This is my first guest post at My Canuck Buck! I’m very excited to have this post, as it’s a topic I don’t know a lot about. Many thanks for Glenn Cooke (see his bio at the end) for providing it.
With all of the marketing hype surrounding different types of life insurance it’s easy for consumers to get distracted and confused. Advocates of one type of insurance assure us that there’s only one way to go, while others try to steer our attention to various aspects of the insurance policies.
In reality different types of life insurance are almost identical. Say you have two people with different structured policies that each payout $500,000. If both people die, both families receive payouts of $500,000. Can you tell the difference between the two policies? You can’t. The payouts are same; any other differences are irrelevant.
Toss away the glossy brochures and the competing opinions and you’re left with a fairly simple insurance product—a product that’s not that much different than car insurance or house insurance. In fact, there are only two attributes specific to life insurance that you should care about: the death benefit and the premium.
Unfortunately, the older we get, the more expensive life insurance gets. This is different than car insurance or house insurance, where our premiums may remain level throughout the years.
Life insurance companies could charge the year-by-year cost of life insurance and give us policies where the premiums go up every year. Consumers, however, won’t buy these types of policies. The insurance industry’s response is to take these annual cost increases and level them out over various periods of time. This is the key difference amongst the different types of life insurance—how long the insurance company has levelled the premiums out for.
Let’s say your life insurance costs over the next five years would be: year one, $300; year two, $350; year three, $400; year four, $450; and year five, $500. You could simply pay those annually increasing costs. If you did so, this type of insurance would be called one-year term.
Alternatively, we could take the average cost over those five years ($400/year) and simply pay that premium level each year for five years. This type of life insurance would be called 5 year term life insurance. Term life insurance basically averages out our increasing costs over a specific period of time: five years, 10 years, 20 years, and even as long as 30 years.
Now what happens if we average those costs out over an even longer period of time? Let’s say over our entire life? Doing so would level the life insurance costs for life. This kind of life insurance is called permanent life insurance.
With permanent life insurance policies, you are paying more than the cost of the policy in the early years, and less than the actual annual cost in the later years.
Due to the long-term nature of these policies, the insurance companies save or ‘reserve’ those extra premiums paid in the early years inside the policy. This money helps pay the expenses in the later years of the policy. Should you cancel this type of policy at some point in the future, the insurance company will refund you back some of that reserve. This refund is called a cash surrender value or cash value, and this type of life insurance (level premiums for life and a cash value if you cancel) is called whole life insurance. Note that these cash values are the frequent subject of marketing techniques by the life insurance industry.
In response to objections and concerns over the marketing tactics surrounding those cash values of whole life policies, the industry produced a second type of permanent life insurance policy called Term to 100. Term to 100 is basically a whole life policy, with no cash values. Put simply, it means you get level premiums for life, but you don’t get a refund if cancelled. As a result, the premiums for Term to 100 are generally lower than whole life insurance.
The third and final type of permanent life insurance is Universal Life. While this product comes with a lot of options, you can think of it as a bank account with a Term to 100 insurance withdrawal. Every month you deposit your Term to 100 insurance premiums into the ‘bank account.’ If you deposit exactly the same amount as your insurance premiums, your account balance stays at zero. If you deposit more than your insurance premiums, this money is invested according to the options you chose when you bought the policy. And if your investment balance grows large enough to cover your insurance costs then you may be able to skip paying premiums that month. These policies are often marketed using various non-guaranteed investment scenarios that focus on the investments rather than the insurance. And by non-guaranteed, I mean using really rosy assumptions that are likely to fail dramatically over the coming decades.
So that’s it, all the types of life insurance are the same except we pay the premiums differently across long periods of time. If you want cheap insurance today at the expense of higher premiums when you’re older, term insurance fits the bill. If you want insurance affordably in the long term, any of the three types of permanent insurance polices will allow us to lock in our premiums today for the rest of our life. The trade off with permanent policies is, of course, that their premiums today are higher than term insurance premiums.
Glenn Cooke is a life insurance broker and president of Life Insurance Canada.com.
We went with the Term Life Insurance but because we smoked it dramatically increased the cost for us. I’m interested to see what will happen now that we are smoke-free after one year but from the sounds of my advisor he says it won’t make a big difference. I was hoping maybe Glenn could touch on the smoking topic and how it affects the policy. Thanks for explaining them all. Cheers Mr.CBB
I was also wondering if people commonly carry both Whole Life and Term and why it would be necessary or unecessary to do. Is it simply a back up plan for people? Thanks
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Life insurance does seem like a rather complicated decision. Unless you are an expert on the matter, it’s just so tough to figure out what the best policy is for you. Thank you for explaining some of this stuff Glenn. I’m just not sure whether I would want to pay consistent premiums or whether I should just get the high premiums out of the way early. Luckily I have plenty of time to think about this since I’m single with no kids.
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Hey guys – glad you enjoyed the post. I encouraged Glenn to drop by, but he may have not have had a chance yet – I’ll send him a reminder!
CanadianBudgetBinder: Quitting smoking should cut your premiums in half. Call your insurance company and ask for a ‘request for reconsideration’. The customer service dept. should be able to step you through it.
For people that are in the midst of quitting smoking , I recommend taking the shortest term possible (generally a 10 year term) but with a company that will let you bump up to a longer term after you quit smoking for a year. Some companies will let you jump from 10 to 20 year to 30 year just by filling out a form. IIRC the companies are Equitable, RBC, Canada Life, Transamerica, and Wawanesa. Don’t quote me on that entire list
. Anyway, you pay the cheaper premiums on the shorter 10 year term while you’re smoking, and don’t bump to the higher longer term premiums until you qualify for the nonsmoking premiums.
In terms of carrying both Term and Permanent, here’s an example. You want $500,000 of coverage for the next 20 years while you have kids, then you know that you will want $100,000 of coverage after that for your lifetime. Then blend $100,000 of permanent and $400,000 of 20 year term today in one policy. You have the total $500K for now, and in 20 years you drop your coverage down to $100,000 of permanent – but the premiums for the permanent were based on your age 20 years ago when you bought the policy.
Question is, do you want that $100,000 of coverage permanently? If not, or unsure, just make sure your term has ‘conversion’, which allows you to jump your term over to permanent without a medical exam.
Modest Money: The initial choice is this. If you want insurance forever, buy permanent. If you don’t expect to want insurance when you’re older, buy term.
Second choice, if you want insurance when you’re older but don’t like the premiums of permanent insurance, buy term insurance and make sure it has a ‘conversion’ option which allows you to switch to permanent insurance later without a medical exam. This defers the decision (at a higher cost) of locking in to permanent insurance premiums until you’re older. Its not technically perfect, but a lot of folks like this approach because ‘cheaper now, expensive later’ fits well with most folks’ budgets – what with kids/mortgages/savings/expenses all chewing up the income on the front end.
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Great article, this is a murky area for many people…this article does a goo job of laying it all out!
Permanent life insurance: It sounds good but should we think out of something like cancelling our account? It is necessary and once we apply for a insurance plan we should never back out even if we aged 100. It was smart of the insurance industry to add the Term to 100, i believe this life insurance policy does not get give a refund if a client reaches 100 year-old compare to permanent life insurance.