Term life insurance is a contract that specifies that, in exchange for a premium, the life insurance company promises to pay a death benefit if the life insured dies within the fixed term of the contract. The “term” is the period of time during which the coverage is guaranteed to remain in place, as long as the policy’s premiums are paid.
The most common terms for life insurance are 1 year, 5 years, 10 years or 20 years, or to a
specific age (e.g., to age 60). However, other terms, such as 3 years, 15 years or 30 years, may
also be available, depending on the insurance provider.
Most insurance companies will not provide term insurance coverage past a specific age, often around age 75 or 80, simply because the risk of having to make a payout is too great. This means that they will stop issuing new policies at about age 65 or age 70, depending on the policy’s term. When insurance is provided to older ages, the premiums are very expensive.
Renewable vs. non-renewable insurance
Term life insurance can be either renewable or non-renewable. With a renewable term insurance policy, the policyholder is guaranteed the right to renew the policy at the end of the term for another term, without having to provide proof of insurability at the time of renewal. The right to renew is usually limited to a specific age (e.g., to age 70).
With a non-renewable term insurance policy, the policy expires at the end of the term, and the policyholder has to apply for new life insurance if he requires continued coverage. If the health of the life insured has deteriorated, the policyholder risks higher premiums or even being denied coverage.
Renewable policies are more expensive than non-renewable policies. With a renewable policy, the insurance company is taking the added risk that they may have to continue coverage on the life insured after the end of the term, even if his health has declined.
Convertible vs. non-convertible
Convertible term insurance gives the policyholder the option of converting the term policy to some form of permanent life insurance (i.e., whole life, term-100 or universal life insurance) at some future date. The conversion does not require proof of continued insurability, so the policyholder can acquire lifetime protection even if the life insured is no longer insurable.
Convertible term insurance is more expensive than term insurance that does not include a
conversion option, because it exposes the insurance company to additional risk beyond the
original term. In fact, the people who are most likely to convert the policy are those who have experienced a decline in their health, which would make a new life insurance policy too expensive or even impossible to get.
The insurance company may also restrict the age at which conversion is permitted.
Advantages and disadvantages of term life insurance
Low initial cost. In the early years of the policy, the premiums for term insurance will be lower than those for permanent insurance, making it affordable for those who cannot afford permanent insurance;
Premiums are guaranteed over the term;
Renewable and convertible provisions can be used to extend coverage;
Term of coverage can be customized to meet a specific need.
Premiums and coverage are not guaranteed beyond the term or renewal period;
Premiums increase as the life insured ages, and can become prohibitive;
Coverage is usually not available past a certain age;
Policy is worthless at the end of the term.
Using term insurance
As a general rule, term insurance should only be considered to be temporary insurance, to be used for risks that will end before the life insured reaches 60 or 70 years of age. If the risk will extend until life expectancy, some form of permanent insurance should be considered.
This Section provides some examples of when term insurance might be appropriate.
Term insurance is particularly suited for short-term risks of known duration. If there is a possibility that the risk could extend beyond the anticipated duration, the policyholder should choose a renewable policy.
Decreasing term insurance may be well suited for covering risks that diminish over time, such as mortgages or other loans that are repaid over a known amortization period. Examples of other risks that diminish over time are given below.
Limited cash flow
Perhaps one of the most common reasons people opt for term insurance over a permanent policy, is that they simply do not have the cash flow to put towards a permanent policy.
Another reason some people opt for term insurance over permanent insurance is that they would rather use the difference in premiums for investment purposes, because otherwise they would not have enough free cash flow to contribute to their registered retirement savings plan (RRSP), tax free saving account (TFSA), registered education savings plan (RESP), etc. This approach of “buy term and invest the difference” can certainly build wealth over time, provided that the policyholder is disciplined enough to actually make those investments, and that those investments actually perform well over time.