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Convert term policy before it expires

Hanging on to inexpensive term life insurance policies too long can force unprepared families into a serious financial pickle down the road.

While financial advisers promote term insurance as an excellent way of protecting against financial disaster, they warn against sitting on that same policy until it is too late to replace it with a permanent option.

Also called temporary insurance, term life insurance guarantees a fixed benefit if the policyholder dies during a set period of time. For example, a 20-year term policy with a death benefit of $100,000 may cost $25 a month. If the policyholder dies before the 20 years end, the company pays the death benefit.

Outliving the term
But if the policyholder outlives the 20-year term, the contract expires and the insurance company keeps the premiums.

"I like to tell my clients that term will almost never pay -- and that's a good thing. It means you are still alive," says Val Vogel, president of financial planning firm, Burns, Vogel and Associates in New Orleans.

Term insurance should be considered insurance in the most pure sense, he says -- a hedge against the unexpected.

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Because term is written as temporary insurance and is not intended to pay out, large policies cost a fraction of the cost of a comparable permanent option, such as variable, whole or universal life.

Young families starting their lives are especially good customers for term insurance, says Patrick Bowen, vice president of U.S. sales for Pan American Life Insurance Co.

"That's because you may have a situation where a primary bread winner wants to purchase a large amount of insurance to care for, say, young children and perhaps a spouse without a job," Bowen says.

They would require a lot of money if that breadwinner dies young, and they typically don't have a lot of cash because they are beginning their careers.

Plus, much of the money they do have may be tied up in large debts, such as new mortgages or student loans. This combination of large financial obligations and low cash flow make the inexpensive temporary policies so attractive.

The catch comes as families mature, the breadwinners age and the policies grow closer to expiration. As situations change, families may need to consider transforming their term policies into a more permanent option.

Conversion clauses common
A clause written into most term insurance contracts allows them to do just that.

"The way I would describe it is when someone purchases term, in essence they are leasing insurance with an option to buy," Bowen says. "The convertibility clause is your chance to convert without new evidence of insurability. But if you aren't paying attention and forget to convert within your allotted time, you are out of luck."

The conversion clause allows families, for a price, to transform their temporary insurance into permanent insurance without having to re-qualify or undergo physical examinations.

Not all policies have a conversion clause, and ones that do generally cost more. But that clause can be worth the expense, Vogel says.

Take, for example, a 20-year term policy with a 10-year conversion clause. Nine years into that contract, the policyholder develops heart disease, diabetes or some other health problem. Because she is still within the 10-year conversion period, the policyholder is free to convert the policy. By converting to a permanent policy in time, she would not need a new physical exam and would have the same coverage at a much lower annual premium than she would have faced with a new policy.

If the policy had no such clause, the policyholder would be faced with an expiring policy and astronomical renewal premiums, if she was insurable at all. "The most important rule of thumb is to convert before it is too late," Vogel says.

Don't get surprised
To make sure the conversion window doesn't sneak up, Bowen suggests reviewing your policy with an agent on an annual basis.

"Certainly when you are coming within a year of convertibility -- then you really need to come and take a look at your plan and check your health, financial picture, everything," he says.

The development of a health problem is not the only reason to convert a policy.

As a rule, the older people get, the more expensive they are to insure. So, if you can lock in a fixed rate and begin paying toward a permanent policy while in your 20s, the monthly premium will be much lower than someone in their 50s would pay.

Financial needs also change as families mature. While you may need a policy to replace your income and provide for three young children in your early years, having such a large policy may no longer be as important after you pay down the mortgage and the children grow up.

"A rough rule of thumb on how much you should buy is to take a multiple of your income," Vogel says. "If you only want enough insurance to take care of your family in the years after you die and set them up until they can get back on their feet, buy a policy that pays four to six times your annual salary. But if you want to set them up on a trust fund so they are taken care of for the rest of their lives, then look at something larger, like 20 times your salary. That will give them enough that they can put it in a trust and live off the interest indefinitely."

One strategy is to buy the largest term policy you can afford early on, and when you can afford more, supplement your term policy with a smaller permanent policy meant to cover expenses, such as inheritance taxes, mortgage and funeral costs.

"When the big block of term is scheduled to expire, your children should be out of the house, many of your obligations will be paid off and your financial situation will be such that you may not need so much insurance anymore," Vogel says. "Then you can decide if you want to convert your term."

Michael Giusti is a freelance writer based in New Orleans.

-- Posted: July 28, 2004

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