Term Insurance
The concept of pure term insurance is very simple. If you do not die during the term of the policy, your money is gone. It is the least costly form of insurance and the reason is very simple. More than likely you are NOT going to die owning a term insurance policy. 99% of all term policies that are sold do not result in a death claim.There are many variations and we will now give a brief explanation of the 2 major categories of term insurance.
Annual Renewable Term
In the beginning, this was the only kind of term insurance. The costs go up every year because if you are not dead today you will be dead later. The cost goes along with actuarial likelihood of you guys dying which increases everyday that we don’t die.
So what are some uses of annual renewable term? The main use of it is when there is a very short period that coverage is needed, typically less than 5 years. You are only paying for coverage, even though it goes up every year, that is needed. It will eventually become cost prohibitive. Every year there are less companies writing renewable term. The public and the companies themselves have transitioned mostly to level term products.
Level Term Products
In the math of life insurance, level term products take the actual cost of annual renewable term and average them over the period the premium stays level. There are now 5, 7, 10, 15, 20 25, 30 and even some 40 year level term products. In simple terms the cost remains the same for the term of the product. After that the costs readjust to the cost to insure someone at their attained age. Usually people get sticker shock when they see the increased cost but it is actuarially equivalent to the risk. The cost for a 10 year product is cheaper than a 15 year; the cost for a 15 year product is cheaper than a 20 year, etc.
There are a great number of uses of this type of coverage. Any obligation that has a definite end is a good fit for the right term product. For instance, if you have children, they will not be economically dependent on you forever. Thank goodness you know there is an economic light at the end of that tunnel. Mortgages are of usually a fixed duration. This is a perfect place for a term product to match the mortgage duration. Again, any obligation that you know will have an end is a great match for a level term product.
In the purest form, term insurance is cheap because you are not likely to die during the coverage period. So if you do not die, your money is gone. Some companies are now coming out with Return of Premium Term. In these policies, a level term period is selected, the premium is increased but at the end of the term period if you did not die, you get all of your costs back.
Permanent Insurance
Permanent insurance is the category for any insurance that is actuarially designed to last until you die. There are a number of variations which we will explore, but essentially they all have the same purpose and that is to solve a permanent problem. The first type of permanent insurance was “whole life.” It lasted for your whole life rather than for a term of your life.In easy math terms, insurance companies took the actual cost of annual renewable term insurance and averaged the cost over the life expectancy of the insured. In other words if you would pay (x) cost annually over your whole life, the cost would remain the same until you died and the policy resulted in a death claim. Initially permanent insurance had a fixed cost for your whole life not ever increasing as in term insurance. As products evolved there are a number of variations of this product.
Most permanent products have two distinct features. The first that we touched on is that the cost remains the same. You over pay in the first years so that you can pay less than the actual cost in the later years. The second feature is that since you are paying more in the first half of your life for coverage than necessary, insurance companies give you credit for this. The name of this credit is “cash value.” A policy that provides you with cash value in the policy is a form of permanent insurance. The cash value is what you can get back if you do decide to give up the policy. You can also borrow the cash value, pledge it as collateral or in some instances use it to cover premium payments that are due. Most variations of permanent insurance are variations in how the cash value is credited.
Whole Life
The original, the king, the basis of what is good about life insurance. If no other permanent product had ever been invented all the lawsuits, investor struggles, etc. would have never come about. Whole life is simple. You pay (x) every year and when you die, the insurance company pays. Everything is guaranteed. The death benefit, the cash value and the premium are all guaranteed. You know exactly what you are getting. Plain old fashion greed and a misunderstanding regarding what the cash value was for contributed to the current slate of products we also have today.
Universal Life
In the 1980’s, interest rates were at a historically high rate. The guaranteed rate of return on the cash value of a whole life policy was not a very attractive option. Savings accounts were paying twice as much as the cash value was being credited. Many people were taking money from their cash value and just putting in it a bank to get better returns. The wise actuaries of insurance companies figured out they could pay those high returns as long as they did not have to guarantee them forever like in whole life. This is a huge difference. A universal life policy will have a cash value that has a guaranteed component and a current rate of return. The problem was that when agents used the current rate and projected it out over 40 years the results were amazing. The problem was that rate fluctuated and what it was last quarter is not what it is now. So all the calculations wound up being way, way, way over inflated and the cost of insurance was way understated. At 4%, money will double in 18 years, at 8% it will double in 9 years, at 16% it doubles in 4 ½ years. Illustrating a 16% rate of return over 18 years, $100 becomes $1,600 whereas at 4%, $100 becomes $200. Big difference.
In today’s environment, insurance companies have made a nice hybrid product. Many current universal life products have a guaranteed cost like whole life. If you pay (x) the policy will not lapse. They still give you the upside of having a potential higher interest rate while guaranteeing the death benefit will be in force.
The universal life policy unbundled the entire product. Instead of a fixed premium, you could select a range of costs to pay. The more you paid the more you made in cash value and guarantees. For instance, a universal life cost could be between $1,000 - $1,200 / year whereas a whole life would be down to the penny, the same exact coverage would cost $1,152.18 / year. Instead of a fixed interest rate, the interest rate moves. The death benefit could be lowered inside of a universal life policy as opposed to whole life. The biggest difference was that universal life’s cash value was credited with current interest rates instead of a guaranteed rate over the policy’s lifetime.
Universal life had been the cornerstone of the industry for a decade when greed crept back into the picture.
Variable Life
As with universal life, variable life came about because of the roaring stock market. Why leave money in a fixed interest account when a blind hog could get 20% a year in the market?
The wise actuaries once again stepped up and said we can let people invest their cash value in other stocks and mutual funds if we do not have to guarantee any return or for that fact even guarantee the death benefit. This was the first time in life insurance history that the entire burden of a permanent product was placed on the individual not the insurance company. As so often goes, everything was rosy until….the stock market corrected. Now those 12% projectors were actually 12% declines. What came next? Yes, you guessed it, lawsuits.
Well now even variable life can be bought with a guaranteed death benefit. These are new changes to a product that could have essentially changed and wiped out permanent life insurance as we know it today. The basic difference is that variable life’s cash value can be invested in mutual funds. Whole life’s cash value has a guaranteed return (no higher or lower) and universal life’s cash value is credited with a current rate of interest with some minimal guarantee.
So in summary of permanent products, the biggest difference today is how the cash value of the policy is credited. No wonder it seems so confusing when in actuality it is really that simple.
© R. Allen Greer, Jr., 2007