Types of life insurance

Glenn Cooke offered to do a series of blogs on life insurance. This is one of those areas of personal finance that people most misunderstand, and I jumped at the opportunity to have an insurance specialist give y’all the lowdown. So here is Part 2 of Glenn’s 3 part blog. Part 3 tomorrow.

In our last post we looked at ‘How much life insurance do I need?‘. The basis for estimating how much life insurance was needed was based on replacing a paycheque over a period of time.

In discussing the different types of life insurance we’re going to take the same back to basics approach. Most of the confusion that arises between the different types of life insurance are created by marketing initiatives by the insurance industry so let’s ignore that right from the start. Forget everything you know about what type is best and how it works.

Life insurance has three attributes:

  1. The death benefit
  2. The premiums
  3. The span of years over which you pay the premiums.

In terms of the death benefit, if you are handed a cheque for $500,000 can you tell what type of life insurance the insured had? Of course not. For the same amount of death benefit all life insurance types are identical. The variations amongst the different types of life insurance are based on the premiums and how they are paid over time.

And let’s take one step further back and generalize again. All insurance works like this; you pay your premium and you have your coverage. If you have an accident (die/house burns down/crash your car), the insurance company pays the claim. If you don’t have an accident the insurance company takes your premium, pools it inside the company with everyone else who paid their premiums and pays out whoever did have a claim. And the insurance companies know pretty much exactly how many claims they are going to see in a year. They don’t know who is going to claim (that’s why we buy the insurance) but they know how many. And that’s how the set the premiums. The more claims that are expected, the higher the premiums.

That’s why we all know what happens to bad drivers‚ their rates go up. In life insurance terms what makes us a bad driver is mostly our age. Every year we’re a year older, we’re all a year closer to dying. So every year that we’re a slightly poorer risk our rates need to go up. Or from the company’s viewpoint, their costs are cheap on younger people (not very many claims on 30 year olds) but expensive on older people (lots of claims on 80 year olds).

Here’s what that means. From a ‘pure’ life insurance perspective your rates would look like this; you pay your premium for the year and have your coverage. Next year you’re a year older so your rates go up a bit, and so on, getting higher every year. To compound this increase though, the older we get, the faster it gets more expensive. So this ‘pure’ life insurance premium doesn’t go up in a straight line, it goes up in a steadily increasing curve that looks something like this:

So that’s one variation on paying premiums over time. We can select a time period that we need the insurance for, and pay premiums that go up every year as we get older.

Sound good?

For most people it doesn’t (sound good that is). The older we are, the faster our premiums would become more expensive. Yes, that means cheap premiums now when we’re young. It also means crazy expensive premiums later when we get older, to the point of being unaffordable. This kind of insurance would be called ‘1 year term’.

Term Life Insurance

So here’s what we can do to fix the ‘unaffordable’ problem. Let’s block off the first 5 years of those premiums and take the average. Now instead of paying rates that go up every year, you’re going to pay the average premium each year for the next 5 years‚ your rates have levelled out over that time. In year 6 your premiums will go up because now you’re 5 years older, and you’re going to pay the average rate again over the next 5 year block. This type of insurance is called 5 year term.

What we’ve done is levelled out the costs from going up every year to going up every 5 years. We’re paying pretty much the same total, we’re just paying it differently over time.

And that’s term insurance in a nutshell. Pretty much any time period is available, 5,10,20, even 30 year term is available today. And what you’re doing is simply leveling the costs out over that time period.

Permanent Insurance

Now let’s say we need insurance forever. No matter how old we get, we want the insurance. Even if we had 30 year term we know right now we are going to have a problem in 30 years – our rates are going to become unaffordable in year 31. So term insurance won’t do.

What the companies do is take this ‘averaging’ of the premiums out past 20 years, past 30 years, and stretch it out over your entire life expectancy. Think of it as taking the average of the life insurance premiums over your entire life. This gives us one premium we’re going to pay, level, for the rest of our life. This type of life insurance is called permanent insurance.

If you look at the following chart, you’ll see that with permanent insurance you’ll be paying higher premiums than term insurance initially, but lower premiums later. But that raises a problem from the company’s perspective. Let’s say your premium for permanent insurance is $100 per month. And let’s say that your costs for insurance are $25 a month now, and $400 per month when you’re 70. Today, the company’s making good money. But fast forward until you’re 70 and there’s a problem. They’re paying out $400 a month in claims but you’re only paying $100 a month – same as you were many years ago. Paying $300 a month in claims while taking in $100 a month in premiums is a recipe for disaster for the company.

So how to fix that problem? Remember in the early years you were paying $100 when the company is only paying $25 in costs? Rather than spending that $75 or treating it as profit for that year, they saved it up or reserved it inside your policy. Now when you’re way old the company has a pot of money to apply to the risk of the death benefits they’re paying out. They use the money you overpaid in the early years to cover the higher costs for life insurance later. In short, you pay more now to pay less later.

Whole Life Insurance

Now you’re going along through the years paying higher initial premiums and building up a reserve. Then you change your mind and cancel your policy. The insurance company will refund you back a percentage of that overpayment in premium they were saving. That refund is called a ‘cash value’ or a ‘cash surrender value’.

And that kind of insurance‚ level premiums for life with a cash value if you cancel‚ is called whole life insurance.

Now we need to have a short history lesson. In the 80’s the insurance companies were marketing those cash values as some kind of saving vehicle. Buy a permanent life insurance policy, pay higher premiums then cash out that money for retirement later. But eventually some consumer advocates ran the numbers and discovered that doing so wasn’t a very good investment. Of course not! It’s not an investment at all, it’s a refund of overpayment in premiums. But word got out‚ don’t buy whole life insurance, it’s bad. Is it? Of course not again. It’s a life insurance product with a premium and a death benefit, there’s nothing evil about that. It’s just that it was marketed poorly.

Term to 100

So the insurance industry said ‘you got a problem with cash values? Fine, no more cash values.’ And in the early 90’s or so they took whole life insurance and stripped out the cash values. Doing so let them lower the premiums and gave us our second kind of permanent insurance. This product is called Term to 100 and is quite simply level premiums for life, nothing else. No cash values, no bells and whistles.

Universal Life Insurance

After Term to 100 was launched it took off like a rocket. It was inexpensive, easy to understand, and an all around great product. But it doesn’t offer any opportunity to discuss investments‚ and the life insurance industry loves to talk about investments.

Enter Universal Life. Basically what the companies did was take a Term to 100 insurance cost and tack on an investment account onto the side of it. And unlike whole life insurance in this case it’s a real honest to goodness investment.

Let’s say your universal life insurance premiums are $100, level for life. If you pay the insurance company $100, the insurance company uses that to pay the insurance costs, and your policy remains in force. Your investments? You didn’t put any money into it so your balance is $0. However with Universal Life Insurance you could modify your premiums to pay $150 per month. The first $100 goes to cover your life insurance costs, the extra $50 gets deposited into your investments where it grows and earns interest……or like in 2008, crashes and burns by -40% like everyone else’s investments. But you don’t have to put any money into the investments, you can just pay the minimum level premiums.

Be very careful with Universal Life. It’s a great product if used correctly, however some companies offer an insurance cost that is annually increasing instead of level for life. That means that you’ll get cheaper rates now, but extremely expensive premiums later. This increase is sometimes masked by using future investment return to pay for those expensive premiums but as we noted above, those investment returns are not guaranteed . In the future when the investments crash you may find there’s not enough money in the investments to pay those high premiums.

Summary of types of life insurance

Now lets summarize. We have different kinds of term insurance‚ 5,10,20,30 and so on. And we have 3 kinds of permanent insurance; whole life insurance, term to 100, and universal life.

What’s the best type?

Now that we’re up to speed on all our options, the answer is deceptively easy. We should buy insurance for as long as we need it. If we need insurance for 10 years the least expensive type over 10 years will be 10 year term. If we need insurance for 20 years, 20 year term is going to level our premiums out over that 20 year period and be the least expensive over 20 years. If we want life insurance for the rest of our lives and don’t plan on cancelling it in the future, then over the long term one of the three types of permanent insurance will be the way to go.

Now let’s look at the example from last time; Mom and Dad in their 30’s, two young kids. How long are they likely to want insurance? Remember we were buying this to replace our paycheque. Now, our paycheque doesn’t last forever‚ eventually we retire. So do we need paycheque insurance past that point? Probably not‚ and by extension we don’t need life insurance past then either. We’re young now with a large need, kids,mortgages and bills. When we’re older the mortgage is gone, the kids are moved out and on their own, so we no longer have a need for that $750,000 we saw last time. Add all that up and what Mom and Dad would be looking at is either 20 year term or 30 year term.

It’s important to note that while our available options as to types of insurance are crystal clear, what type works best for you is much more subjective. The example we’ve been discussing (paycheque protection) says we should get 20 or 30 year term. But your needs may change. Or you may just be of the attitude that you want insurance for your kids no matter how when you die‚ even if you don’t ‘need’ it, that’s what you want. It’s impossible to generalize as to what’s the best type‚ just remember that what you do need to do is determine how long you expect to need the insurance and then buy the type that best matches that timeframe.

We’ve now answered the first two questions; How much life insurance do I need, and what type of life insurance do I need. In our last post we’re going to look further at some of the differences between products available in the marketplace as well as how to get the cheapest rates. All that and more next time in ‘Do’s and Don’ts of Buying Life Insurance’.

Glenn Cooke is an independent life insurance broker and president of Life Insurance Canada He can be reached at (866) 662-5433.

36 Responses to “Types of life insurance”

  1. Finally! Someone who can explain life insurance without calling it an investment. That was simple and easy to understand I look forward to tomorrow’s article.

    regards,

    Jason

  2. Ah yes – the smoke & mirrors Universal Life Insurance. Thanks for stating what we didn’t ‘get’ during the fancy sales pitch 10 yrs ago:

    “Be very careful with Universal Life. …companies offer an insurance cost that is annually increasing instead of level for life. That means that you’ll get cheaper rates now, but extremely expensive premiums later.”

    So true. After about 8 yrs we saw how the company took a larger and larger cut of our monthly contributions – and less $ was going into our investments. And to make matters worse, our investments began to have losses due to these whaky economic times. So after 10 yrs of $200/mo payments – we took the $ parked in the investments out once there were no more surrender fees. That was nice getting back half of what we put in – about $12,400.

  3. excellent article.. thank you so much for all the great information.

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  7. Hey, that made sense! I am *so* bookmarking this article and sharing it. Thank you!

  8. Glenn- Thank-you for all of this information. My husband and I have a meeting with our StateFarm insurance agent next Friday to discuss life insurance. We talked to someone from Primerica, and that scared me–especially after looking them up on google and seeing “Primerica Scams” come up as the third search option. I later confronted the Primerica agent about that and he said, “That’s just the competition.” Scary…

    Gail- I love your website and tv shows! I’m constantly quoting you or something I read in “Debt Free Forever”. I’m a regular follower of your blog and find all of your articles and posts helpful and insightful. My husband and I have a monthly budget that really works well for us and includes savings, emergencies, charities, debt repayment (OSAP essentially, boo) and our regular payments. We just bought our first home in June and are planning on starting a family soon.

    I’m happy to post and join the Gail community!

    Lindsay

  9. Thank you for the article. It’s very simple and clear.

  10. Glen you ROCK!!!…we have term 100 insurance…and when my husband became ill and could no longer work we filled out the paperwork to have our premiums paid via the insurance company…we are both still fully insured and we are NOT paying the premiums…every year the company sends another form that my husband’s doctor has to fill out confirming that he is still unable to work and it’s taken care of for another year…the premium for him and for me!…my husband was off work already about a year before I read about this service in the fine print..(we’d had the policy so long I had forgotten about that provision)…so once we were approved they paid us back the year’s worth of premiums…score!…so make sure you read all the details of your policy…you never know what may be in there:)

  11. This is a clear explanation for those planning on buying insurance.
    I used to have life insurance but discontinued it a number of years ago. I’ve prepaid for all burial costs and have no debts so my executors can sell off my property and cover any unexpected expenses.
    There are too many people in debt, and still living the high life, who are waiting for their parents to die with the expectation that they’ll get a lot of money from life insurance, as well as inherit the house. Unfortunately there are also a lot of parents who belief they owe this to their children.

  12. From the last 2 post, I guess my finacee and I will not need life insurance at all. or do we? We have no kids and don’t plan on having any. The mortgage is paid, we are both working full time with excellent pensions (teacher and feds). If one of us dies, there is still nothing to pay. My question is, why buy life insurance in our case?

    Thank you very much for the insight, Glenn.

  13. Very informative and well articulated. Thanks Glenn for taking a complicated topic and an providing easy to understand article.

  14. @Tim

    You likely don’t need insurance or not much. Given you have no dependents and no debts could your fiance live “in the manner she has become acustomed” on just her paycheck. If the answer is yes, then insurance isn’t really necessary.

    On the other hand, you could get a small policy to cover the unexpected expenses that are bound to arise to make sure you or your spouse don’t end up in a tight spot. Funeral, taxes, time away from work, etc.

    Just another discussion you should have to see what you’re both comfortable with. Like paying down your mortgage quickly it doesn’t always make the most financial sense but if it makes you sleep better at night then it might be worth having some.

  15. […] Gail Vaz-Oxlade Making Money Make Sense. Types of life insurance. “Glenn Cooke offered to do a series of blogs on life insurance. This is one of those areas of personal finance that people most misunderstand, and I jumped at the opportunity to have an insurance specialist give y’all the lowdown.” […]

  16. Thanks for a simple and easy explanation. Hubby and I have put this off for so long. Now, I feel comfortable moving forward.

  17. Oh, thank goodness. Finally, a simplified explanation of something that has always confused me to having the existential willies. With this information my husband and I can have an understanding on what we need for us.

    Thank you, Glenn!

  18. […] Types of life insurance « gailvazoxlade.com In discussing the different types of life insurance we’re going to take the same back to basics approach. Most of the confusion that arises between the different types of life insurance are created by marketing initiatives by the … life insurance types – Google Blog Search […]

  19. Tim one reason why you may want insurance is what it can allow you to do:

    A life income annuity (payable until death) is attractive because the insurance company has to pay for life, even if you live to 110. However if you die much earlier than you expect, the insurance company keeps all of the money. Rather than gamble with your family’s inheritance, consider purchasing an insured annuity. This is a 2 step process where the annuity is backed by a life insurance policy for the same amount. If you die early, the life insurance is paid to your beneficiary tax free.

    This example compares GIC vs a life annuity with a matching life insurance policy.

    Example:

    * Current GIC rate 3.25% (five year rate lock-in)
    * 65 year old male purchases $100,000 non-reg annuity and $100,000 life insurance policy
    * Tax bracket 31.41% ($40,970 up to $65,345) Ontario

    Insured annuity GIC
    Gross income $8,165.28 $3,250
    Taxes payable $742.90 $1,012.37
    Life insurance $3,240 $0
    Total net $4,182.38 $2,237.63

    After taxes are considered, a GIC of over 6% is needed to equal the annuity. At higher tax brackets, a GIC paying over 8% is needed! Also, under the annuity strategy, he pays less tax as he is showing less taxable income and is less susceptible to OAS claw backs and age amount (age 65) claw back. This could mean many hundreds or thousands of dollars saved every year.

    Currently interest rates are low, but because the way annuities are taxed, they will always pay a higher income than GIC’s at higher rates.

  20. Hello Gail

    I’m here compiling Canadian Woman Financial resources (slim picking) Remembering you and your program that I have very much enjoyed over the years. Debt: Get rid of it – Check, Invest: Consistence of Time – Check, Life Insurance: rrrrrch (my mental brake slamming on) WWhaaaat? Your willingness to endorse the purchase or a person who sells any permanent life insurance is surprising to say the least. Is there something the Consumer Reports, The Complete Idiots Guide to Personal Finance, Johnathan Chevreau, Money Sense, Charles Givens, The Wealthy Barber, Canadian Buyers Guide to Insurance, Suze Orman, Dave Ramsey, Norman Dacey, Arthur Milton missed that Glenn knows. I’d rather my advice come for whats right for me as a consumer and not at all influenced by potential commissions.

  21. Jasmine,

    I’d recommend that you reread the articles. You’ll notice that I did not in fact endorse any type of insurance, as you suggested. Instead I quite deliberately gave enough information for readers to be able to make their own decision.

    I’m personally familiar with at least three of the authors and organizations you mention. I would suggest that if confronted, all of them would agree that most of the time, term is appropriate, but sometimes permanent is appropriate. For people who need life insurance forever (and that’s not everyone – but it is SOME folks), term is quite simply the wrong insurance product.

    It’s not as simple as always term. Zealots who require that everyone buy term insurance are as blinded by the hype as zealots who advocate only permanent.

    You’ve insinuated that I make recommendations of permanent insurance based on commissions. Nothing could be further from the truth. I’m a big term advocate for most folks – that’s why my blog is located at http://www.thetermguy.com (does that sound like someone who advocates permanent insurance because of commissions?). Despite that, I didn’t advocate term insurance in these articles any more than I did permanent. I advocated KNOWLEDGE, providing readers with information to make an educated decision.

  22. Hello Jasmine: I’m actually not surprised at your reaction. But ya know what honey, all insurance sales earn commission, and the fact that you’ve been lulled into believing that one type of insurance is best and another is worst is just a testament to the sales pitch you’ve been sold, not to your actual knowledge of the subject. Each of us has different needs. Go ahead and become a mom in your late 30 or early 40s and see if you wouldn’t have been better off buying a permanent life insurance plan in your 20s than buying term now! Don’t be so quick to jump, especially if this isn’t your area of expertise, just because you’ve read a few experts who were taking a particular position. The reality is that if you want your life insurance to last until you die to provide estate protection or for some other long-lived reason, permanent insurance may be your best bet. As for Glenn, I think he did a first rate job of presenting all sides of the story. And I thank him for sharing his knowledge with our community. GAIL

  23. this is great! now you really discussed each life insurance even i just read this part 2 i think the part 1 is as great as this. looking forward for the part 3.

  24. One thing leave me puzzled here:

    Your couple (mid-30′) have decided that say 20 years of insurance makes the most sense, and currently need approximately need $750K in coverage (each) to replace lost income.

    The thing here is that their premiums stay the same for that 20 years, but their required coverage would drop every year. If Mom dies today, Dad needs the $750K to pull out $30K per year, but if Mom dies next year, then doesn’t he need only approximately $720 to pull out $30K per year (interest and inflation will change those numbers slightly). At the other end, if Mom dies in year 19 of the policy, then Dad’s making out with much more than he needs.

    If that’s in fact true, then the option (I’m guessing) is to shorten the term of the policy, and when getting a new policy simply decrease your insured amount. So the premium would drop due to a lower coverage, but would rise due to an increase in age.

    If those paragraphs are valid (or am I missing an assumption or fact), then how would I crunch the numbers to come up with an ideal life insurance strategy.

  25. Never mind – you’ve addressed this issue in the third installment, which I just read. Thanks.

  26. The other idea with permanent insurance which is not discussed is how do I get all my money back with insterest if I choose or how I can get a guaranteed return of at least 8% (after age 65)?

    See link below as one idea..

    http://gailvazoxlade.com/blog/archives/1842

  27. […] Gail Vaz-Oxlade Making Money Make Sense. Types of life insurance. “Glenn Cooke offered to do a series of blogs on life insurance. This is one of those areas of personal finance that people most misunderstand, and I jumped at the opportunity to have an insurance specialist give y’all the lowdown.” […]

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  33. This has been a really interesting read, but to me, what it doesn’t address is that if you are financially relatively frugal, over time, your need for insurance will decrease, and your ability to self-insure will increase, so your insurance needs should go down over time. I.e., right now, I’m 34 with two young kids, so I need a lot of life insurance. But in 25 years, I’ll be 59, my kids will be independent, my house will be long paid off and I will have significant investments. So at that point, I might not need any life insurance at all.

    Through my union, I have access to one-year term life insurance at an excellent rate, and it’s an excellent rate for quite a long time for me, and as my insurance needs go down, I will lower the amount I’m insured for, as there is no point in paying for over a million dollars in coverage when the need for it simply isn’t there. As well, if something happens to me after I retire, my defined benefit pension has a survivor benefit of 50%, so again, the need to insure goes down.

    It just seems to be something that people don’t think about – over time, insurance needs will go down, and the ability to self-insure should go up. So in 20 years, you don’t need a million dollars in life insurance, so why would you pay for it now?

  34. You said: “It just seems to be something that people don’t think about – over time, insurance needs will go down, and the ability to self-insure should go up. So in 20 years, you don’t need a million dollars in life insurance, so why would you pay for it now?”

    If you need $1MM now and don’t buy it now because you may not need it later, you’re guaranteeing that you’re underinsured now – and that’s way worse than maybe overpaying for a bit of life insurance at some point in the future.

    If you are going to assume a decreasing need for life insurance, over time, then the correct solution is tiiering – layering different types of coverage in one policy. Let’s say a 45 year old needs $500K now, and $250K at age 55. In one policy we layer $250K of term 20 and $250K of term 10. Total is $500K for the first 10 years, then the term 10 drops off reducing coverage down to the $250K of term 20 for the last 10 years.

    We don’t have the ability to do s smooth decrease, so we’re stuck with big blocks of 10 years normally. This is the least expensive way to get a reducing coverage amount – it’s cheaper than buying the $500K of term 20 and reducing the coverage in 10 years.

    However, inflation and pay increases can make insurance needs go up. And in my experience, ‘life” makes insurance needs last longer than most people expect. So the initial numbers may show need decreasing over time, but it’s OK to assume level insurance needs over time since we’re guessing anyway. Most people go with level, but tiering is perfectly valid as well. My personal insurance is a tier of term and permanent (because I didn’t assume that my insurance needs go to 0 at age 65).

    You can layer pretty much any combination of different terms and permanent in one policy. The common terms are 10 year, 20 year, 30 year and term to age 65. There’s term 15 and 25 as well, but they’re much less competitively priced in today’s market.

  35. This article has clearly explained the types of life insurance that I wasn’t able to get from the dozen others I have read. It seems so simple but they make it so complex….After reading this it makes me realize the other writers really did not understand what they were explaining.

  36. Is primerica real or a
    Scam?????? I need to know quick!

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