policy owners can take withdrawals and loans from the cash value of permanent life insurance. An owner can surrender their policy during the insured person’s lifetime, and receive the cash surrender value of the policy. Most banks will even accept a permanent life insurance policy as collateral for a loan. Permanent forms of life insurance have a value even while the insured person is alive. This value makes them more expensive from a required annual premium perspective.
A term life insurance policy has no such features. All the premium payments simply go in the pockets of the life insurance company, and a term life insurance policy only has value if a claim is paid out. No additional value exists to the owner of the contract during the lifetime of the insured person other than the value of the financial protection provided by the insurance coverage (which is still very valuable).
No Dividends For Term (Non Participating Policy)
Term life insurance policies do not pay dividends to owners. This is known as a non participating policy. Whole life insurance policies get to participate in the earnings of the company, therefore they do pay dividends. Because owners of whole life insurance have the right to participate in the earnings of the company, it adds additional value to the policy. Dividend payments can become extremely valuable over time. Many owners of whole life insurance will actually make money on their policies after 10-20 years because of dividend payments.
While term life insurance policies do not typically participate in any dividend distributions from the life insurance company, they do require much lower premium payments. This is a trade off that many owners are gladly willing to accept.
While Term Requires Less Annual Premium, Other Forms Of Life Insurance Can Make Money
Cheaper is a relative term. It is important to keep in mind that the different structure of different kinds of life insurance can actually make permanent forms of life insurance less expensive over a very long period of time, but more money (at least for the first years) on an annual basis.
Term life insurance requires the least amount of premium payments by the policy owner, by far, compared to any other form of life insurance. If life insurance coverage is required for a long period of time, a permanent form of life insurance may actually end up being less of an expense. Dividend payments from whole life insurance policies, earnings from variable sub accounts in variable universal life insurance policies, or interest earned from universal life insurance policies can all become large enough to completely cover the cost of life insurance. The potential exists for policy owners to stop making premium payments on permanent forms of life insurance, and have the policy stay in force until a claim is filed.
The potential for permanent forms of life insurance to earn money should be kept in mind when you consider purchasing a term life insurance policy. It may also be more valuable for you to “buy term and invest the difference“, so the costs and benefits must be carefully weighed before making a purchasing decision.
Term Is Cheap and Simple
Term life insurance is so much more affordable than permanent life insurance because term is a “no frills” form of life insurance. There is no cash value, the coverage is temporary, and the policies do not participate in dividend distributions.
Term life insurance does provide valuable life insurance coverage. Term life insurance has the same rules for paying life insurance claims as any other forms of life insurance, and you can count on it to be there if you need it. Term life insurance does exactly what life insurance is designed to do, it provides financial security to beneficiaries against the risk of death. It simply accomplishes this in a more straightforward way, and for a temporary amount of time, thus making it the least expensive form of life insurance available.