“Why Buy Permanent Life Insurance? Part II” is the second half of a two-part series of guest posts by insurance expert Glenn Cooke.Glenn has written about various insurance topics, including permanent life insurance, for Gail Vaz-Oxlade’s blog (among many other well-known sites). He recently contributed to this book. Comment with your questions about permanent life insurance cause he’s the guy to ask! |
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In part I of this article, I addressed Joe’s original question as to why someone might consider permanent life insurance. Part of Joe’s concern is the idea of whole life insurance and savings within life insurance being terrible investments. I couldn’t agree more – my rule of thumb is to never mix insurance and investments. The real reason you would purchase permanent life insurance is because you want life insurance for the rest of your life. If that’s the case, then it’s important to understand how these products work. In part II of this article I’m going to define and clarify the various types of permanent life insurance available in Canada.
Let’s start with a general definition:
Term life insurance has premiums that increase over time. Permanent life insurance has premiums that are level for life. It’s how the premiums are paid over time (increasing over time, or level for life) that differentiate between these two types of life insurance.
Most will be familiar with the different types of term life insurance. 10 year term, 20 year term, 30 year term, etc. Permanent life insurance has three specific types: Whole Life Insurance, Term to 100, and Universal Life. All three start with the basic premise that premiums are level for life.
Whole Life Insurance
Basic whole life insurance has premiums that are level for life. To keep the premiums level over these long periods of time insurance companies charge premiums that are more than their annual costs for the policy during the early years of the policy. Many years later as we get older and people start to die (and thus the company is now paying death claims) the annual premiums may actually be less than the costs for the policy.
So how can a life insurance company stay in business when they know that, eventually, the money being paid in from premiums will be less than the money going out for death claims? Simple: the insurance companies are savers and investors. In the early years of the policy when your premiums exceed the policy costs, the insurance companies don’t spend that excess. Instead, they save it. Later on when your premiums are insufficient to cover the costs they have the savings in reserve to make up the shortfall. It’s not any more complicated than paying more now to pay less later.
Now what if you cancel this policy? The insurance company doesn’t need those saving anymore, so they refund a portion of it. This refund is a cash value or cash surrender value. It’s that simple, but many of the misconceptions and sales tactics are derived from this simple idea of cancelling your policy and receiving a cash value as a refund of early premiums.
And that’s whole life insurance. Level premiums for life and a cash value if you cancel.
Whole Life Insurance with Dividends
Prepare to be dazzled. If cash values are fancy footwork, wait until you see how dividends work!
Some whole life policies receive an annual payment back from the insurance company called a dividend. If you understand nothing else about dividends, understand this: they are not guaranteed. The insurance companies have no obligation or set formula they must follow to determine how much dividend they are going to pay back to you.
You can do many things with this dividend, but the most common one is something often called enhanced whole life. First, you purchase a basic whole life policy as described above. Top off the policy with another layer of term life insurance. Your total insurance is the whole life plus the term. When you receive the dividend, the company automatically purchases a small ‘sliver’ whole life policy for you. That whole life policy is a single premium for life policy – one dividend pays the premiums for the entire lifetime for that small sliver. This small policy then replaces a portion of the the term insurance you bought. So after the first year you have your whole life insurance, plus your term insurance (but a bit less of the term insurance because it got replaced by the sliver policy) plus the sliver whole life policy. Over time those sliver policies entirely replace the term life insurance. And because the sliver policies also have cash values and generate their own dividends, over time the total cash value of your policy increases as do your dividends. Eventually all those dividends may even pay your premiums every year!
What’s the most important part about all that? Remember that dividends aren’t guaranteed, hence all that other complicated stuff that depends on dividends? Not guaranteed either. It’s a house of cards, and if you’re confused, you have a right to be. While fully guaranteed whole life insurance is a perfectly valid life insurance policy, life insurance with non-guaranteed elements is simply not a suitable option, particularly for consumers with little understanding of the mechanics of all this.
Term to 100
Want simple permanent life insurance? Take a whole life policy (level premiums for your entire life, plus possible cash value refund if you cancel) and get rid of the cash value. All you have is level premiums for life. That’s Term to 100.
Term to 100 should be the least expensive permanent product but in today’s insurance environment that’s not always the case. Sometimes the other insurance products may actually be less expensive. That doesn’t make numerical sense; it’s an idiosyncracy in the marketplace today.
Universal Life Insurance
Say you open a bank account with a life insurance company and buy a Term to 100 policy from them. Each month you place the exact amount of your premium into the bank account. The insurance company does its monthly premium withdrawal and your account balance goes to 0.
That’s a universal life insurance policy. When simplified like this there’s little difference between a universal life insurance policy and a Term to 100 policy. In fact if you’re shopping for permanent life insurance it’s worth comparing these two.
However, with a universal life policy you could (but don’t) put more than your monthly premium into the bank account – maybe $50 a month more. Now when the company withdraws your insurance premiums there’s $50 left over. That $50 is now invested. It’s also generally open to market crashes and all sorts of other ups and downs. This investment option is what really distinguishes universal life insurance from term to 100.
Now let’s imagine that, over time, all those extra $50 deposits add up. And your investments somehow didn’t crash and burn but instead grew and flourished. Eventually you could have a tidy sum in your account. You could even stop paying premiums entirely, because there’s enough money in there for the company to take out its monthly premiums. Sounds great right? It’s not – remember that part isn’t guaranteed. Who knows what’ll happen in 20 years? Or 30 years? Or even longer?
To complicate things, some universal life policies have insurance costs that go up every year instead of level premiums. You may (again, don’t) take that insurance option and start paying higher premiums in the hope that the investments will grow faster than the insurance premiums. Good luck with that!
In the end, the interplay between the two insurance costs (level or increasing every year) and the investments can make this either a complicated product or very simple (i.e. level insurance costs and no investments).
And that’s it for permanent life insurance. Whole life insurance, Term to 100, and Universal Life. If you’re looking for life insurance forever, instead of for a shorter period of time like 10 or 20 years, one of these three options is going to be a solid choice. Just make sure that everything about the policy that you’re going to use is fully guaranteed.
Glenn Cooke is a Canadian life insurance broker with Life Insurance Canada.com Inc.
The decision to get life insurance is a lot more complicated than I expected! It really does seem like fancy footwork!
lol for the record, I was the one who added the Chromeo song. Couldn’t resist. Good song, too.
I’ve never really taken the time to learn about permanent life insurance before. That was interesting. Universal Life Insurance seems kind of stupid to me though. If you make the decision to go permanent then want to save extra I don’t know why you would put it all with the life insurance company. I get the feeling you’d be better off with that money elsewhere but that I suppose is just an impression.
Kathy, as I noted in the article:
with a universal life policy you could (but don’t) put more than your monthly premium into the bank account.
“but don’t” being the operative words.
Possibly super dumb question, but when I was reviewing the article I couldn’t help but ask myself:
Is “Term-to-100″ actually permanent or if I live to 101 does it not get paid out?
Back when Term to 100 was first issued, the companies were all over the place on this, including some that didn’t even address what happens at age 100. These days if you live to age 100 I would expect the policy will either become paid up, or simply continue paying premiums. So you can ignore the ‘to age 100′ thing as it’s really just a naming convention.
And speaking of naming conventions – be careful. Just because the insurance is called ‘term to 100′ doesn’t mean it is term to 100. It could be a whole life or other insurance type from a company with a good marketing department.
and one further clarification. One company does pay out at 100. This is a bad thing because if they pay out before you die, it gets taxed heavily. I expect most people who live to 100 would rather the money be paid out tax free when they do die.
Thanks for the clarification. I got an online quote from RBC for $500k worth of Term-to-100. It seems it’d cost me about 9x what I’m currently paying for my current coverage — and twice what my guaranteed maximum renewal premium would be for my 20 year term, which would take me to age 65 (even though I could probably renew for less, so long as I didn’t become a smoker and I didn’t have a terminal illness). So, as you note, permanent insurance isn’t for everybody.
Honestly after reading these articles, however, I can’t help but reconsider the merits of permanent insurance (and I mean this truly; I’m not paid by any insurance companies so it’s a legit change in heart). If everybody was like me (or commenters Kathy or Sam) and saved a huge percentage of their income — heck, if they saved 20% of their income — starting in their 20s and simply eschewed debt, they’d have a comfortable retirement and would probably even leave a decent estate. But most people aren’t like us.
Given the average Canadian’s pathetic savings rate and dismal money-stupidity, a forced-savings program like Term-to-100 could help some people actually leave estates. 6-in-10 Canadians are now retiring with debt. That’s freaking nuts. With Defined Benefit pensions disappearing and the pending collapse of the housing bubble, what are the chances that this will improve? My comment on permanent insurance is that it is sub-optimal — there are more cost effective ways of leaving an estate (even considering the tax benefit mentioned) — but the truth is that the average Canadian is sub-optimal.
Somehow I feel like if an insurance agent said to the lower quartile or tercile of the population “Give me $150 from your biweekly paycheque/CPP cheque, for the rest of your life, and I’ll give you $500,000 tax-free when you die,” that it really wouldn’t be hurting them, even if that agent did make several grand in commish. It breaks up building an estate much like a Rent-to-Own store breaks up payments on overpriced television sets. Remember the epic “daily cost of ownership” debate I had with readers on the Moneyville article? I said that tactic is disingenuous, and it is (sales people know it works on the gullible — http://www.changingminds.org/disciplines/sales/closing/closing_techniques.htm), but that insurance agent would be doing a lot more for a person’s future than a Rent-to-Own store.
Yea, 101 wow… that would be a real stinker. On the plus side when you turn 101 even a 10 million dollar policy will be chump-change. lol But yea, the question remains does it cover you beyond 100?
If I didn’t have insurance through work… I would only buy life/permanent if it never ran out… medical science will continue to move forward!
Term is generally the right course of action for the rest of us.
Thanks for the articles Glenn, posting them here must feel like walking into the lion’s den
I’ve always thought some of the cash back/dividend stuff/return of premiums was a bit funny. Sometimes it’s explained as a way you can make more money in the future, but it’s not guaranteed. So if you’re depending on that as income and it’s uncertain, does that mean you need insurance on your insurance?
I’m generally for term insurance for anyone who can take care of their finances, but there are two things that can favor permanent varieties:
- The insurance can be paid out directly to someone without going through the estate/will process. I’m not entirely sure and it may vary by province, but for immediate expenses this could be more convenient than liquid assets that are under you name.
- Speaking of insurance on your insurance… some people do retire and then lose all their assets when they had enough to be self-insured. If they have paid-up permanent insurance and they don’t cash it out or otherwise dispose of it then they can still leave something behind other than the bill. This is a pretty low probability and inflation will reduce the value, but to really protect everything I have a small whole life policy with no premiums after 20 years. An alternative would be to build the assets first and then just buy paid-up insurance directly when you end the term.
lol Glenn has been valorous in showing me a new perspective.
I’d add one quick note: even for people without pensions, there are ways to guarantee income in old age despite market fluctuations (and besides keeping it all in CDIC-insured cash accounts). For example, annuities.
Agreed, annuities may play a part later on. Assets don’t always buy the mental health to preserve them