June 2008

This is part 2 in a 3 part article intended to make the types of life insurance less confusing.

These three articles should be read in order.

1. Life Insurance Types - Term life insurance
2. Life Insurance Types - Whole Life and Term To 100
3. Life Insurance Types - Universal Life Insurance

(Continued from previous article)

Enter permanent life insurance. There are three basic types of permanent life insurance but they share one common feature. They all have level premiums for life.

Effectively what the insurance companies do is average the premiums for the 1 year term product, but over your entire lifetime. We end up with one premium, that while substantially higher than the 1 year term, will never go up. Later in life when the term premiums increase to the point of unaffordability, permanent life insurance purchasers will still be paying the same premium they were paying when they first bought the policy – eventually permanent premiums become less expensive than term.

What you’re really doing (and I’m being conceptual here) is overpaying your premiums above the true cost of insurance, or the 1 year term. The insurance company then reserves that overpayment in premiums you make in the early years. Eventually when the actual cost of insurance and the claims they’re paying out exceed what you’re paying for permanent insurance, they can make up that difference in premiums out of their reserves they’ve built up – using your overpayment in premiums from the early years. This concept works well for those needing permanent insurance.

Now what happens if you cancel your policy early? You’ve overpayed your premiums for future use, which now you’re not going to use. The insurance company will refund you a percentage of your overpayment in premiums. This refund is called a Cash Value. And this product – level premiums for life, with cash values if you cancel your policy early – is called Whole Life Insurance.

Unfortunately through the years the insurance industry has decided to sell this refund of overpayment of premiums as a great savings vehicle when it really isn’t. Consumer advocates realized this was a crappy deal for consumers (who for the most part just needed some cheap term life insurance). So Whole Life Insurance got a deservedly bad rap.

The insurance companies had a response to this. They took a permanent insurance policy and removed the cash values. This allowed them to lower the premiums. This product – level premiums for life with no cash values if you cancel early – is called Term to 100 Life Insurance.

This is part one in a 3 part article intended to make the types of life insurance less confusing. These three articles should be read in order.

1. Life Insurance Types - Term life insurance
2. Life Insurance Types - Whole Life and Term To 100
3. Life Insurance Types - Universal Life Insurance

Note: You can run a term life insurance quote in the right sidebar of this site.

I speak to many people about life insurance every day and one common theme I see is complete confusion over what the various types of life insurance are. Some folks have read up on what the consumer advocates have to say and demand only term life insurance regardless if that’s what’s best. Others just have to have something where they ‘get their money back’, again regardless of whether that’s the best deal or even the right type of insurance. Ultimately I believe this confusion stems from the insurance industry selling products using wild and colorful presentations that focus on just about everything but the insurance aspect. Consumers are confused and skeptical of being sold the wrong type of life insurance.

There’s a fix to that. Quit treating life insurance as a financial product and start treating it as an insurance product. Life insurance is insurance – not a savings or investment account. It’s generally not a tax saving strategy either (occassionally it is – but it’s only a solution to tax problems if you actually already have tax problems. Are you seeking a solution to your tax problems?). Look at life insurance the same way you would your car insurance. Would you consider saving for your children’s education via your car insurance? Do you want all your premiums ‘back’ from car insurance as a savings plan? Of course not. And that’s because we all know our car insurance is an insurance product not a financial product.

In fact, at it’s core life insurance works very similar to car insurance. We pay a premium for a year. If we have a claim (we die) the insurance company pays the benefit. If we don’t have a claim the insurance company uses our premiums to pay the claims of whoever did have a claim. That’s simple enough.

Just like car insurance, if we’re a bad driver our rates go up. What primarily makes us a bad driver with life insurance is our age. Every year we’re a year older, we’re a year closer to dieing. So the way pure life insurance would work is we’d pay a premium for a year and have our coverage. Next year our rates would go up a bit, as they would every year thereafter. Eventually the insurance premiums would be out of site since we’d be such a bad driver (we’d be old).

The product just described does exist. It’s called 1 year term life insurance. It’s 1 year term because the rates go up every year. It’s term life insurance because there’s no bells or whistles or cash values in the policy and the rates basically follow our age. The problem with this product is that no one will buy it. Who’s going to buy a life insurance product where they know the rates are going up every year and eventually will be too expensive? Nobody.

So what the insurance companies did is take the rates over 5 years and figure out the average premium. Using that average premium, they can now provide a product where the rates are level for 5 years, then they go up and again are level for another five years, and so on – basically staircasing upwards every five years. That product is called 5 year term life insurance. 10 year term, 20 year term life insurance, they all work in the same fashion.

If you’re younger and raising a family and need a lot of insurance, term insurance fits the bill. A 20 year term life policy will give you level rates for 20 years; generally long enough to get the kids mostly out of the house and pay down the mortgage. And since the premiums are based on your age and you’re not paying for cash values or other features, it’s pretty much the cheapest type of life insurance available.

However even with 20 year term premiums going up every 20 years, they will eventually get too expensive (in fact most term policies expire around age 70 to 80). So while longer term life insurance is great for many folks, there are some folks who have life insurance needs no matter when they die – 50, 80, 99, or 120. For those folks term life insurance simply won’t work, the premiums will eventually be unaffordable.

I came across this video ad on life insurance for father and son. It’s quite touching.

http://blip.tv/file/1030864

Not surprisingly the ad uses a bit of shock value to get you to think about life insurance. They’re trying to get you to think about dying and thus want to buy life insurance. In the life insurance industry this practice is known as ‘driving the hearse up to the door’. I don’t particularly like the practice as I prefer to be more factual and financial on the purchase of life insurance than emotional.

Nevertheless the video is an interesting perspective on family and children; from that angle it’s a great video. Reminds us that we’re all gone at some point and our kids will leave sometime too - so treasure the time we have together and ensure you have no regrets.

In the first post on this topic I mentioned how the first level period of a term insurance policy is priced using the cheaper ’select’ table. Future renewals are then priced using the much more expensive ‘ultimate’ rates table. The underlying difference is that the select table rates are for people who have just taken a medical and proven their health. After 10 or 20 years without a medical exam the average health of insureds starts to look like the general population - the insurance company no longer knows if you’re still healthy and prices accordingly.

HOWEVER! It didn’t use to be this way. Older term policies purchased in Canada prior to the mid 90’s or so were far, far better. If you have a term policy prom that period or prior, you should think long and hard before you cancel it for a newer policy. These older policies were far superior than current policies.

The difference was the renewal premiums. Older term policies used the ’select’ rate tables for the first level premium period…and for future renewals. That’s right, at renewal you would receive the same rates as someone who’s just taken a medical exam, but without taking a medical exam.

For example, a 30 year old who bought a 10 year term policy would initially receive select rates. Upon renewal at age 40, their new, higher rates would be based on someone 40 years old who had just taken a medical exam and proven their health - they would receive ’select’ rates for a 40 year old (and all of this would normally be fully guaranteed until the policy expires). Contrast that with a current term policy where the premiums at age 40 skyrocket since the insurance companies assume you’ve not taken an exam and are potentially unhealthy. In other words, the old policies have pricing similiar to current policies assuming you take a medical exam every 10 years - without having to take the medical exam.

Unfortunately in the 90’s a few American insurance companies entered into the Canadian marketplace. They brought with them lower pricing on the initial premiums, but at the expense of a number of things Canadians were used to in their term policies. Moving from only using the select rates for initial and renewal premiums to only using select rates for the initial premium and ultimate rates for renewal premiums was one of the sacrifices to policies that Canadian insurance companies had to make to remain competitive on the initial premiums.

In summary, if you have a term policy from the mid 90’s or prior, make sure you don’t have one of these older style policies before letting it lapse or cancelling it. You won’t be able to buy a policy with renewal premiums like that again.

In my previous post I discussed how term policies in Canada are technically renewable but the higher renewal premiums mean that for most of us the policy won’t be renewed. Let’s look at what our options actually are upon hitting the first renewal period for your term life insurance policy.

1. You’re healthy and still need the insurance. Well, that’s simple enough - shop out the life insurance (you can use the quoting system on the right side of this page), take a new medical exam and buy a new policy from whatever company is currently offering inexpensive prices.
2. You’re healthy and don’t need the insurance. Well, I guess you might want to drop the insurance. If there’s no current or future need for insurance, no need to pay for it. In my experience though, this is rarely if ever the case.
3. You’re unhealthy. If that’s the case, even if you don’t immediately need the insurance you probably still want to keep it. If you know you’ll either never get life insurance again or only at greatly increased premiums, then hanging on to your existing policy is probably a good idea. But that leaves you with the prospect of those horribly high renewal premiums - the ‘ultimate’ rate tables. Yikes! But there’s a solution that will allow you to go back to the ’select’ rate table without taking a medical exam. This is called the conversion priviledge and I’ll discuss it in detail in a future post. Most but not all companies in Canada offer this conversion priviledge at no cost. I recommend you only ever purchase a term policy that has this conversion priviledge.

Now this might seem that the thing to do is to buy a term policy then take a new medical every few years. In fact, that’s not the proper approach. The problem with this approach is that you are assuming the risk of being able to take a new medical exam in the future. Instead, make sure you buy the proper length of term insurance. If you need insurance for 20 years, buy 20 year term instead of 10 year term twice, with a medical exam in year 11.

Most (but not all) term life insurance policies offered in Canada are known as Renewable and Convertible Term. In this post I’m going to address the ‘renewable’ part of the product description.

Term policies have a period during which the premiums are level and guaranteed not to increase. 10 year term life insurance has premiums that are level for 10 years. 20 year term life insurance has premiums level for 20 years, and so on. The renewable part refers to what happens at the end of that level term.

Quite simply, a renewable term policy means that at the end of the initial level term period the policy does not automatically expire. The premiums will increase but as long as you continue to pay these premiums the policy will continue to be in force. In other words, the policy is automatically renwable as long as you continue to pay the increasing premiums. Generally level term products tend to renew for the same duration as the initial level period. 10 year term, in year 11 has a drastic price increase, but that new higher premium will remain level for another 10 years (years 11-20), then the premiums go up again and are level for another 10 years and so on. This pattern continues to until the expiry date of the term policy - somewhere between the ages of 70 and 80 for most term policies in Canada.

Let me go off on a tangent here for a sec as I lay the groundwork for something else that’s important with the renewable part of term policies. Actuaries (the statisticians that price life insurance) have two sets of rate tables they use for pricing. These two tables are called ‘Select’ and ‘Ultimate’. The select tables contain the mortality rates and prices for those people who have just completed a medical exam and proven their insurability. They would naturally get better rates than the general population (since we know they’re healthy). The ultimate tables reflect people who haven’t taken a medical exam lately. We don’t really know their health.

The premiums for the first 10 years of a 10 year term policy would be priced using the lower select rates since you’ve just taken a medical. The renewal premiums in year 11 and onwards would be priced using the higher, ultimate rate tables since at renewal it’s been 10 years since you proved your insurability and the insurance company no longer knows for sure if you’re healthy or not.

So - initial premiums, cheaper and priced using the select table. Future renewal premiums are priced using the more expensive ultimate tables. As a result, renewal premiums tend to be very expensive. And that means most people want to drop their policy at the first renewal and requalify (take a new medical) for a new policy so that they move back to the less expensive select rates. In fact, the renewal premiums on term policies tend to be so expensive that you’d be nuts to continue with the policy if you’re able to take a new medical exam. So while term insurance is technically ‘renewable’, in effect the high renewal premiums mean few people (only those unhealthy and thus unable to take a new medical) would renew their term policy.