How Does Term Life Insurance Work?
Term life insurance helps your loved ones after you’re gone
Term life insurance is a type of life insurance policy that is in effect for a limited time, such as 30 years. It pays a death benefit if you die during the term of coverage. It's designed to protect those who depend on your income or the services you provide in case you pass away while people are counting on you.
"Term life insurance makes sense for most families, and is a useful tool to provide liquidity after a death," John Strohmeyer, a tax and estate planning attorney and proprietor of Strohmeyer Law PLLC in Houston, told The Balance via email.
Learn how term life insurance works and if it makes sense for your situation.
What Is Term Life Insurance?
Term life insurance policies are a form of insurance coverage that protect your loved ones in case you pass away while the policy is in effect. If you die before your coverage term ends, your beneficiaries receive the death benefit. If you don't, your policy ends and there are no benefits paid out.
How Does Term Life Insurance Work?
When you apply for term life insurance, you'll need to choose which type of policy is right for you and how large your death benefit should be.
You'll complete an application, which may involve a medical exam, and will pay premiums based on the insurer's assessment of the risk of your passing during the term. Your policy will provide coverage in most circumstances if you pass away, although there are some exclusions to be aware of.
Applying for term life insurance involves providing some details on your health history, age, and gender. Most insurers allow you to apply online, but you may need to undergo a medical exam in person.
Once you've submitted an application, it will go to underwriting, which is the process of assessing risk. Underwriting determines if you can be approved and how much you'll pay for coverage.
"The younger and healthier you are, the cheaper it will be," Riley Poppy, a certified financial planner and owner of Ignite Financial Planning in Seattle, told The Balance via email. "If you secure term insurance when you're younger, the premium can be level, which means it won't change. This can be a major cost-saver over time."
Your age isn't the only factor that determines your premium costs either.
"Aside from the amount and duration of coverage you choose, your age, gender, current health, medical history, family history, and tobacco status may all impact the price you pay for term life insurance," Michael C. Staeb, an insurance advisor and wholesaler with over 19 years of experience, told The Balance via email.
Staeb explained that cigarette smokers may pay as much as triple what a nonsmoker would. However, those who have been tobacco-free for 12 months may be able to qualify for nonsmoker rates with some insurers.
The key to term life insurance is that the policy is in effect only for a limited number of years. That's called the "term" of the policy, and you have a choice of how long it will be.
"Term life insurance provides options to choose from that vary in length of coverage," Jim Kirk, owner of Rocky Mountain Financial Solutions, told The Balance via email. "The term length can range from one year to 35 years."
You'll want to make sure your term lasts for as long as your loved ones need the financial protection the insurance provides. When the term is up, the policy ends and no death benefit will be paid out in the future. However, some policies are "guaranteed renewable," which means you can opt to continue coverage on a year-by-year basis at the end of your initial term.
If you're not sure exactly how long you'll need protection, choosing a guaranteed renewable policy may be smart.
While a guaranteed renewable policy ensures you can keep your coverage at the end of the term, it doesn't guarantee your premiums will remain the same. Your policy could become much more expensive, which is why it's so important to choose the right term length from the start.
The Death Benefit
The death benefit is the amount that's paid out from your policy if you die during the term of coverage. You can choose who receives the payout—which is usually a family member but in some cases could be a business partner or other person who depends on you.
Those who receive the money are called beneficiaries. You can name multiple beneficiaries who will split the proceeds, or you can have a primary beneficiary and a backup beneficiary in case the primary beneficiary passes away.
Most often, a death benefit is paid out in one lump sum and it is usually not considered taxable. You'll have a choice of how much your death benefit will be, but a policy that provides a larger benefit comes with a higher premium.
You need a living beneficiary or your life insurance proceeds become part of your estate and must go through the probate process.
While a term life insurance policy is designed to pay out a death benefit when you pass on, most policies contain certain exclusions. For example, your policy may not pay out your death benefit if you:
- Die by suicide
- Pass away as a result of participating in a specific dangerous activity, such as hang gliding
- Die as a result of a plane crash on a private plane
- Die while engaged in an illegal activity
- Die as a result of an act of war
- Were living outside the United States
Because exclusions vary from one insurer to the next, you should read your policy terms carefully to determine under what circumstances your death may not result in the policy paying out.
Types of Term Life Insurance
Although all term life insurance provides coverage for a specific period of time, there are different kinds of term life insurance.
Level Term Life Insurance
"Most policies come with guaranteed level premiums, which means your monthly life insurance premiums will remain the same for the duration of your term," Yaron Ben-Zvi, co-founder and CEO of Haven Life, told The Balance via email.
If you want the predictability of knowing your payments will never change, this may be the best option for you.
Group Life Insurance
This is offered as a workplace benefit. Your employer may pay the premiums but you'll generally lose the policy if you leave your job, which can be a big problem if you end up having to buy your own policy later in life when it's more expensive.
In some cases, you may not need to take a medical test if you sign up through a group.
No-Medical-Exam Life Insurance
"Many insurance companies have figured out ways to get you covered without going through the personal health exam that you needed to do in the past," Jeremy Keil, a certified financial planner with Keil Financial Partners, told The Balance via email. "This has made the insurance buying process easier and is even more important with COVID-19 causing people to shy away from interacting with others."
However, policies that don't require medical exams often come with lower coverage limits, so this may not be the best option if you want a substantial amount of coverage.
Decreasing Term Life Insurance
Your premiums don't change the entire time your policy is in place but the amount of your death benefit goes down annually with this policy. This can provide more affordable premiums but you won't have as much coverage as time goes on. If you expect your loved one's need for replacement income to decrease over time, you may want to choose this type of coverage.
Renewable Term Life Insurance
Premiums start low but can go up as you renew your insurance policy each year. If you're not certain how long you'll need your coverage, this option may be a good one.
Return-of-Premium Life Insurance
With this type of policy, you'll get your premium payments back at the end of the coverage term if you don't pass on while the policy is in effect. Premiums are higher but if you'd prefer to get a lump sum back at the end of the term, it may be worth paying for.
Mortgage Protection Term Life Insurance
This insurance pays out to your mortgage provider (the beneficiary) and ensures your loved ones will own the family home free-and-clear if you pass away. Because your mortgage balance goes down over time, it's a form of decreasing term life insurance.
The right term life insurance choice depends on how long you want your coverage in effect, whether you value predictability or a low starting price, and your monthly budget for premiums.
Term Life Insurance vs. Whole Life Insurance
Unlike term life insurance, whole life insurance remains in effect for your entire life as long as you continue paying premiums. Whole life insurance also has an investment component, as you pay premiums higher than the cost of coverage and the additional money is invested.
"Term insurance is going to cost less than a whole life policy, and it generally won’t have any cash value," Strohmeyer said. "A whole life policy will last for the rest of the customer’s life and will have a cash value that can be accessed, but it will cost more."
For many people, term life insurance may be a better option—even if it may not seem that way at first.
"Many people want whole life insurance because they feel like term insurance is ‘renting’ insurance,” Keil said. “But we never hear anyone complain that their car insurance is a rip-off just because it doesn’t have a ‘cash value’ or that they are missing out because they are renting an apartment. Sometimes ‘renting’ is the cheapest, best way to go."
How to Choose a Term Life Insurance Provider
It's easy to find life insurance online or through a broker (someone who sells policies from multiple insurers), and many companies make it quick and simple to apply through an online application. But it's important to make sure your insurer is financially sound, offers affordable premiums, and has limited coverage exclusions.
To choose the right term life insurance provider, consider the following details:
- Review data from independent ratings firms such as Moody's Investment Services, A.M. Best, or Standard & Poors, to assess the company's financial stability.
- Check with the National Association of Insurance Commissioners (NAIC) to determine if your insurer is licensed, to see the number of complaints against it, and to get more insight into how it treats policyholders.
- Compare life insurance products to make sure the company has the coverage you're looking for. For example, not all insurers offer policies that don't require medical exams, so if that's a priority for you, you'll need to find one that does, such as Gerber Life. Some insurers also have much larger coverage limits. For example, John Hancock offers up to $65 million in coverage while others cap coverage as low as $5 million.
- Get a personalized quote. You'll want to find out exactly how much a policy will cost based on your age, health history, and coverage needs.
Once you've chosen your term life insurance company, you can complete the application process to purchase your policy.
- Term life insurance can be more affordable than a whole life policy, and guaranteed level premiums ensure your policy cost won't go up.
- Term life insurance pays a death benefit, but only if you pass away during the term the policy is in effect.
- You'll want to research term life insurance companies carefully, checking financial ratings from A.M. Best and Moody's Investment Services as well as determining if there have been complaints against the insurer to the NAIC.