Types of life insurance
Posted by gcooke | Filed under 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:
- The death benefit
- The premiums
- 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.
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.
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.