Decreasing term insurance

What Is Decreasing Term Insurance?

Decreasing term insurance is a type of term life insurance where the death benefit, the amount paid to the beneficiary upon the policyholder's death, decreases over the life of the policy according to a predetermined schedule. It falls under the broader category of Life Insurance, which aims to provide financial protection to dependents in the event of the insured's passing. Unlike policies with a level death benefit, decreasing term insurance is specifically designed to align with declining financial obligations, such as a mortgage or other long-term debt. Premiums for decreasing term insurance are typically constant throughout the policy's term, while the coverage amount steadily reduces. This structure makes it a cost-effective option for covering liabilities that diminish over time.²⁸

History and Origin

The concept of life insurance dates back centuries, with early forms including Roman "burial clubs" and agreements to provide financial security to families.²⁷ The first known true life insurance policy can be traced to a term life policy from 1583 in London.²⁶ In the United States, the first term life insurance company was established in Philadelphia in 1759 to support the families of Presbyterian ministers.²⁵ Early life insurance contracts were often handwritten and straightforward, offering a fixed sum upon the policyholder's death within a specified term. For many years, such policies were expensive and primarily accessible to wealthy individuals like merchants and aristocrats.²⁴

As financial markets evolved and the needs of a growing middle class became more complex, different forms of life insurance emerged. Decreasing term insurance gained prominence as a specialized product designed to match the declining balance of amortizing loans, providing targeted financial protection without the higher costs associated with level coverage.

Key Takeaways

• Decreasing term insurance features a death benefit that reduces over the policy's term.²³
• It is often used to cover specific, declining financial obligations such as a mortgage or a business loan.²²
• Premiums for decreasing term insurance are typically lower than those for level term or permanent life insurance due to the declining coverage.²⁰, ²¹
• Unlike whole life or universal life insurance, decreasing term policies do not build cash value.¹⁹
• Coverage for decreasing term insurance is temporary and expires at the end of the chosen term, usually between 10 and 30 years.¹⁸

Formula and Calculation

While there isn't a single universal formula for all decreasing term insurance policies, the core principle is that the death benefit decreases over time. The reduction often mirrors the amortization schedule of a loan.

For a loan with an initial principal $P_0$, an annual interest rate $r$, and a term of $N$ periods (e.g., months or years), the outstanding balance at any given period $t$, denoted as $B_t$, can be calculated. The decreasing term insurance policy's death benefit would ideally track this balance.

The periodic payment ($PMT$) for a fully amortizing loan can be calculated as:

$PMT = P_0 \frac{r(1+r)^N}{(1+r)^N - 1}$

The outstanding balance ($B_t$) after $t$ payments can be calculated as:

$B_t = P_0 (1+r)^t - PMT \frac{(1+r)^t - 1}{r}$

Where:

• $P_0$ = Initial Principal of the Loan (and often the initial death benefit of the decreasing term insurance policy)
• $r$ = Periodic Interest Rate (e.g., monthly interest rate if payments are monthly)
• $N$ = Total Number of Periods (e.g., total months of the loan)
• $t$ = Current Period Number

The death benefit of the decreasing term insurance policy at any given time would then be approximately equal to $B_t$. Some policies may use a simplified straight-line depreciation rather than mirroring an exact amortization, but the principle of decreasing coverage remains.

Interpreting the Decreasing Term Insurance

Decreasing term insurance is primarily interpreted as a highly targeted form of financial protection. Its value lies in its ability to provide coverage that directly corresponds to a declining financial liability, such as a mortgage or a personal loan. The decreasing death benefit reflects the idea that as a policyholder pays down a debt, the financial need for a large lump sum to cover that specific obligation diminishes.

When evaluating decreasing term insurance, individuals consider their specific financial obligations and how those obligations will change over time. It's particularly useful for those who want to ensure a particular debt is cleared for their beneficiary without over-insuring as the debt reduces. This type of policy offers a more affordable way to secure coverage for a temporary, declining need compared to policies with a level payout.¹⁷

Hypothetical Example

Consider Sarah, who just purchased a new home with a $300,000, 30-year mortgage. Her primary concern is ensuring her family can pay off the mortgage if she were to pass away unexpectedly. Sarah opts for a 30-year decreasing term insurance policy with an initial death benefit of $300,000.

In this scenario, the policy's death benefit is designed to decrease over the 30 years, mirroring the reduction in her outstanding mortgage balance.

• In the first year, if Sarah were to pass, her beneficiaries would receive close to the initial $300,000 (minus the small amount of principal paid). This amount would be sufficient to cover the remaining mortgage.
• After 15 years, as Sarah has paid down a significant portion of her mortgage, the decreasing term insurance policy's death benefit would have also reduced. For instance, if her outstanding mortgage balance is $180,000, the policy's death benefit would be approximately $180,000.
• By the end of the 30-year term, when the mortgage is fully paid off, the decreasing term insurance policy's death benefit would have declined to zero. At this point, the specific financial need the policy was intended to cover no longer exists.

This example illustrates how decreasing term insurance provides targeted and cost-effective financial protection for a specific, declining debt.

Practical Applications

Decreasing term insurance finds its most common practical application in situations where an individual seeks to cover a specific, decreasing financial obligation. The primary use cases include:

• Mortgage Protection: This is the most prevalent application. Many homeowners purchase decreasing term insurance to ensure that their outstanding mortgage balance would be paid off if they died during the loan term. The policy's death benefit is structured to decline in tandem with the mortgage's amortization schedule.¹⁶
• Business Loans: Business owners may use decreasing term insurance to cover the balance of a business loan, protecting their company or partners from significant financial strain in their absence.
• Personal Loans and Debts: For large personal loans or other significant debts that are gradually being repaid, decreasing term insurance can provide peace of mind by ensuring these liabilities do not fall to surviving family members.
• Estate Planning: While not a primary tool, it can be part of a broader financial planning strategy to ensure specific debts are settled, thereby preserving other assets for heirs.

When considering life insurance, consumers are advised to compare similar policies from different companies and understand the guarantees and surrender penalties. The National Association of Insurance Commissioners (NAIC) provides guidance and resources for consumers navigating the complexities of life insurance purchases.¹⁵

Limitations and Criticisms

While decreasing term insurance offers a cost-effective solution for specific financial needs, it comes with certain limitations and criticisms:

• Declining Coverage: The most obvious limitation is that the death benefit decreases over time. If a policyholder's financial needs evolve or new financial obligations arise that are not tied to the original decreasing debt, the remaining coverage might be insufficient.¹⁴ This can be a drawback if broader financial protection for a family's general living expenses is desired, rather than just covering a single debt.
• No Cash Value Accumulation: Unlike permanent life insurance policies like whole life insurance, decreasing term insurance does not build any cash value. This means there is no savings component or surrender value at the end of the term; the policy simply expires.¹³
• Limited Flexibility: These policies are generally less flexible than other types of term insurance. They cannot typically be converted to a permanent policy, and the predetermined schedule of declining benefits offers less adaptability if life circumstances change unexpectedly.¹²
• Risk Classification: Insurers face challenges in accurately classifying risk, and factors such as interest rates and contract duration can influence the demand for different types of term insurance.¹¹
• Potential for Under-insurance: Critics argue that relying solely on decreasing term insurance might lead to under-insurance in later years, especially if the insured's overall financial responsibilities (beyond the initially covered debt) remain high or even increase. Consumers should be aware that the policy might not cover additional costs like funeral expenses.¹⁰
• Regulatory Scrutiny: Historically, the complexity of various life insurance products, including term policies, has drawn scrutiny from regulatory bodies, with calls for clearer consumer information to help individuals evaluate costs effectively.⁹

Decreasing Term Insurance vs. Level Term Insurance

The primary distinction between decreasing term insurance and level term insurance lies in how the death benefit changes over the policy's term.

While both are forms of term life insurance providing coverage for a defined period, the choice between decreasing term and level term depends on the specific financial needs and goals of the policyholder. Confusion often arises because both types offer coverage for a "term," but their payout structures differ significantly, impacting their suitability for different types of financial protection.

FAQs

What is the main purpose of decreasing term insurance?

The main purpose of decreasing term insurance is to provide financial protection for specific, declining debts or financial obligations, most commonly a mortgage. It ensures that a particular liability can be covered if the policyholder passes away, with the coverage amount aligning with the decreasing balance of the debt.

Are the premiums for decreasing term insurance always fixed?

Yes, typically, the premiums for decreasing term insurance remain constant (fixed) throughout the entire policy term, even as the death benefit decreases. This makes budgeting for the policy straightforward.

Does decreasing term insurance build cash value?

No, decreasing term insurance does not build any cash value. It is a pure insurance product designed solely to provide a death benefit for a specified period, without any savings or investment component.³

Is decreasing term insurance cheaper than other types of life insurance?

Generally, yes. Because the death benefit decreases over time, the insurer's potential payout is reduced, which typically results in lower premiums compared to level term insurance or permanent life insurance policies with the same initial coverage amount.²

What happens if I outlive my decreasing term insurance policy?

If you outlive your decreasing term insurance policy, the coverage simply expires at the end of the specified term. Since the death benefit has likely decreased to zero by the end of the term, there is no payout to the beneficiary if you are still alive. You will not receive any money back, as there is no cash value component.¹