Demystifying Life Insurance - Term Insurance

Term Insurance... the affordable choice

Last month, we left off talking about the two different types of life insurance: permanent and term. We likened each to owning or renting a home. Although that analogy is generally accurate, it is also a little simplistic. Life insurance contracts are complex financial tools that few people read or understand. Therefore, in order to understand the features, benefits and drawbacks of term insurance, we will use an example... my friend, the doctor.

My friend has a $2,000,000 term insurance policy that he took out five years ago. It is a 20-year, level payment, convertible term policy. That means the doctor will pay exactly the same premium (monthly, quarterly, semi-annually or yearly) for 20 years. The insurance company promises to pay his beneficiaries $2,000,000 should he die within the coverage period. Let's say the doctor's annual premiums are $2,000. He has already paid $10,000 in premiums in the first five years and, assuming he outlives his coverage, he will pay an additional $30,000 over the next 15 years toward that policy. Now, if the doctor dies prematurely (he's in his early 40s) any time in the next 15 years, his beneficiaries will receive $2,000,000. That's a good deal, right? He pays a maximum of $40,000 in premiums for his beneficiaries to receive $2,000,000. That's a great rate of return! But, how often do people die prematurely? Well, insurance companies hire really smart people called actuaries to crunch all kinds of numbers to determine the price to charge consumers for term insurance. How many term insurance policies in the United States actually pay a death claim? The answer is ... less than 3%! So, in reality, the good doctor will pay $40,000 to insure his life in case of premature death. However, odds are that he will outlive his coverage and his $40,000 goes into the insurance company's pocket.

So, why would anyone buy term insurance if the likelihood of benefiting from it is less than 3%? Well, in most cases, we buy insurance IN CASE something bad happens. For my friend, who has a wife to support and kids to rear, paying for term insurance is the affordable solution to an unthinkable problem. He can get a high amount of coverage for a reasonable price (incidentally, two million dollars is not enough coverage for him). Since my friend believes he will probably outlive his term insurance coverage, he still wants the benefit of having life insurance that he can keep until he dies, no matter when that happens. My friend needs some permanent insurance. We'll discuss permanent insurance next month.