By Richard A. Aubrey, CLU
This question goes back decades, if not generations. Should you have term insurance or permanent insurance? What’s the difference and what difference does it make? How do they work and which suits a given situation?
Term insurance is relatively simple. Keep in mind that the cost of insuring you for a year goes up each year. The older you are, clearly, the more it costs. If you were to graph out the numbers, you’d have a curve because the difference in cost—mortality cost—between, say, age 25 and age 26 is far less than the difference between age 65 and age 66. There is a kind of term plan whose premiums start low and go up each year more or less in parallel with the mortality costs. It’s known as annual renewable term or yearly renewable term. Most people don’t like it and few companies sell it any longer. People prefer their premiums to be level for a set period and available level-premium periods range from five to 30 years.
The company prices the policy by cutting an average of all the mortality costs within the specified period. Then there’s an adjustment for interest earned and for other considerations and…there’s your premium. The premium is higher at the beginning than the cost of insuring you in the beginning, so that it can be lower at the end than the cost of insuring you at the end. That’s how you get a level premium.
If you think about it, you’ll note the company has a little extra money at the beginning. They consider the projected earned profit on that extra money in order to reduce the premium from the raw average of all mortality charges. They have the money. You can’t get it. And it slowly disappears and, by the end of the level premium period, is gone. No cash value. That’s one of the characteristics of term insurance.
Until about 15 years ago, the level premium periods available were five and 10 years. When that period ended, the policy renewed at a higher but reasonable level for the next level premium period. Eventually, though, it got to be unaffordable.
With today’s contracts, at the end of the level premium period, the premium goes up by a huge factor. It is not reasonable, it is not affordable and you will not, I say again, you will not be paying it. Nobody will. So, although the policy officially can go to age 95 or some such, it is only good for the level premium period you chose. That’s the other major characteristic of term insurance. Eventually, it gets too expensive.
So why have it? It’s cheap. You can get a huge amount of life insurance for a surprisingly reasonable premium—especially if you’re a non-smoker and otherwise a good risk—and that’s a good thing. It’s a particularly good thing if you need a lot of insurance and you have a tight budget. Young families are grabbing quarter-million-dollar term policies without blinking.
Permanent insurance is also known as cash value life insurance, or whole life, or straight life.
So, what’s permanent insurance? Consider permanent insurance as term insurance whose premium is level to age 100. The company cuts an average of mortality charges between now and your age 100, adjusts for having extra money on hand and…there’s your premium. The problem is that the company is insuring some really old people or they are pricing their policies with that possibility in mind, since that’s how long the contract runs. The premium is high. Much higher than term insurance. So, even though you might think coverage for life (no matter how long it is) is a good idea, the cost is certainly a serious factor.
What’s this cash value? That’s a story. Some time ago, when there really were term-for-life contracts, one insured lapsed his policy for non-payment. He went to court to get it reinstated, claiming his premium had been lost in the confusion surrounding the Civil War. We don’t know if it’s true, but we don’t hear that one much anymore.
The court didn’t address the postal system’s inadequate response to the fact of a civil war. Instead, the court looked at the term-for-life contract. You must have some extra money up front to allow you to have a level premium for life, the court said to the insurance company. The insurance company’s lawyer probably figured out where this was likely to lead, but he had to admit it was true. Then, said the court, you have to give him credit for that money of his you have which is not necessary to insure him today, but to insure him decades hence. That’s the origin of what is known as the non-forfeiture values. The values in the policy can be used to avoid forfeiting (lapsing) the policy for lack of premium payments, whatever your excuse is.
The most commonly known non-forfeiture value is cash value. Unlike level-premium term where the extra money—which is very little—is not available to the policy owner, with permanent insurance it is available. You can borrow it, cash the policy out or withdraw part of the cash. Once the companies saw where they were required to be on this issue, they made the best of it and designed contracts with substantial emphasis on cash value as a selling point. The cash value available to the policy owner increases each year. The contract is designed to mature at some advanced age, from 95 to 100. At maturity, the cash value equals the death benefit and the company sends you a check, even if you don’t want it; that is, if you live that long.
While the companies began to structure their policies to emphasize cash value accumulation, the primary benefit of a permanent plan is the level premium. It allows you to afford the policy for life; that is, if you can afford it to begin with. And the cash value can come in handy sometime in mid-life or as a savings supplement at retirement when you may want to cash it out as no longer necessary. But keep in mind, for all the talk of cash value, the primary reason for permanent insurance is the premium which is level for life.
Seeking to be competitive by offering choice and flexibility, companies devised more and more versions of the basic whole-life policy. There was life paid up at 65. The premium was higher than a whole-life premium, but you were through paying at 65 while the coverage was for life. The cash value accumulated faster and earlier. There was 10-pay life and 20-pay life and 30-pay life. Premiums were higher for the shorter pay periods and the cash value accumulated sooner.
There were lower premium plans with modest cash value. There were plans whose premiums began low and increased over 10 years. There were plans whose premiums began high and dropped to some lower level over 10 years.
There were policies with dividends, which is extra cash value and policies without dividends and some of the policies with dividends had higher dividend projections than other policies.
I have an old rate book which has at least 20 policy types for most ages. So we spent a fair amount of time learning the policy types and more time considering which would be best in a given situation.
Then came universal life. That was about 25 years ago. Universal life has such a simple structure that it makes people crazy trying to figure it out, so I won’t explain it. The key to universal life insurance is that the premium is flexible, at your choice and, as you change it, you change the long-range performance. If you chose a high premium for good cash value accumulation and changed your mind later, you can pay a low premium and the only difference is that the cash value accumulation will be lower. With the advent of universal life, the rate books with a dozen or two of whole-life policies went away. You can design your own from a single-policy frame. Some companies still sell whole life for good reasons, though.
So, which is best?
The question is only answered when we know the situation. For maximum coverage for a limited budget, at the cost of having a limited duration, term insurance is the answer. Situations might include coverage for the breadwinners in a young family or to cover a business note or to start out with for a business buy-sell arrangement. All of those situations and many others, can have a probable end point. That’s not certain, but it’s likely. At some point, we pressume, the need will end. So why pay the high premium for some version of permanent insurance if you’re only going to need it for, say, 20 years?
Why would you need coverage on the day you die if you live to be 96? You can think of a good many reasons, all falling into the category of final expenses. Then there are estate taxes—depending on the law at the time and your estate at the time—and estate liquidity to allow families to divide assets without having to sell them. And the desire to leave something to the next generation is a popular one.
Estate liquidity is frequently overlooked. It’s not complicated. All it means is that you have enough cash on hand to pay the bills, generally known as final expenses and enough cash left over that the heirs can split up solid assets, like homes and businesses and other non-liquid entities without having to sell them. “You take the cash, I’ll take the lake house,” is a lot easier if the cash in question is close to the value of the lake house. Otherwise, there could be arguments, or the lake house goes to some other family.
Suppose you pick term and find, later on, that you need permanent coverage. Now what? It could be a problem. You have to be insurable to be able to get insurance. That means you need to show you’re in good health and don’t have dangerous hobbies such as skydiving. If you qualify now, the likelihood that you will again is less 20 or 30 years from now. But you don’t have a problem. Almost all term plans contain the conversion privilege. That means you are guaranteed the right to switch to one of the company’s permanent plans as if you’re completely insurable. No questions are asked. The only caution here is that there are a few companies whose conversion period is limited. Perhaps it’s only available for the first five years. That’s something to find out.
How about some numbers?
I went to a company I use a lot and calculated their second-best underwriting class. It is possible to get a lower premium, but the underwriting requirements are strict and probably a quarter of the non-smoker applicants get it. I think it’s better to be more realistic. In addition, I added the waiver of premium rider which will make paying the premium unnecessary if you are disabled.
I calculated a male aged 35 and used a death benefit of $1,000,000. For 30-year term, the annual premium is $1,475. At the end of 30 years, going into year 31, the premium is $32,535. It rises annually thereafter. That’s why I say nobody is going to have this after the level premium period, which in this case is 30 years. There is one exception. If you are already on waiver of premium for disability, the company will continue to waive those huge premiums. Being disabled may be a bad idea in all respects, but at least you can keep the term indefinitely.
The whole-life premium is $8,900 annually. That’s $7,425 more than the term premium. It’s about six times the level-term premium. It’s also about one-quarter of the term premium in year 31. So the difference is clear if you’re concerned about having coverage for life.
I’m almost done with the arithmetic. A couple of additional items: The cash value at the 12th year equals the total difference in premium. So if you cash out in year 12—for some reason we don’t expect—you get the entire extra premium back. After that, you get further ahead each year.
If you have the whole life and decide, at 30 years, that you should have had the term and you made a mistake, it works out like this: The cash surrender value, which is guaranteed, is $363,063. You will have paid in $222,750 extra. So you get back all your money and about $140,000 over. Not too bad for making such a mistake.
Assume you bought the term and really did, as everybody promises, invest the difference. Assume further that the resulting investment fund is separate so that we can keep an eye on it. We don’t know what it will do, of course, since it’s a prediction. But, if we’re trying to be accurate here, we ought to be conservative in our speculation. That’s because the whole life contract is not a prediction and it’s not speculation. It’s a contract guaranteed to the last penny in every respect for life or in this case, 65 years more, whichever comes first. I mean, whichever ends first.
Suppose you bought term and discovered at the 30th year or most of the way through the term, that you really need coverage for life. You can convert. No questions asked. But switching from term to permanent at an advanced age is expensive. It would be like walking in off the street and buying it at age 50 or 60, except there is no way you can be turned down. If you use a conservative (but not excessively conservative) projection for the return on the extra money you saved by buying term, you will find it’s all gone trying to pay the higher premium of purchasing permanent insurance at an advanced age. As the guys trying to sell an oil change used to say, “Pay me now or pay me (a lot more) later.” How can we manage to cover both needs, the need for large amounts of coverage at an affordable price and the need for permanent coverage at an affordable price?
The best way is to layer the coverage. Start out with the term contract you need. At some point in the next few years, convert a portion of it, the amount you think you’ll need for life. The total death benefit will be the same, since we’re changing the form and not the amount of the coverage. And, since you won’t be converting the whole thing—you probably won’t calculate you’ll need that much permanent coverage—the total premium will be affordable. By delaying the permanent purchase for only a few years, you won’t be paying noticeably higher rates for the permanent coverage than if you started at once and since you choose the date, you’ll be able to do so at a time when it looks feasible and affordable.
One last thing about the whole-life contract. What happens if you are permanently disabled? The company calls it waiving the premium. But, actually, they pay the premium. The cash value increase is just exactly the same as if you were paying the premium. Look at as if your rich uncle is paying. That’s why whole life is referred to as a self-completing savings plan. Live and pay premiums and the result is guaranteed. Die and the result is guaranteed. Become disabled and the result is guaranteed.
Which to do? It’s frequently prudent to start out with term. But before you do, make sure you look at both. That way, you’ll know why you did what you did and didn’t do whatever it is you didn’t do. Eventually, you’ll want to have some permanent insurance. Some of my clients don’t have a specific reason. They, “just want something when I die” which, although vague, refers to a number of real issues.
If you think you might, “want something” when you die, no matter how far into the future that seems, see your agent about having at least some permanent insurance.
About the author
Richard A. Aubrey CLU has been in the life insurance business for more than 30 years. His interest is in individual insurance, both life insurance and disability income coverage. A graduate of Michigan State University, Aubrey is at Piper McCredie Agency Inc. and can be reached at email@example.com