Federal Employees: Understanding the Different Types of Individual Term Life Insurance Policies
Edward A. Zurndorfer
This is the third of four FEDZONE columns during the month of September in conjunction with September being designated as “Life Insurance Awareness” month. This column will present the choices federal employees have with respect to choosing an individual term life insurance policy offered by an insurance company.
Individuals who need to buy a life insurance policy that pays only a death benefit and does not accrue any cash value are advised to purchase a term life insurance policy. Among the reasons why individuals would want to purchase term life insurance are income protection for dependent family members and paying off a large debt such as a mortgage. In both cases, the need for life insurance protection is for a set period of time (10 to 40 years) and not for a lifetime. This is why these individuals are advised to purchase term rather than more expensive permanent (cash value) life insurance.
Life insurance companies offer term life insurance policies in four types, namely: (1) Annual renewable term; (2) Level-term; (3) Decreasing term; and (4) Return of premium term. These four types are discussed and explained.
Annual Renewable Term Life Insurance
Annual renewable term (ART) life insurance allows the policyowner to lock in the insurance premium rate for one year at a time. The initial premium for the first year can be appealing. However, policyowners need to be aware that the premiums will increase every year as the insured gets older.
An ART insurance policy offers life insurance coverage that renews automatically (without the insured having to furnish evidence of insurability) from year to year provided the policyowner pays the premium. The policy renews each year up to a certain age. The maximum age of renewal can vary by state. For example, New York law sets the ART age renewal limit at age 80.
The ART annual premium starts out low and can look attractive. However, premiums will increase as the insured gets older. The insurance policy’s face amount (the amount paid to beneficiaries if the insured dies during the time the life insurance policy is in force) remains the same.
There is another type of term life insurance offered by some insurance companies called level term life insurance which is discussed below. With a level-term life insurance policy, the premiums remain the same (as does the face amount of the policy) every year until the life insurance coverage ends.
The following chart is a comparison of ART and a 10-year level-term life insurance policy premium rates. The sample rates are based on a healthy 30-year-old male.
|Age||ART Premiums*||Level-Term Premiums*|
ART life insurance may be appropriate and suitable for individuals who need to cover short-term (10 years or less) debts or who are in-between jobs and anticipate buying life insurance through a future employer.
The main downside of ART life insurance is that if the policyowner renews for many years, the policyowner will likely end up paying more in total premiums compared to having bought a level-term life insurance policy. That is why ART life insurance policies are recommended only if the insured has short-term life insurance needs.
Level-Term Life Insurance
Level-term life insurance is another type of term life insurance that has the same death benefit and the policyowner pays the same premium for the entire life of the policy. Level-term life insurance is the most common and popular type of life insurance coverage because it is straightforward and is an affordable way to provide financial protection for a family. Life insurance coverage lasts for 10 to 40 years.
Level-term life insurance works much life other term life insurance policies in the following ways:
- 1. The individual applicant for level-term life insurance policy chooses a coverage amount and term length. These two factors, together with the applicant’s health and age, will affect the premium cost of the term life insurance policy.
- 2. If approved by the insurance company, the policyowner pays premiums annually, semi-annually, quarterly or monthly.
- 3. If the insured dies while the insurance coverage is in effect, the face amount of the life insurance policy is paid in a lump sum tax-free to the named beneficiaries.
- 4. If the policyowner/insured outlives the policy, then the policy expires at the end of the term and the policyowner stops making payments.
Advantages of Level-Term Life Insurance
There are two advantages associated with owning a level-term life insurance policy, namely: (1) It is usually the cheapest form of life insurance for most individuals. Level-term insurance is for most individuals cheaper than a comparable whole life insurance policy for the same amount of death benefit; and (2) The unchanging premiums or death benefits. Policyowners do not have to worry about his or her budget in order to accommodate life insurance coverage.
Disadvantages of Level-Term Life Insurance
There are three disadvantages associated with level-term life insurance, namely: (1) A level -term policy will expire. This means that if the policyowner needs life insurance coverage after the policy expiration, then a new policy will be more expensive because the policyowner is older. Also, this assumes when renewing the life insurance, that the policyowner can qualify for coverage at that time; (2) There is no Cash value to grow tax-deferred savings; and (3) The premiums paid are not refunded if the policyowner outlives the policy.
Decreasing Term Life Insurance
Decreasing term life insurance is a life insurance policy with a set premium and a death benefit that decreases over the coverage period. Decreasing term life insurance is often used to protect a specific debt. Coverage lasts as long as the debt and the benefit decreases as the debt is paid off.
How Does Decreasing Term-Life Insurance Work?
The duration of a decreasing term life insurance policy is anywhere from 5 to 30 years. The death benefit decreases and the amount it decreases by is set by the policyowner when the policy is bought. For example, decreases may correspond with a loan payment schedule, or the insurance company could set the death benefit to decrease by an amount; for example, $50,000, every five years.
When Should An Individual Apply for a Decreasing Term Life Insurance Policy?
As individual may want to apply for a decreasing life insurance policy when the individual has saved enough to support his or her family when the individual dies. The only reason the individual is buying life insurance is to pay the balance of a loan in the event of death. In so doing, the individual should never pay for more life insurance than is needed.
Many individuals will encounter decreasing term life insurance as “mortgage protection insurance” (MPI). MPI is a decreasing term life insurance policy that the policyowner purchases at the bank or mortgage company that issued the mortgage. The MPI premiums may be paid as part of the monthly mortgage payment. In the event of the policyowner’s death, the life insurance company pays the death benefit (equal to the principal balance left on the mortgage) to the mortgage company. A comparison of decreasing term and level-term insurance is presented:
Comparison of Decreasing Life Insurance and Level-Term Life Insurance
|Policy Feature||Level-Term Insurance||Decreasing Term Insurance|
|Duration||10 to 40 years||5 to 30 years|
|Guaranteed Death Benefit||Yes||Yes, but benefit decreases over time|
|Premiums||Guaranteed to remain Level||Guaranteed to remain level, even as benefit decreases|
|Must Appropriate for:||Individuals who need coverage for several years and for more than one debt or other reasons||Covering one large debt or loan|
An alternative to a decreasing term life insurance policy would be for an individual to buy multiple level-term life insurance policies of varying lengths and coverage amounts. The “laddered” insurance policies would expire as the policyowner’s obligations decrease.
Return of Premium Term Life Insurance
A return of premium life insurance policy is another type of term life insurance. As term life insurance, the life insurance coverage lasts for a set period of time and then expires. But unlike traditional term life insurance, the insurance company refunds the policyowner all premiums paid at the end of the term.
Average Cost of Return of Premium Term Life Insurance
Since a return of premium life insurance policy comes with a “money-back” guarantee if the policyowner outlives the policy, the policy is more expensive (higher premiums) than a typical term life insurance policy. The average cost of return of premium life insurance policy is usually about two to three times higher than a basic term policy.
Advantages of Return of Premium Term Life Insurance
For some individuals with specific life insurance needs, there are a few advantages of owning a return of premium life insurance policy, including: (1) A return of premiums paid in a lump sum payment that are not taxable; (2) “Forced” savings if premiums are returned; and (3) Usually lower premium cost than whole life insurance for the same amount of death benefit.
Disadvantages of Return of Premium Term Life Insurance
For most individuals, the disadvantages of a return of premium term life insurance policy outweigh the advantages. The disadvantages are (1) The cost of the insurance is more expensive compared to an ART, level-term or a decreasing term life insurance policy; and (2) The extra premium dollars paid are better invested or saved elsewhere in a different savings vehicle, such as a Roth IRA.
A return of premium term life insurance policy may be appropriate for an individual who can afford to pay extra premiums each month and wants a low-cost “forced savings” vehicle. But it is not appropriate and suitable for most individuals who need a term life insurance policy to protect their families.
While receiving a tax-free lump-sum amount of money when close to retirement seems attractive, a refund of premium term life insurance policy is a subpar investment. This is because the money “invested” in a refund of premium term life insurance policy has lost out on years of compound interest, meaning that the money paid in premiums is likely to be worth less than if the money were to be invested or saved in a traditional savings account. In a sense, a refund of premium term life policy is giving an interest-free loan to the insurance company. Putting money in and getting less money out because of inflation.
These policies have exclusions and/or limitations. The cost and availability of life insurance depend on factors such as age, health and the type and amount of insurance purchased. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Guarantees are based on the claims paying ability of the insurance company.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be dependable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those, Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.