Sunday, February 24, 2008

Concept of term insurance

Term insurance is a contract where you pay a premium and hope that you do not have to make a claim.

For example, assume that for a group of working people, an average of 2 in 1,000 people will die each year due to accidents or illness. The participants can each contribute $200 into the pool to pay $100,000 to the family of the person who passes away.

Each person hopes that he will not be the person who makes a claim and that his contribution helps the family of the unfortunate person.

The life insurance company enters into the picture to provide a service to the 1,000 people. The company needs to have a loading of about 30% to cover the expenses and the cost of capital to support the pool (in case there is more than one claim in a certain year). Each participant pays a premium of $260. This is a fair loading to the true cost of insurance.

Many insurance companies offer other product that requires a high premium of $2,000 to $5,000 to cover $100,000, but provide some cash value (i.e. partial refund of the premium). However, most of these product are still too expensive, as a large part of the premium is used to pay commission and other expenses. The expense charges are likely to be more than the total premium payable under the term insurance.

It is better to pay a fair premium for the term insurance and hope that you do not make a claim.

1 comment:

Anonymous said...

With reference to the products with the higher premium. Often, they have a level premium for life, whereas term does not.

Term may increase every 5, 10 or 20 years and the insurance will expire, at age 65, or some predetermined year. (The exception being T100 - which is term insurance to age 100).

Whole life insurance means that you will pay the same premium for your entire lifetime. So the premium you pay when you purchase the plan at age 30, is still the same premium you pay at age 90.

Due to this level premium approach for whole life, you will "over pay" at age 30, above the true cost of mortality, and "under pay" at age 90. This is why you build up cash values, as the mortality cost you over pay at age 30, is invested to help pay for age 90.

If your insurance needs are temporary, then term insurance is better. If your insurance needs are permanent, then a whole life plan is better.

You may have permanent needs due to tax estate planning, dependent children (say a disabled child who is dependent on you for their life), a spouse who will need protection past the expiry age of the term plan.


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