How Does Term Life Insurance Work?

Jose Hernandez
Head of Education

Life insurance can play a major role in a household’s comprehensive financial strategy. Unfortunately, it is not well understood by most Americans. Appropriate coverage, policy type, and strategy all vary depending on individual circumstances and preferences. Regardless of your situation, however, your life insurance, whether it be whole or term, should work for you.

While there are several different types of policies available, the two primary types of life insurance contracts fall under one of two categories: term life insurance and whole life insurance.

This article will cover the basics of term life insurance, from what it is to how it’s used.

Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. Insurance situations can be very complex and laws vary by region. It may be wise to consider the help of an industry professional when it comes to insurance-related decisions.

If you don’t yet have industry professionals handling your portfolio, we can help! Check out Financial Professional’s investment marketplace, where we partner with some of the best in the business to help find the right investment for you.

What Is Life Insurance, and What is it For?

Before anything, let’s review what life insurance is.

Life insurance is simply a contract between a policyholder and a life insurance company. The contract states that if the person whose life is insured passes away, the life insurance company will pay a set amount of money to the beneficiaries named in the contract.

Life insurance is essentially a “transfer of risk” from the person who is insured to the life insurance company. In exchange, the policyholder pays a premium to the life insurance company. This makes life insurance a risk management tool – but what is the risk that needs to be managed?

Simply put, the risk is that someone passes away, leaving dependents behind in need of financial support. Unless someone has a large asset base that their dependents can inherit, those dependents will be hurt financially unless the surviving parent or guardian can provide the same level of financial support.

There are other potential uses for life insurance, such as paying for a funeral or extinguishing the dearly departed’s existing debt. However, covering expenses for those left behind is the most common.

How Does Term Life Insurance Work?

Term life insurance refers to a life insurance contract that is effective (“in force”) for a specified period of time (or term). Once the term is up, the policyholder can decide whether or not they want to renew the policy.

The premiums for term life insurance tend to be level for the term of the policy. However, if the insured person decides to renew at the end of the term, the premiums will go up to reflect the older age of the insured.

Term insurance primarily serves to provide coverage for a specified period of time. The most common use of term life insurance is for young couples that have children at home. For instance, a 20-year term policy would provide a death benefit to the beneficiaries if the insured parent were to pass away within that time window.

Note that the beneficiary does not necessarily need to be a child. It is not uncommon to see a spouse named as the beneficiary of a life insurance policy.

What Is The Death Benefit?

Generally, the death benefit provides the surviving spouse and/or their beneficiaries with a replacement for the income that the insured person was providing. It is also common to see people use life insurance to protect their beneficiaries or surviving spouse from being responsible for a large liability (such as a mortgage).

In some cases, life insurance proceeds are used strategically in order to pay for the tax liability of an estate (via an ILIT policy).

Who Needs Life Insurance?

Remember, life insurance is a risk management tool. Whether or not it is right for you depends on several things – after all, your term life insurance should work for your specific situation.

The main variable to consider is whether or not you have people in your life that are currently depending on your ability to earn an income in order for them to be able to live comfortably. If you have children or dependents, it’s likely that you need some sort of coverage.

On the other hand, if you’re in a position where you have a substantial amount of assets that you could leave behind to heirs, life insurance may be less important.

If that is the case, it is still wise to review your estate plan. If the estate you’ll leave behind is large enough, it may be subject to the estate tax. Furthermore, if the tax liability is large enough, you should give careful consideration to a policy that would pay for that liability without having to use assets that belong to the estate. This sort of planning should be done by an estate planning professional.

Where Can I Get Life Insurance?

The first place to check for life insurance coverage is through your employer. Most employers offer group term life insurance at a very low cost. This is due to the fact that the cost is spread out among a large group of people (the employees). Just note that the level of coverage offered by your employer may not be sufficient.

You can purchase additional coverage via a number of different outlets, either online or with a brick-and-mortar life insurance broker. Either of these options will be able to provide you with a plan and recommendation based on your needs and circumstances. However, an online broker does so with much less human interaction. If you are looking to get started online, Sproutt can be for you. Sproutt’s technology matches you with an insurance plan for your lifestyle.

What Goes Into Applying for Life Insurance?

All life insurance policies (aside from employer-provided ones) require the potentially insured person to go through a medical exam.

The life insurance company requires this exam in order to get an idea of how likely it is that the potentially insured person will pass away. If the life insurance company perceives the applicant as “high risk”, they will issue the policy with a higher premium. On the other hand, someone who is “lower risk” will have a lower premium in comparison.

This is why people with health complications or unhealthy habits (nicotine usage) tend to pay higher premiums.

As mentioned previously, age is a factor that plays a role in the application process. The younger an applicant, the lower their premium will be, all other things being equal.

Once the medical exam is complete, the life insurance will finish the rest of the underwriting process. They will then let the applicant know whether or not they are willing to extend coverage, and at what rate.

Term vs Whole Life Insurance

While the aim of term and whole life insurance is to provide beneficiaries with a death benefit, there are some notable differences.

Generally speaking, term policies tend to be cheaper than whole life policies. This is because term policies tend to be in force for a specified term.

Whole life policies, on the other hand, tend to be active for the insured’s entire life.

Furthermore, whereas term life insurance policies do not accumulate cash value, whole life policies do. Based on your plan, you can withdraw these funds via a policy loan throughout your life.

There may be other differences, but these are the most important. Coverage, costs, and features will vary by carrier. As always, keep in mind that what makes sense for one household may not for another.

A Final Word

Whether you go with term insurance or not, it’s important to make a decision based off of what’s most relevant and important to you.

If you’re someone that values keeping costs low, and you only need the coverage for a specified period of time, the term may make sense. The only thing to keep in mind is the fact that your premiums are likely to go up, due to your increased age if you decide to renew after the initial term expires.

Have questions on how term life insurance works? Let us know.

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Jose Hernandez
Jose Rafael Hernandez is known as "@thejoserafaelhernandez" on Instagram. He and his family are immigrants to the United States from Venezuela. The unique challenges that he faced at a young age taught him the real value of money and its importance in life. Jose studied finance at Mercer University, where he also competed in Division 1 Baseball. After his athletic career, Jose began his professional career in the finance industry. He started his career as a wealth management advisor for one of the top Investment Advisory firms in the US, where he was responsible for just north of $20mm in AUM. Jose currently holds the Series 7 and 66 licenses. Jose decided to leave the firm so he could have the freedom to create his brand on social media, geared towards educating millennials in the areas of personal finance and investing. His mission is to leave a positive impact on others while building his own legacy and providing for his family.