Permanent Life Insurance
This is the second half of a two part article on the types of 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.
So in summary, term insurance has premiums that go up every so many years, permanent life insurance has premiums that are level for life.
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’.
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.
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.
By contributing into the investment component you would expect those investments to increase and grow over time. However most universal life insurance investments are NOT guaranteed. Those investments can AND DO decrease. The recent stock market crash is an example of this, where many people’s universal life insurance policies suffered extensively due to the market crash.
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.
Now that you’re familiar with the types of life insurance, see our article on the best type of life insurance.
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