How Does Term Life Insurance Work

Understanding how term life insurance works for young adults is one of the keys to purchasing the right policy. Other than children, young adults in excellent health will always pay the lowest premiums. Young adults who have just married are usually the target market for term life insurance, because term insurance is the best choice to insure an income. Unlike older, wealthier couples with significant assets, young people tend to have smaller incomes, more debt and fewer assets.

Young couples typically purchase their first term life insurance policies when they purchase a house. The amount of the death benefit, which is paid to the beneficiary upon the death of the insured, is most often large enough to at least cover the outstanding mortgage. Most couples also choose a death benefit that will cover other outstanding debt, such as student loans, car payments and credit card bills.

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Term Life Insurance for Seniors

Senior citizens over the age of 55 can benefit from term life insurance in several ways. For those on a limited budget, term insurance coverage can be purchased for less than permanent coverage. Especially for seniors who simply want to provide family members with enough to cover final expenses, term life insurance works better than other forms of insurance.

Term life insurance works for seniors in that they can often purchase a policy that will cover them for the amount of time that is best for their unique needs. For example, a 55-year-old can purchase a term policy for 5, 10, 15 or 20 years. He or she can usually choose between a policy that provides a level benefit or a level premium. A level benefit policy pays the same death benefit regardless of the year death occurs. If the death occurs in year four or year 14 of a 20-year-term policy, the death benefit will be the same. The premium paid on a level benefit policy, however, will usually increase at five-year intervals. A level premium term life policy works in the opposite way. The premiums remain level for the entire term, but the death benefit is reduced over time.

Term Life Insurance for Children

Term life insurance for children works in much the same way as insurance that is purchased later in life. The term is in effect for a set number of years, cash value is not built and the only payment made by the insurance company occurs when a claim is made upon the death of the insured. But, term insurance for children has several advantages. Most insurance companies that provide insurance for children allow the conversion of the policy at age 21 to an adult policy. The child need not provide the answers to health questions or take a physical to provide proof of insurability. The previous policy serves as proof of insurability.

Term Life Insurance for Life Insurance Companies

Term life insurance can be the most profitable form of insurance for life insurance companies. Insurance industry and government statistics show that the death benefit is paid on fewer than 5% of all term life insurance policies issued. Because term life insurance is temporary insurance that expires at the end of the term, the insurance company will have kept the entire amount of the premiums paid if a claim is not made. For this reason, life insurance companies use actuaries to determine the likelihood of paying a claim based on the risk factors an applicant presents.

For example, in most cases, the younger a person is, the less he or she will pay in premiums. However, in some cases, young men, especially those under the age of 25, present a greater risk to the insurance company in the form of accidental death. Young men often take more risks than young women or older men and are therefore more likely to present a greater risk of death.

Term life insurance works for insurance companies because the costs of administering the policies are very low. Unlike permanent insurance, which build cash value in an investment account over the life of the policy, term insurance is strictly a "one-time-pay" insurance. If the insured dies within the term, the death benefit is paid. If he or she does not die, coverage ends.

The death benefit payment on a term life insurance policy works because the insurance company has taken in premiums from all of its policy owners, but has not paid a benefit to all of its policy owners. But, because a life insurance policy represents a future liability to the company, it's always wise to choose a term life insurance company with a solid credit rating as determined by A.M. Best, Fitch, Moody's Investor Services or Standard and Poor's. Further, life insurance companies are subject to different capitalization requirements than other financial institutions such as banks.

Each state regulates the insurance companies that are charted within that state. Most states require insurance companies to keep assets in the general account separate from money in what's known as the sub-account. The general account contains money that is invested in fixed-income assets, while the sub-account contains money that is invested in variable assets. This ensures that losses in variable accounts do not deplete assets in the general account.

While each state insurance board sets the amount of money a life insurance company must retain in its reserve fund, most require that assets equal or exceed the liabilities. In other words, life insurance companies maintain at least a 1:1 ratio of assets to liabilities. For every dollar they expect to pay out in claims on all policies, they keep a dollar in the reserve fund. This is especially important during times of financial crisis when capital and credit are difficult to obtain, and during times when a large number of claims need to be paid at the same time, such as following a natural disaster or other event during which there is a catastrophic loss of life.

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