Saturday, 25 July 2020

Different Types Of Life Insurance - (The Beginners Guide)

Different Types Of Life Insurance

In this article, I'm going to explain the differences between term life insurance, whole life insurance, and universal life insurance. We are going to start with a concept that underpins prices for insurance, which is directly related to explaining the differences between types of life insurance policies available.


Let get started



Mortality Rates Increase Exponentially

In plain English what that means is the likelihood of you dying increases the older you are. But that rate of increase, increases. looking at the United States in 2016, the odds of a 40-year old man dying within the next year, were 0.2420%. This means, for 40-year-old men, 0.2420 out of 1,000 would be expected to die in a given year. For 41-year-old men, that rate increases to 0.2530 out of 1,000. And for 42-year-old men, it increases again to 0.2663% out of 1,000. What you'll note is that the increase, increases. The increase in the odds between 40 and 41 year-olds is 0.11. But the increase in odds between 41 and 42-year-olds is 0.133.



Conceptually, if we were to plot the likelihood of dying in the next year on the y-axis and age on the x-axis, we would get a curve that looks something like this;


If every year, you were to buy a new one-year life insurance policy, you could use this same graph, and replace the likelihood of dying with the insurance premium in dollars. Remember, is just the fancy word for the cost of the insurance. So what this means is that, if you were repeatedly buying a 1-year life insurance policy, the price would go up every single year, and later in life, it would become unaffordable. This change in cost doesn't really get dramatic, until later on in life. For example, the same amount of coverage or death benefit that costs say, $10 dollars per month for a 20-year-old, might cost $20 per month for a forty-year-old, $100 per month for a 60-year-old, but might shoot up to $1,000 per month for an 80-year-old.



This brings us to our first type of life insurance 


Term Life Insurance

If we take our graph, and we separate it into 10-year intervals, an insurance company might say, instead of just increasing the price every year, we'll set a static cost for the entire ten-year period or term. And this fixed cost, during the term would be a bit higher, than the one year cost earlier on in that term, but a bit lower than the one year cost later on in that ten-year term. So essentially they're averaging it out.

To be clear, for this 10-year term life policy, the monthly premium would stay the same for that entire ten-year period. After that ten years is up. There would be a higher monthly premium for the next ten-year term, and the same for the third 10-year term, it would go up.

Let's look at an example policy to just spell this out. Let's say that we had a 30-year-old with a term 10 life insurance policy, with a coverage amount or death benefit of $250,000. The cost of the policy might be $15 per month, and so what that would mean is, they would pay $15 every month for the next 10 years for the same $250,000 death benefit should he die. 

In year 11, which would be the beginning of the second 10-year term, the premiums would increase to maybe $100 per month if they kept their policy. They would still have the $250,000 coverage amount, and in the third 10-year term, the premiums might again jump up to something like $300 per month.

Another option that is available, for example, is a 20-year term life insurance policy. In this case, all that means is that the monthly premium would remain the same for a 20-year period, and the amount of the premium might look something like this, for the first term

It might look something like this, for the second 20-year term.


As you can see the costs start out really low, but soon escalates to the point of being very very expensive. So it's relatively cheap to get lots of insurance coverage when you're young and healthy. But very expensive when you are older. For many people, this might be all the type of insurance that they ever need or want, over time as your assets grow, your need for protection decreases. 


Term Life = Temporary Life Insurance

Term life insurance is synonymous with temporary life insurance. And this is quite a different beast compared to what's known as permanent life insurance, which I'm going to explain now. 


Permanent Life Insurance

Most insurance companies don't even offer term life insurance if you're 80 years old, it's just insanely expensive. But there are some reasons why some people may still want some coverage at that age, and some of those reasons include paying for funerals, covering off a tax liability on real estate, or a business that is deemed to have been disposed at death, creating an inheritance. Some people use life insurance in specific financial planning strategies for more than just the death benefit. There are what are called living benefits that may be of interest as well. A few caveats before we start breaking down permanent insurance, as the name implies, the permanence of these policies, means you really need to research them. They can be complex involve long term trade-offs, and many people make a lot of money selling you permanent or temporary insurance, so you have to be mindful of sales incentives when they exist. 


Let's start by explaining permanent insurance, by explaining what is called whole life insurance.


Whole Life Insurance

  • 30 Year Old
  • $250,000

  • 20 Year Term Life
  • Initial Premium $20/Month

  • Whole Life 
  • $200


let's again take a look at a 30-year-old who wants $250,000 in coverage as an example, if they wanted a 20-year term life policy, the initial monthly premium might be $20. 

For a whole life policy, the monthly premium might be closer to $200. So why the massive difference?. Well, You can think of a whole life policy as a term life policy, except, instead of a series of 10 years or 20-year terms. There's only one term, which is your whole life. The concept is that you overpay early on, in exchange for underpaying later on. But the early overpayment is much more pronounced, but here is another major key to understanding life insurance.

Ask yourself this question, what exactly happens with those overpayments? Essentially, the insurance company invests the difference. The difference between the premiums you pay and the cost to provide pure insurance is set aside into what is referred to as either reserve or cash value. And this excess is invested and grows over time. Let's say that we have a whole life insurance policy, and the death benefit is $100,000. The person gets this policy once there's 30 years old if they die, and their policy is in force, their beneficiaries get the $100,000 as promised. But the cash value, or the reserves, build up over time. The difference between the death benefit and the reserves is the amount that the insurance company has at risk. They have this cash, and so they would have to pay out the difference in order to give you your $100,000 death benefit. So if someone had this policy until they're like a 100, the insurance company may not actually have any risk at that point as the reserves may be equal to the death benefit. 

Now here's another major point to consider, over very long periods of time, even very small changes in some assumptions can lead to a wide range of outcomes. 


If you use a very conservative estimate for the rate of return on these reserves, you are projecting that they aren't going to grow very fast, and so that means you would potentially charge a higher premium because as the insurance company you would need to put more money into the reserves, and if the returns actually earned are higher than your prediction, the insurance company is going to end up rich.

There are other factors as well that go into these formulas


  • Mortality Rates
  • Expected Claims
  • Operating Expenses
  • Policy Lapse Rates
  • etc


For example, if fewer people died than predicted, if operating expenses go down over time, and if more people let their policies lapse because of non-payment, then all of these things increase the profitability of the insurance company. 

This is the perfect point to talk about the difference between what is called "non-participating whole life insurance" versus, "participating whole life insurance" the whole life policy we've described so far is a non-participating whole life policy, and don't worry that name is going to become crystal clear in about a minute.


Non-Participating Whole Life Insurance

In that non-participating policy, everything is guaranteed. How much your premium is, what your death benefit is going to be, and even how much your cash values will be overtime. All of that is guaranteed on your policy illustration as it's called when you're sold a policy, they give you an illustration, and it'll show all those things that are all guaranteed. Again, if the insurance company's assumptions are conservative, it basically means you'll end up paying more than you had to, and the insurance company makes out like a band.


Participating Whole Life Policy

Participating whole life policy is a little different. It gets its name because you participate in the profits of the insurance company with respect to these reserves. Let's say that in year one fewer people die, and make claims than expected, and the reserve fund grows faster than expected due to investment performance, the insurance company will pay out part of these profits to you every year, and what's called either a dividend or a bonus, depending on what country you live in. For now, you'll generally have the option of taking it in cash, using it to reduce the premiums that you pay, using it to purchase additional insurance, or you can put it into an interest-earning account with the insurance.

All other things being equal, the initial premiums for a participating policy going to be higher than a non-participating policy. But over long periods of time, the participating whole life policy may or may not work out to be less expensive, again, it mostly depends on how far off the assumptions were, versus what actually happens, but insurance companies tend to be conservative in some of these estimates.


These whole life policies are going to initially look way more expensive than term, but they're designed to be around forever. They take part of your premiums early on and invest them into these pools called reserves or cash values. 


Buy Term And Invest The Rest

Let's go back to the 1970s, back then, interest rates were high, and were climbing higher. And at the very peak in the early 1980s close to around 20%, unemployment was all very high with lots of people losing their jobs, and this created a perfect storm of events that led to a lot of change in insurance industries around the world, on one hand with whole life policies, the insurance companies were making money hand-over-fist because the rates of return they used to calculate these premiums were much lower than the rates of return that they were actually getting on these reserves. With lots of people losing their jobs but having these high premium whole life policies, they were looking for ways to reduce their expenses, but also keep their coverage for their families. So the timing was right for a movement to be born, and so the idea of "buy term and invest the rest" became wildly popular. 

What this refers to is the strategy of buying a term life insurance policy which we've seen is much cheaper than whole life for the same death benefit amount, especially when you're young. And taking the difference between these two premiums and investing it yourself. Right?. So buy term, invest the rest. You're getting the insurance coverage while building up your own reserve over time. At some point, you would no longer need the term life insurance because you would be effectively self-insured with your own reserves in a separate investment account to fall back on.

To counteract, this insurance company started to heavily push a different type of permanent insurance which allowed you to choose how the cash value of your policy was invested.


Variable Life Insurance

  • You Choose How Reserves Are Invested


A variable life insurance policy is one where you can select how the reserves are invested. That means, instead of relying on insurance companies more conservative investments, you could pick investment funds that have more potential return but also more risk.


Universal Life Insurance

  • Adjust Death Benefit Up Or Down
  • Adjust Premium You Pay


This refers to a policy that has a number of parts that you can tinker with, you can adjust your death benefit up or down over time, you can also adjust your premiums up or down, and in theory, you can design it to look like any other type of life insurance policy. So this ability to tinker with it and the different moving parts make it Universal in application potentially.

Now, in some countries like Canada for example, when people refer to universal life insurance policies, they mostly associate it with the ability to pick the investments for the reserves. In the United States, this is not the same, you can find four main types of universal life insurance policies;
  • Guaranteed Universal Life
  • Universal Life
  • Indexed Universal Life
  • Variable Universal Life


Sounds like a lot, but trust me, you actually now have all the knowledge you need to understand all this more easily, the main differences between these four types of universal life policies are, and how the reserves are handled.


  • Guaranteed Universal Life
  • They are not designed to build cash values, and so the premiums are a bit lower


  • Universal Life
  • Regular universal life puts the reserves into a conservative interest-bearing investments 

  • Indexed Universal Life
  • Indexed universal life puts the reserves into a type of investment that is exposed to stock market indexes, but with guardrails. Your upside is capped, and your downside exposure is also limited, so there are some trade-offs to that.

  • Variable Universal Life
  • Allows you to pick from different mutual funds to invest in, with a wide range of risk and return profiles. 







Conclusion

We can build a basic framework for how life insurance works in general, you always have to be mindful of jurisdictional differences. I hope you now have a full understanding of different types of life insurance

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