Thursday, October 21, 2010

Life Insurance Primer. Part Two: Term Insurance

In the first post in this series, I introduced the most common flavors of life insurance.  Now I will do a deeper dive into the simplest one:  term life insurance.  As I stated in Part One, this is the form of insurance that 99.9% of people should consider.

Before I start, I want to just say a few more words about life insurance in general.  Life insurance is a very morbid thing to think about. I mean, who wants to think about dying? It is a subject that few people want to consider. However, you've got to man-up (or woman-up as the case may be).  When you are an adult with people who depends on you, part of your responsibility to them is to make sure that they are taken care of.  There are too many stories of a mother or a father dying unexpectedly, leaving their widow/widower and kids without the means to take care of themselves.  So I say, suck it up, look the Grim Reaper square in the eye, and deal with it!

Term insurance is straightforward; you pay a premium to an insurance company and, in return, the insurance company pays your heirs the policy's face amount if you die.  If you don't die, you and your heirs get nothing.  In this respect, term insurance is a lot like car insurance or homeowners insurance.  You pay a premium but if you don't have any claims, you get nothing.  Term insurance gets its name from the fact that the insurance lasts for a limited period of time, which is coincidentally called the term.  Normally, you have the ability to renew the policy when the term is up, although the insurance company can raise your premium depending upon the terms (no pun intended) of the policy.

Setting the Premium:

Your premium is tied to how likely it is that you will die during the term of the policy.  The insurance company employs actuaries to determine how much they should charge each person, based upon their risk.  If you have a higher risk of dying, you will pay a higher premium, just like you would pay more for car insurance if you got lots of speeding tickets.  Common factors that insurance companies consider are age, gender, health, and geographic location.

Usually, insurance companies will quote you their "best" rate, which is the rate that they would give to somebody in perfect health.  However, it is possible that you won't be able to get this rate.  When you apply for your policy, insurance companies will go through a process called underwriting.  This involves asking the applicant lots of personal questions, requesting medical records, taking blood samples, and so forth.  The more insurance you want, the more involved the process will be.

Once this is done, the insurance company will come back with an assessment of your overall risk.  Normally, they will classify applicants into a variety of categories like "preferred", "standard", or "rated".  The exact classifications vary by company.  The important thing to note is that each classification has a different premium.  Once you have been quoted your exact premium, all that is left to do is sign the contract, and you are good to go.

Varieties of Term Insurance:

The simplest type of term insurance is one-year renewable term.  With this type of insurance, you have the option of renewing the policy every year without going through the underwriting process.  However, your premium increases from year to year, reflecting the fact that as you get older, your risk of dying increases.  Eventually, the premium might get so high that you might cancel the policy.

A second form of term insurance is level term insurance.  This type of insurance is similar to one-year renewable term, except your premium is guaranteed to stay the same for some fixed number of years.  The catch is that the longer the guarantee period, the higher your premium will be.  Once the guarantee period is over, the insurance company is free to raise your rates.  Many people will drop their insurance once the guarantee period is over rather than paying the higher premium.  This type of insurance might make sense for those who want certainty in their premiums and only anticipate needing insurance for a limited period of time.

You Should Consider Term Life Insurance If:

- If you have a family that depends upon your salary to pay the bills.

- If you have a family that depends upon your time and effort as a stay-at-home parent.  This is one situation that many people don't consider.  Even if you aren't the breadwinner, if something happened to you, your surviving spouse will now be faced with the added expense of childcare, or maybe he or she will have to work fewer hours (and make less money).

- If you want to make sure your kids have money for college if you die.

- If you want to make sure your mortgage is paid off so your family doesn't have to move if something happens to you.

Because the premiums rise with age, term insurance makes sense if you need protection for some limited period of time.  Generally, as you get older, your kids are on their own, your mortgage is paid off, and you have hopefully put aside savings for retirement.  Therefore your need for life insurance goes away, which is why term insurance makes sense for the majority of people.

When Shopping For Term Insurance:

- Consider the health of the insurance company.  You want to make sure that the company will be around for the next 10, 20, 30 years so that way if something happens to you, the company will able to make good on the policy.  There are several independent agencies that rate insurance companies for financial health, so only consider companies that is well regarded.

- Consider the premiums.  If you know the insurance company is financially sound, there really isn't any difference between company A and company B.  There really isn't much else to differentiate one company from another other than price.  However, most companies will quote their best price.  Just because company A has the lower preferred policy doesn't mean that all of its policies are cheaper.  Ask for a rate comparison for different risk levels.

- Buy enough insurance.  Determining the amount of insurance that you need is a tricky problem.  Perhaps I will dedicate a future article to it, but for now, the best advice that I can give is to do your homework and buy what you need.

1 comment:

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