Life insurance has two primary attributes – the premium and the death benefit. If we strip away the marketing aspects from life insurance those are the two base attributes we should be concerned about. If we die, how much do our beneficiaries receive? And how much does it cost to receive those benefits?
Let’s look at the death benefit first. If person A has $100,000 of one type of life insurance and person B has $100,000 of another type of life insurance and the both die, how much do the beneficiaries receive? In both cases, the beneficiaries receive $100,000. The beneficiaries can’t tell what type of insurance they had! The point here is that the death benefit is the same for all the various types of life insurance. It’s the premium that differentiates the different types of life insurance.
Premium Life Insurance
It’s the premium that differentiates the various types of life insurance available to us. How are the premiums different? Let’s first look at the basic underlying ‘cost’ of insurance.
Life insurance premiums, like all insurance, are based on the concept of risk. Higher risk means higher claims and that dictates higher premiums. For car insurance, drivers that get into accidents tend to be poorer risks and that leads to higher insurance premiums. But what makes us a poorer risk with life insurance?
For most of us, it’s our age. Younger people generally don’t die as often. Claims are less, so costs – and therefore premiums are lower. Larger numbers of people tend to die as we age, so therefore costs are higher. This is intuitive for most of us – life insurance is cheaper when we’re younger and gets more expensive as we get older.
If the insurance company was to directly charge us the direct cost of insurance based on our age then, our premiums would go up every year and would look something like this graph.
One year term insurance isn’t palatable to most consumers. Consumers would rather not pay premiums that they know are going to increase every year.
Term Life Insurance
(Term Life Insurance, first of two types of life insurance. Sub-types: 10 year term, 20 year term, 30 year term)
Now the underlying cost of insurance shown in the above graph must be paid for all types of life insurance. But because one year term insurance isn’t a well liked product (due to the constant premium increases) the insurance companies smooth out these costs over periods of time or ‘terms’. Lets say they take the premiums in the above graph for a period of 5 years. Now rather than charging you the increasing premiums every year, instead they charge you the average premium over that 5 year term. You pay the same total costs, but now your premiums are level for 5 years. At the end of 5 years, your premiums increase and the company charges you the average premium over the next 5 year time period. The costs are the same, but now you’re premiums are level for 5 year increments. This type of insurance is called 5 year term.
And that’s term life insurance in a nutshell. Rather than paying the direct cost every year, your premiums are smoothed out or averaged over terms. 10 year term insurance, 20 year term insurance and 30 year term insurance are all common life insurance products in Canada today.
Continue reading the second half of this article: Permanent life insurance.
Permanent Life Insurance
(Permanent Life Insurance, second of two types of life insurance. Sub types: Universal Life Insurance, Whole Life Insurance, Term to 100).
We saw in the first half of this article that what differentiates life insurance is the premiums – and more specifically, how those premiums are paid over time. The underlying cost of all life insurance goes up every year as we get older. Term life insurance smooths that process out by leveling our premiums over periods of time called ‘terms’.
Now what happens if the insurance company takes the costs and average them out over an even longer period of time? Let’s say the insurance company averages your costs of insurance (that go up every year) over your entire lifetime? If they did that, we would see premiums that are level for life. And that’s the core definition of permanent insurance – level premiums for life.
Whole Life Insurance
If you look at the above graph and compare the blue line (the cost of life insurance on a yearly basis) with the white line (permanent insurance, premiums level for life), you’ll see that in the early years, the whole life premiums far exceed the actual cost of insurance – the company is taking in premiums far higher than they need. But look at the right side. As we get older, the costs of life insurance on a yearly basis will actually exceed the premiums you would be paying with permanent life insurance. In those years the company is taking in less money than they are paying out in costs and claims. No company can run a sustainable business where they are planning to pay out more in costs than they take in in sales. So what gives?
The answer lies in the early years of the policy. In the early years you’ll notice that the premiums are actually far higher than the company’s costs. Unlike most products we buy, life insurance companies don’t take that additional premium and put it into their annual profit – they don’t run out and spend it. Instead, they take that additional premium and save it up (it’s called ‘reserving’) inside your policy. These premiums that you pay above the base cost of insurance in the early years then build up inside your policy. In the policy later years when costs exceed your premiums, those reserves are then used to handle the additional cost of life insurance at the later ages. In short, you pay more now to pay less later.
Now if you are building up this reserve inside your policy to keep your premiums level when you’re older, and you cancel your policy, the insurance company will actually refund you a percentage of that reserve. They no longer need it to pay the later costs (since you just cancelled your life insurance policy) so they give some of it back to you. This refund of your overpayment of premium is called a cash surrender value or cash value.
This type of life insurance – premiums level for life and a refund of overpayment called a cash value if you cancel – is called ‘whole life insurance’.
Term to 100
In the late 1980’s and early 1990’s some nimble life insurance companies capitalized on consumer dissatisfaction with whole life insurance. Whole life insurance was useful in keeping life insurance premiums level for life but there was some discord over how it was being marketed to consumer. The dissatisfaction centered around the way cash values were being marketed.
These insurance companies offered a permanent life insurance product where they had removed all cash values. This allowed them to lower premiums below whole life insurance. This second type of permanent life insurance is called Term to 100 and is characterized by level premiums for life with no cash values.
Universal Life Insurance
Also in the late 1980’s and early 1990’s the insurance industry introduced a third type of permanent life insurance known as Universal Life Insurance. This insurance product has two sides to it. The first side is a well defined insurance policy, typically treated as a term to 100 insurance policy (though some companies offer an insurance component that is one year term). The costs and the death benefit for this half of the policy is specified by the insurance company. The second side of the policy is an investment account. Any premiums you pay above and beyond the insurance costs are placed into this investment account. The amount of these premiums are variable and defined by you. They can be as low as $0 (i.e you can pay the ‘minimum premium’ of just the insurance cost) or you can increase your total premiums to start making contributions above your base insurance costs into the investment component of the policy.
Universal Life Insurance
There are two basic types of life insurance in Canada, dictated by how life insurance premiums are paid. Term life insurance has premiums that are initially less expensive and increase as we get older. There are different types of term life insurance policies including 10 year term, 20 year term, and 30 year term. Permanent life insurance policies typically have level premiums for life. We have three types of permanent life insurance, whole life insurance, term to 100, and universal life insurance.