Michael James wrote a thoughtful post
comparing temporary (term) life insurance and permanent life insurance. Like our canine friends above, both are similar, yet different. The best choice depends on different factors. A winner on one scale loses on another. As Michael’s analysis shows, comparisons can be misleading or omit important elements (like inflation).
Typical Plans
A temporary plan like Term 10 is often
- renewable to extend coverage for another 10 years for a higher-but-guaranteed premium
- convertible to permanent insurance without underwriting up to a maximum age
Since a permanent plan lasts for life, there’s no need for renewal or conversion options. Here are typical plans.
| Temporary Life Plan | Permanent Life Plans |
| Term 10 (renewable, convertible) | Term 100 |
| Term 20 (renewable, convertible) | Whole Life |
| Level term to age 65 | Universal Life |
We won’t be looking at which form of insurance is better. We’ll be looking at how they’re different.
First Principles
Mortality rates underlie all life insurance. The
mortality rate is based on the true probability of someone like you (same gender, age, smoking status and health) dying during the year. Your mortality rate increases annually because you’ll die eventually (based on current medical science and how we define life).
Your retail
premium rate is based on your wholesale mortality rate with margins added for expenses and profits. Your
premium is the premium rate multiplied by how much insurance you’re buying. There may be additional loads for premium tax and Investment Income Tax (IIT).
One Year At A Time
When you buy insurance, you are getting one year of protection at a time.
Comparing With Property Insurance
With your car and home insurance, the insurer will usually offer you coverage for another year under similar conditions. Your new premium depends on factors such as their claims (actual vs. projected), expenses (actual vs. projected), investment earnings (actual vs. projected), capital requirements and profit targets.
The insurer could refuse to insure you next year or change the contract provisions (e.g., weaken protection for water damage). You could decide to switch companies.
The Additional Guarantees With Life Insurance
Life insurance also protects you a year at a time but usually
- you have the right to renew your coverage until a maximum age (even if the insurer stops new sales)
- your premium rate scale is fully guaranteed (e.g., you keep your nonsmoker rates if you start smoking or stop exercising in the future)
- your insurer can’t modify the contract unless the change is an improvement
You get this extra protection because you may not be able to switch insurers if your health has deteriorated. You might even become uninsurable.
Yearly Renewable Term
The building block of all life insurance is Yearly Renewable Term (YRT), which is sometimes called Annually Renewable Term (ART).
Do you see the problem?
Your probability of dying during the year increases from 0.01% to 1% to 10% to 80% to 100%. This means your YRT rates will increase every year and become increasingly unaffordable as claims becomes more likely. That’s not good for you or your beneficiaries.
There is a solution: prefunding. Suppose you need insurance for 22 years. You could average the premiums and put that amount into a savings account every year and make withdrawals to pay the YRT premiums.
You could have the insurer invest for you instead. With Term 10 life insurance, you pay a level premium for 10 years at a time. The insurer does the averaging and bears the investment risk. At the extreme, Term 100 life insurance has a level premium for life (and is really permanent insurance and often continues beyond age 100 without further premiums).
Whole life insurance uses YRT rates (which might not be guaranteed). Universal life usually offers two guaranteed scales: YRT and LCOI (Level Cost of Insurance).
Start With The Need
Is your need for insurance temporary or permanent? If you’re addressing the risk of dying while you have financial obligations (e.g., children, a mortgage, a spouse or ex-spouse, other family members), life insurance is the ideal way to create or enhance your estate — if you’re insurable. How else can you get a specified tax-free lump sum at death?
For a temporary need, term life insurance is ideal. You get the most protection for the lowest price.
What If You’re Wrong?
A need which initially looks temporary may last longer than you expect. For instance, a child may have a lifelong disability due to an accident. If you guess wrong, term life insurance gets expensive. You can often renew coverage up to a maximum age without underwriting but the premiums shoot up each time.
Compared with renewing, you may be able to save money by buying a new term plan with new underwriting.
Conversion
Term life insurance often allows you to convert to permanent protection without underwriting up to a maximum age (e.g., 65). You pay the premiums for your age at the time of conversion (your “attained age”).
Example: Suppose you buy Term 10 at age 32. If you convert eight years later, you pay the permanent premium for a 40 year old. This will be more than the permanent insurance premium at 32 and may be more than what a newly underwritten 40 year old would pay for permanent insurance.
Why Permanent Insurance?
You might want permanent life insurance for estate planning. You may not see the need now because you’re not thinking of your legacy. Maybe you will in your 50s or 60s.
The tax-free insurance proceeds can be an inexpensive way to pay taxes at death, leave money for heirs or help a charity. Coverage is available in a cheaper form called Joint Last To Die (JLTD), which insures you and your spouse. The money gets paid when the longest living spouse dies. That’s when the bulk of taxes are due.
Some younger people buy a small amount of permanent insurance for their legacy and a large amount of term insurance for their temporary needs.
An Appreciating Asset
Why does permanent life insurance have a savings component? Further, why do the savings grow on a tax deferred basis? The government doesn’t give valuable advantages without reasons. There are ways you can benefit with planning.
Permanent life insurance grows in value every year because the payout becomes more likely — especially if your health has deteriorated. Your insurance contract could easily have a market value which is much higher than the cash surrender value. An investor may want to buy your contract, pay the future premiums and get the death benefit. That’s called a life settlement. They are legal in the US and several Canadian provinces (but not Ontario).
More
Permanent life insurance gives you the opportunity for tax-deferred savings. Universal life provides the most guarantees, flexibility and transparency. You could
- invest more (limited by the Maximum Tax Actuarial Reserve (MTAR))
- select the investments
- stop paying premiums (e.g., in 20 years or at age 65), though not always guaranteed
Having more options helps with tax planning, especially for incorporated businesses.
Affordability
You can offset the cost of your insurance by reducing your coverage as
- your financial responsibilities drop (e.g., children older, mortgage smaller, spouse’s income)
- your assets grow (e.g., savings, pension)
Before you do, consider inflation which decreases the value of money. Also, your financial obligations could grow (e.g., new children, divorce, health issues).
Conclusion
Temporary life insurance gets compared with permanent life insurance but both cover different needs and timeframes. Since advisors get paid much more for selling permanent insurance, they may have biases they don’t even realize. Explore different scenarios before deciding and re-evaluate your needs over time.
For general questions, ask below. I'll answer what I can here or on
Question an Actuary (QanA). For personalized answers, reserve time to
Learn About Life.
Links
PS Remember insurance for disability, critical illnesses and long-term care too.
There are lots of reasons to read a book about money and there are lots of books about money. Tony Robbins has a new one, Money: Master The Game.
