What is term life insurance and how it works?

Term life insurance is a sort of life insurance that offers assurance to pay the pre-determined death benefit if the policyholder dies within a specific term. Term life insurance work in a way that it gets expired after a specific term and can be renewed for the next term, converted to a permanent insurance policy, or terminated.

What is insurance?

Before going into details of permanent life insurance and its way of working, first to discuss what is insurance? Insurance is a legal contract between an insurer or insurance company and the applicant of an insurance policy.

• According to this contract, the policyholder pays the money on an annual or monthly basis, that is known as insurance premium, and in return, the insurance company provides the reimbursement for any accidental harm to vehicle, property, health, crops, pets, or life, depending upon the type of insurance policy that a policyholder has bought.

• Insurance policy acts as a shield against unexpected losses and provides relief to the policyholder by providing financial support according to the pre-determined limit of the policy. Policy premium, deductible, and policy limit are the components of an insurance policy.

What is life insurance?

Life insurance is an agreement between an insurer and a policyholder, that is represented by an insurance policy. According to this agreement, the policyholder pays premiums to the insurance company, either monthly or annual and when the insured dies, the company provides a pre-determined death benefit to the beneficiary of a policyholder.

To unleash deeply that what is life insurance, life insurance provides a barrier against the financial crisis that may have to be faced by heirs or dependents of a person who dies. In the case of life insurance, dependents receive a death benefit that helps them to survive and make up their needs of life.

How does life insurance work?

If a person wants to buy a life insurance policy, his first inquiry about it is how does life insurance work and how will it serve his heirs after his death. After choosing a suitable life insurance policy, either term life insurance or permanent life insurance, the next step is the choice of a beneficiary.

The beneficiary of an insurance policy

The beneficiary of an insurance policy is a person that is nominated by the policyholder to receive the death benefit in case of an accidental demise of the insured. There are two types of beneficiaries that are nominated:

1. Primary beneficiary
2. Contingent beneficiary

Primary beneficiary

A person who is nominated as a preferred person to receive the death benefit when the policyholder dies.

Contingent beneficiary

In some cases, the primary beneficiary may also die along with the policyholder or just before receiving the death benefit, or maybe there are unexpected situations like divorce. In this situation, there will be the need for another person, referred to as a contingent beneficiary to receive death benefit instead of the primary beneficiary.

Claim for the death benefit

When a policyholder dies, there is a possibility that the insurance company may be unaware of it. So, the beneficiary has to contact the insurance company and make a claim for death benefit by submitting the required documents e.g. death certificate of an insured. After proper verification, the insurance company provides the death benefit within the duration of one month.

Is life insurance taxable?

In this era of dearness, with a lot of taxes at each and everything, a person who is going to buy a life insurance policy is highly concerned about the thing that is life insurance taxable? Generally speaking, life insurance is not taxable except for some special circumstances. These situations can be:

Employer-paid premiums

Employer-paid premiums mean that the employer of a company pays premiums on behalf of the employee, as happens in group term life insurance, and that coverage exceeds the limit of $50,000, then it becomes taxable.

Delayed delivery of death benefit

If the policyholder wants to deliver a death benefit to the beneficiary after a certain period, there may be interest accumulation over this death benefit. That interest money is liable to tax.

Cash value plan

In permanent life insurance, an investment account is referred to as a cash value account. When the money is accumulated for years by the growing interests, that money other than the total premiums is considered as taxable.

Summary
Life insurance is a contract between an insurer and insured. An insured pays premiums and insurer pays a death benefit to his beneficiary when he dies. Generally, life insurance is not taxable except some specific circumstances.

What is permanent life insurance?

Permanent life insurance is a blanket term that covers multiple types of life insurance policies. They differ from term life insurance in a way that they don’t get expire. Permanent life insurance offers an attractive combination of the death benefit and an investment account.

Types of permanent life insurance

There are two basic types of permanent life insurance:

1. Whole life insurance

2. Universal life insurance

Whole life insurance is a kind of policy that provides lifetime coverage to a policyholder with pre-determined and guaranteed growth of saving account

Universal life insurance is also similar to the whole life insurance with lifetime coverage and saving elements. It just differs from whole life policy in a way that it offers a different premium style and the cash value rises or falls according to the performance of the stock or bond market to which it has been invested by the insurer or policyholder.

Advantages of permanent life insurance

• Permanent life insurance is better in a way that the premiums are split into two parts. One is taken as payment and the other is saved in a cash value account and serves as an investment account.

• The insured can also take a loan against the cash value and if he is not able to pay the premiums, and there is enough amount in the cash-value account, premiums can be paid from the cash value account.

• The increase in cash value is generally tax-free, which means that the insured doesn’t have to pay the tax on the amount that is accumulated in the cash value account until he withdraws it.

Summary
Permanent life insurance offers a cash value plan along with the guaranteed death benefit. Cash value serves as an investment account and keeps on growing due to accumulated interest.

What is term life insurance?

Term life insurance is a type of life insurance policy that guarantees to pay the pre-decided death benefit to the beneficiary/beneficiaries if the policyholder faces an unlucky demise within the specified term.

That term may consist of certain life years, and after the term ends, the policy can proceed in three different ways.

1. Renewal of the policy for another term
2. Money is withdrawn and the policy is terminated
3. Term life insurance is converted to another type of policy e.g. permanent life insurance.

Term life insurance doesn’t offer a saving component like universal or whole life insurance and the only benefit that is provided is a death benefit.
Premium amount is decided according to the health conditions, age, and expected life years of the applicant. If a person dies just the day after the expiry of term life insurance, there will be no death benefit provided by the insurance company.

How does term life insurance work?

After a brief introduction that what is term life insurance next is to understand that how does term life insurance work. Term life insurance works in the following way:

Determination of premium

• When an applicant goes for a term life insurance policy, the first step that is taken by the insurer or insurance company is to determine the premium amount. Premiums are decided according to the medical condition, present age, gender, and expected life years of the applicant.

• If there are chances of morbidity or mortality are high, premiums will also be larger than normal. Some other factors are also investigated by an insurance company that may include hobbies, job nature, present medication history, or family history to determine if there is any threat or not.

Provision of the death benefit

• If a policyholder dies during the term of the insurance policy, the beneficiaries will be provided with the cash benefit by an insurance policy.

• This death benefit or cash benefit is tax-free and can be a great financial help to the dependents of the policyholder.

• If the term of term life insurance gets expired while the policyholder is still alive, and doesn’t proceed in the previously mentioned wats, he will get nothing from the insurance company.

Reason for low premiums

• Term life insurance is considered as insurer-friendly as it mostly gets expired before the death of the policyholder.
• This is the reason that insurer offers low premiums as compared to the permanent life insurance that is much costly regarding premium rates.

Summary
Premium rates are determined and then the beneficiary is chosen. Term life insurance just offers a death benefit with no luxury of a cash-value plan.

What are the types of term life insurance?

Just like permanent life insurance, term life insurance is also categorized into various types depending upon the situation of a policyholder. These types can be described as:

1. Level term policy

• Level premium insurance or level term policy is a type of term insurance that offers coverage for a period of 20-30 years. The best thing about this policy is that the premiums don’t vary with age or time and remain fixed.

• Similarly, the death benefit is also fixed but the premiums are relatively larger than the normal term life insurance that is renewed on annual basis.

2. Annually renewable term policy

• This policy is also known as the yearly renewable term policy. This type of term life insurance doesn’t have a specific duration and is generally renewed each year.

• Premium rates keep on varying each year depending upon the age or health condition of the policyholder. It’s not so attractive because of the no specific term and the increasing premiums with the increasing age of the policyholder.

3. Decreasing term insurance

• Decreasing term life insurance is a type of insurance in which the death benefit keeps on decreasing on an annual or monthly basis while the premiums are fixed.

• The rate of decrease in death benefit is already determined in the policy, however, the premiums are comparatively lesser than the regular term life insurance.

• This policy is beneficial in a way that with an increase in the age of the policyholder, usually the expenses e.g. debts or mortgage loans also reduce.

Why to choose term life insurance?

There are several factors that are convincing for a person to go for a term life insurance rather than permanent life insurance. Some of these plus points have been mentioned below:

1. Cheapest of all

Term life insurance is best in regard to low premiums as compared to the other policies. A person who can’t afford to pay the higher premiums can take the best benefit from term life insurance.

2. Flexibility in value

• In terms of life insurance, there is no need of buying a high amount of policy and suitable for people who have a family to support or to pay the mortgage loan, etc.

• As these expenses are decreased with time, the reducing term life insurance is the best option in such situations.

• Moreover, a person with term life insurance can make separate investments and this trend is gaining popularity nowadays.

3. Short term coverage

• By purchasing a term life insurance, the policyholder can choose the term duration according to his wish e.g. 20 years or 30 years.

• After the term expires, he can drop the policy if there are no needs for payouts. It’s the best choice for the requirements that are disappeared with time.

• For example, people mostly buy a mortgage policy that covers the payment of the house in case of a policyholder’s death.

4. Convertible policy

• If a policyholder wants to convert the term insurance into permanent insurance, it’s quite possible.
• After the expiry of the term, the insured can discuss with the insurer and can convert the insurance policy from one form to another depending upon his budget and other circumstances.

5. Guaranteed premiums

• In level term policies, the policyholder can lock the premium rates for specified term e.g. 5, 10, 20, or 30 years with no increase in premium rates.

• Moreover, there is an option to buy a full life guaranteed term insurance with fixed premiums throughout life.

Summary
Term life insurance has the benefits of flexibility, convertibility, and low premium rates. Premiums are low and can be locked for the desired term. It can be converted to permanent insurance after the term gets expired.

Who not to choose a term life insurance?

Although term life insurance is associated with certain benefits, yet there are some disadvantages of term life insurance that render it less attractive. These cons can be described as:

1. Increase in premium rates

In certain policies, there is an increase in the premium rate after the expiration of an initial fixed term. For example, if a policyholder has an initial term of 15 years, at the renewal of policy after 15 years, there will be a rise in premiums for the next term.

2. No cash-value account

The cash value account serves as an investment plan for a policyholder. But cash value is not a part of term life insurance as it offers just a death benefit. So, for a person who wants to make an investment in addition to the guaranteed death benefit, term life insurance is not a good option for him.

3. Health issues

Term life insurance premiums are increased with the increasing age or declining health of a policyholder. Also, if there are some serious health issues to the policyholder, there may be no renewal of a policy after the expiry of a term.

4. Cost-prohibitive policy

As the premium rates keep on increasing with the time and age, they may be increased to a level that is unaffordable for a policyholder. Hence, this cost-prohibition is a major drawback of a term life insurance policy.

Frequently asked questions

People who want to buy an insurance policy, have certain queries related to the nature of insurance and about the thing that how does insurance policies procedures. Some of these additional questions and their answers have been discussed below:

1. What are the average rates for whole life and term life insurance?

Whole life insurance premiums are relatively higher as compared to the term life insurance. Here is a slight comparison for the monthly rates of both types of policies, up to the age of 50 years.

2. Can you have a cash-value in term life insurance?

No, there is no facility of cash value account in term life insurance as it is offered in the whole life insurance. Term life insurance just provides the death benefit to beneficiaries if a policyholder dies within the specified term.

Rather than an investment account, term life insurance just serves as a cheaper companion for the pre-determined term after that it gets expired and needs to be renewed, terminated, and converted to the other type of policy.

3. What are the best insurance companies in Pakistan?

Names of the best insurance companies for the year 2020 are given below:

4. Can I withdraw money from a term life insurance?

• Money is usually withdrawn from the cash-value account that keeps on growing because of accumulated interest money.

• But this cash-value is the specialty of a permanent life insurance policy that acts as an investment plan other than the provision of the death benefit.

• In terms of life insurance, money can be withdrawn only when the term ends and a policyholder wants to terminate it permanently.

5. What is the difference in permanent life insurance and term life insurance?

One of the main differences between permanent life insurance and term life insurance is the basic package that they offer to the policyholder. Some other differences in both types of policies are tabulated:

Conclusion

• Term life insurance is a legal contract between the insurer and insured, according to which the insurer pays a specific death benefit if the policyholder dies during the term.
• Term life insurance works in a way that offers low premiums and gets expired after a pre-determined term.
• After the expiry of a term, the policyholder can renew it for the next term, convert it to a permanent policy, or can terminate it.

References

1. https://www.investopedia.com/
2. Term Insurance Plan & Its Types in India 2023
3. Permanent Life Insurance: Definition, Types, Vs. Term.
4. Term Life Insurance: Advantages and Disadvantages
5. What is term life insurance and how does it work? | Insure.com.

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