Generally, term insurance is not the most effective type of life insurance for all of these death benefit needs. However, term insurance may serve the insured’s needs in many circumstances. Because term insurance is not just one product, but rather many variations on a general theme different types of term insurance are indicated for different types of needs.
Keep in mind, term insurance, more than any other type of insurance, is pure death protection with little or no ancillary or lifetime benefits. Therefore, the two overriding considerations in the use of term insurance, regardless of the specific application, are: (1) Will death protection alone meet the need? and (2) Will the coverage last as long as the need? In short, with term—as with any other decision about the appropriate type of coverage—the product must match the problem.
With these thoughts in mind, term insurance would be indicated in the following circumstances:
- When the need for life insurance is temporary – For example, assuming a parent has adequate income to pay college expenses on a pay-as-you-go basis and adequate life insurance for other purposes, the parent might use term insurance to assure payment of a child’s college education expenses in the event of the parent’s death during the child’s college years. For this type of need, a five-year nonrenewable term policy might offer the best cost/benefit relationship. Similarly, decreasing term policies are often used to pay off the mortgage on the family’s principal residence in the event of the breadwinner’s death.
- When the need is long-term but cash flow is currently insufficient to buy the needed coverage using higher premium ordinary whole life – Parents in younger families often have major long-term support obligations for their young children and spouses, have committed expenses that already strain the family’s budget and, therefore, simply cannot afford the premiums necessary to buy the amount of coverage they need to protect their families using ordinary whole life insurance.
Term insurance, especially at younger ages, provides the greatest possible coverage for the lowest premium outlay. In these circumstances, one-year or five-year renewable and convertible term insurance is generally recommended. As the family breadwinner moves into his or her higher earning years and can afford the higher premium outlay, it is often advisable to convert to ordinary whole life insurance. Upon conversion there will be a one-time premium increase. But premiums will remain level from then on.
- When the policyholder has better investment opportunities outside the insurance policy than inside the policy – If the policyholder has investment opportunities that will pay a higher tax-free or after-tax yield with the same level of safety as the insurance policy, it may be better to buy renewable term insurance and to invest the early years’ premium savings outside the insurance contract. However, they should not base this “buy-term-and-invest-the-difference” choice solely on differentials in potential yields inside and outside the policy. The cash value policy may offer many features not available on the outside investment including: (a) creditor protection; (b) a minimum rate guarantee; (c) waiver of premium in the event of disability; (d) loan provisions; and (e) a host of flexible nonforfeiture and settlement options.
- To guarantee a savings fund – Many parents set up a savings program for their children’s college educations well before their children start college. A decreasing term policy is often a perfect vehicle to assure the necessary savings fund if the parent dies before completing the funding. One can use term insurance to assure an adequate savings fund in many other similar types of applications.
- For liquidity in the event of death – One major life insurance application is to provide estate liquidity and to pay estate and inheritance taxes. Because of the ages typically involved, term insurance applications for estate planning and estate liquidity purposes are rather limited.
However, the need for liquidity may stem from temporary special or extenuating circumstances not directly associated with payment of death taxes. New business startups are a case in point. The cash flow needs of starting a new family business preclude the higher premiums of cash value policies until the business passes a critical break-even point or attains minimum profitability. Similarly, it is not uncommon for a successful small business owner to tie up virtually all of his or her assets in the business. This general lack of liquidity becomes even more severe when the business is expanding and engaging in capital improvement projects, such as building a new warehouse or plant, or starting new projects, such as developing and marketing a new product line. If the business owner should die while the expansion project is in process, it might jeopardize not only the expansion project, but also the entire business.
Although liquidity in the event of death will always be a problem (which might best be solved using a whole life policy), one can often best hedge the temporary added liquidity risk during these expansion periods using a term policy. Similar logic may apply in dealing with any potential liquidity squeeze. Instances would include an executive who has received sizable bonuses of restricted stock in his or her company, an investor who has committed a significant portion of his or her portfolio to a temporarily illiquid position, and a real estate developer who is in the process of subdividing and developing a large tract of land.
- For business purposes – Term insurance may be the most suitable form of insurance for business purposes in many circumstances. For example, one problem of funding buy-sell agreements with a cross-purchase arrangement when the ages of the business owners are disparate is the relatively high premium cost that the younger business owner must pay for coverage on the older owner. Initially, at least, term insurance or some combination of term insurance and ordinary life insurance may provide an affordable alternative.
Similarly, often term insurance may be the most affordable alternative when insuring key employees, especially when these employees are engaged in special projects where their expertise is critical to the successful completion of the particular task or project.
- When insureds desire additional death benefits in conjunction with other permanent forms of life insurance or packages of policies – Insurers often package level, increasing, or decreasing term riders with permanent forms of life insurance to create a combination of death benefits and living benefits that fit a person’s particular needs and resources. For instance, a person can use a participating whole life policy combined with a decreasing term rider when that person cannot afford the premiums necessary to fully insure using whole life insurance alone. One can design the package so that the policyowner uses dividends on the whole life to buy paid-up additions that replace the term insurance as its face amount declines over time.
Family policies are another example. The family package policy consists generally of some level of ordinary whole life insurance on the principal breadwinner, half that amount in term insurance on the spouse, and about half that amount again of term insurance on each of the children. It is less expensive for the insurance company to cover several persons in one policy than to issue separate policies for each person. The savings help to reduce the overall cost of the coverage to the family.
- To assure coverage in the event of unemployment or loss of employer-provided coverage – Renewable and convertible term insurance provides a relatively low cost method to cover the contingency of continuing protection in the event of unemployment or discontinuation of employer-provided coverage.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM