Life Insurance Policy Basics
Some people get all worked up over the topic of life insurance.
They call it “gambling” while others call it an “outright scam.” And… some people are just plain confused and don’t know what to think about it.
But, it’s probably best to clear up that misunderstanding now, and fast.
Life insurance is a contract used to accumulate a sum of money for the future. In other words, it’s a special form of savings — conditional savings.
The contract pays out when you die or, in some cases, if you live to a certain age. Some policies allow you to spend your death benefit before you die while also growing an equity value (cash savings) you can spend and use within days of buying your policy.
The policy is a legally-binding contract where an insurance company makes certain promises and takes on certain obligations in exchange for payment from you, the policyowner.
The purpose of any life insurance policy is to transfer financial risk away from an individual and onto an insurance company, which provides that individual with economic protection against financial loss that might occur if certain events happen — death, illness, or disability.
Some life insurance policies protect only against the financial risk of death, while others make provisions for chronic illness, disability, and other financial risks.
Make sense so far?
Then, let’s dig further into the details…
Why Does This Matter?
Why does this matter?
The tl;dr version:
- Insurance is for anyone who has something valuable they want to protect. If you believe your income and savings is valuable and worth protecting (for yourself and/or your beneficiaries), and you want to guarantee it will never be lost, a life insurance policy is for you.
- A life insurance policy may also help you accumulate a savings and pay off debt in a more efficient manner, eliminating the risk of you not saving enough money for your future goals and needs.
- Some life insurance policies can protect you from a wide range of risks while you’re alive, including the risk of illness, unemployment, or loss of savings from a bad investment.
Basic Structure Of A Life Insurance Policy
The premium is how life insurance companies charge for insurance policies. It includes the cost of insurance as well as other factors which the life insurance company must account for.
Premiums can also include excess investible monies which may or may not be returned to you, so… premiums do not necessarily represent the “cost” of insurance, because they can include refundable amounts, amounts set aside for cash values, and other benefits.
It’s best to think of a premium as the payment you make in exchange for having the policy.
Determining what that payment should be is the job of a life insurance actuary. An actuary is a professional mathematician who is responsible for bringing together various financial and statistical data.
Establishing a sustainable or realistic premium for a policy is very important, since the wrong premium can cause an insurance company to become insolvent or bankrupt.
For example, insurance rates that are embedded in a premium have to be high enough to cover the costs of paying death (and other living benefit) claims of the life insurance policy, but also low enough to be competitive.
Rates for term life and universal life insurance are usually expressed as an annual cost per $1,000 of insurance. While cost-per-thousand is not explicitly disclosed in whole life policies, it can be calculated indirectly by your insurance agent or broker.
This “per $1,000” is a sort of “unit cost” or “unit price” of insurance. And, it can be very useful in comparing two different insurance policies to see which one offers an overall lower premium. Lower cost per $1,000 doesn’t always mean a better deal, but it can.
For term insurance, the premium is usually fairly close to the actual cost of insurance plus commission for the agent. In whole life and universal life, premiums diverge from the cost of insurance because a substantial portion of the premium must be set aside to build the guaranteed cash value, non-guaranteed cash value, and for other policy benefits.
In other words, premiums for whole life and universal life represent more than the actual cost for life insurance.
The death benefit is exactly what it sounds like. It is the amount of money the insurance company pays to your beneficiaries when you die.
This is essentially what you are buying when you buy a life insurance policy — the death benefit. Death benefit is sometimes called “net amount at risk” or “pure insurance protection” because it is the amount of money the insurance company is risking if you die.
In some policies, like whole life insurance, the pure insurance or net amount at risk is the difference between the total death benefit and the net cash surrender value of the policy.
For example, a $1 million term insurance policy is made up of $1 million of pure insurance. But, a $1 million whole life policy which has $100,000 of cash value only has $900,000 of pure insurance ($1,000,000 death benefit – $100,000 of cash value = $900,000 of pure insurance), with the remainder of the death benefit “covered” by the cash value of the policy.
Some life insurance policies have special provisions, called “accelerated death benefits,” which allow you to spend your death benefit while you’re still alive.
For example, a policy might allow you to spend down your death benefit if you have a chronic or terminal illness. The newest policy designs in the marketplace allow you to convert your death benefit into monthly income once you reach age 85.
But, normally, the death benefit is reserved for when you die. The money is paid to your beneficiaries.
Cash value is the savings portion of whole life, universal life, and variable life insurance policies. It is, technically, money that is set aside to help pay for the future death benefit.
Not all life insurance policies have cash values. Term insurance, for example, has no explicit cash value. It may, however, have implicit cash values or reserve amounts which are refunded to the policyowner at the end of the fixed term period.
Life insurance policies with explicit cash values (called “cash surrender value”) usually have a guaranteed growth rate. In addition to the guaranteed growth rate, there may be a non-guaranteed growth rate that fluctuates each year according to various factors determined by the type of contract, the insurance company, and the policyowner’s actions. Non-guaranteed, in this context, means that the growth rate is not known in advance. Regardless, once non-guaranteed interest becomes known, and is credited to the policy, it becomes part of the guaranteed cash value.
The exception to this is variable life and variable universal life insurance, which have no guaranteed cash values. All cash values for these policies are non-guaranteed. Non-guaranteed cash values for variable and variable universal life may lose value, so it is possible for cash values to be reduced to $0.
In both cases, cash values represent the equity in the policy, which can be surrendered, withdrawn, or borrowed against (using the policy as collateral for the loan).
Policyowner or Policyholder
The policyowner (or policyholder) is the individual or company that has ownership rights in the policy. They own and control the contract, can make changes to the beneficiary designations, are responsible for paying premiums, and so on.
A policyowner who owns a whole life insurance policy with a mutual life insurance company also acquires ownership rights or membership rights in the life insurance company. As such, he or she is entitled to the profits of the company (which are typically paid as an annual dividend) as well as vote the board of directors, CEO, and other officers of the company.
The person insured by the contract is listed as the “insured” in the policy documents. This person’s life is insured. Their death triggers payment of the death benefit.
In most cases, the policyowner and insured are the same person. However, the policyowner and insured can be two different people.
The beneficiary is the individual, people, or organizations which receive the death benefit proceeds after the insured person dies.
Beneficiary Designations And Distribution Methods
Why Name A Beneficiary?
The tl;dr version is… it prevents your beneficiaries from being royally screwed over.
Naming a beneficiary means that the death benefit proceeds go directly to the person or people (or organization) you name in the contract as beneficiary.
Without a named beneficiary, the death benefit proceeds are paid to your estate after your death. Then, those proceeds must go through the normal probate process, which can be very costly.
If your will or estate is contested, or there are any disputes during the estate settling process, it can tie up the death benefit proceeds for months or perhaps years.
Named beneficiaries prevent this and ensure all of the death benefit is paid quickly and directly to your heirs in the manner in which you intended it to be.
The primary beneficiary or beneficiaries are the “first in line” to receive your death benefit proceeds.
If the primary beneficiaries are deceased, then those benefits are paid to your named secondary beneficiary (sometimes called a “contingent beneficiary”).
Otherwise, all proceeds go to the primary beneficiaries.
Life insurance policies allow for tertiary (“third in line”) beneficiaries, but most people do not name them.
It might be a good idea, however. If both the primary and secondary beneficiaries cannot take possession of the death benefit proceeds, then they are paid to the tertiary beneficiary.
How Your Death Benefit Can Be Distributed
Or “by branch”… this method of distributing your death benefit proceeds gives each “branch” of your family or non-family beneficiaries (e.g. if it’s a non-profit organization) an equal share of the death benefit.
If one of your beneficiaries dies before you do, then their share of the death benefit is split equally among their beneficiaries. Your other surviving beneficiaries receive their normal share.
For example, let’s say you leave $100,000 to 3 beneficiaries, A, B, and C.
Both A and B die before you. C survives.
C receives 1/3rd of your death benefit. A has 2 beneficiaries and B has only 1 beneficiary.
So, A’s beneficiaries split A’s inheritance equally, meaning each of A’s beneficiaries get $16,666.66.
Meanwhile, B’s beneficiary gets $33,333.33.
This is how most people do it and the default method used by many life insurance companies.
Or “by the head”… this is an alternative method of having your death benefit proceeds distributed to your heirs.
Under this method, if one (or more) of your beneficiaries dies before you do, then your surviving beneficiaries receive their normal share but… your deceased beneficiary’s beneficiary (your heir’s heirs) split whatever is left over equally among themselves.
For example, let’s say you leave $100,000 to 3 beneficiaries, A, B, and C. A and B both die before you do. C survives.
C receives 1/3rd of your death benefit. The remaining 2/3rds is split between A’s and B’s beneficiaries or surviving heirs.
So… in this example, C would get $33,333.33. But, A’s and B’s beneficiaries would split the remaining $66,666.66.
If A has 2 beneficiaries and B has 1 beneficiary, then each of their beneficiaries gets $22,222.22.
A Visual Model Of Per Stirpes and Per Capita
Of course, you can also choose a customized distribution of your death benefit, if you want to. Reasons for this might be that you don’t want B’s beneficiaries to get anything because you think they’re spoiled brats or you just don’t get along with them.
Or, maybe you want to give one of A’s beneficiary’s more money than the other.
Most insurance companies are happy to split the death benefit proceeds up any way you like. However, if you are making a personalized or customized distribution plan for your death benefit, it must be in writing. Most life insurers have special beneficiary distribution forms you must fill out for this purpose. Also, the distribution plan must be reviewed by the insurance company’s home office to make sure there won’t be any legal or other problems distributing your death benefit.
They will approve just about any distribution plan you want, but again just keep in mind every plan must be reviewed. The review process can take several weeks.
Death Benefit Settlement Options
You have lots and lots and lots of choices when it comes to how your death benefit is paid.
Aside from just naming beneficiaries, you can also restrict access to your death benefit. Why would you do this?
I dunno. Maybe you think your heirs are bad with money so you want to make sure it lasts. Or, maybe your spouse isn’t comfortable handling a large lump sum of money and would prefer a monthly income instead.
You can specify this in your life insurance policy.
Payment options are sometimes called by their more formal (AKA boring) name: “settlement options.”
So, if you hear or see the word “settlement option,” it refers to how your death benefit will be paid out to your beneficiaries.
Generally, there are 5 different accepted settlement options:
- Lump sum Interest-only fixed period fixed amount and Lifetime income
- Interest-only Fixed period fixed amount and Lifetime income
- Fixed period Fixed amount and Lifetime income
- Fixed amount and, Lifetime income
- Lifetime income
Lump Sum Payment
Lump sum means your beneficiaries get a lump sum of money.
This used to be the only option available to beneficiaries, but today, most people opt for a structured income option.
Under an interest-only option, the lump death benefit is left with the insurance company and the company invests it for you in its general investment account or guaranteed interest account. The major benefit to this approach is death benefit amount stays intact and is never depleted.
Both the general account and guaranteed interest account pay a stable, fixed, interest rate. Your beneficiaries draw only the interest from the death benefit. This is a good option if you have enough death benefit to generate the income your heirs need.
The guaranteed rate can never be below the contractual minimum, but it may be higher if the insurer is able to generate excess profits with the money. Either way, both the death benefit and interest income is guaranteed so it cannot be lost.
A fixed-period option pays your beneficiaries the death benefit over time in equal installments. The death benefit remains invested, so your beneficiaries receive both the death benefit and any interest earnings the death benefit earns.
If you’re familiar with a period certain annuity or how some pension payments work, it’s very similar to those.
The fixed-amount option is an income option in which your beneficiaries receive a specific income, which either you or they choose, and which is guaranteed for as long as the proceeds last. The death benefit is invested and generates interest, which is added to the payment.
The payment amount, and interest earned, determine how long the payments last.
Life Income Options
Your beneficiaries receive a guaranteed income for the rest of their life, no matter how long they live. The payment amount is determined by the amount of the death benefit and the amount of interest the insurance company is willing to guarantee at the time of your death.
Payments are fixed and guaranteed and cannot be higher or lower than promised. Even if the death benefit is completely depleted, the payments must continue for as long as your beneficiaries live.
This option is basically a lifetime annuity payment. Some insurers will also offer a cash refund or beneficiary income payments after your beneficiaries die. So, it’s possible for your death benefit to span generations.
Viatical And Life Settlement
It’s possible to settle your death benefit before you die, effectively disinheriting your beneficiaries.
Some people choose this option if they need money before they die and decide they don’t want to keep their life insurance. This option allows you to sell your life insurance death benefit to an investor through the secondary viatical settlement or life settlement marketplace.
Viatical settlements are for individuals who have a terminal or severe chronic illness from which they are not expected to recover. Hopefully, you never find yourself in this position but, if you do, you can sell your life insurance policy for cash.
The proceeds are usually paid as a lump sum.
When you die, your death benefit is paid to the investor or company that purchased your life insurance policy.
A life settlement works very similarly to a viatical settlement except that you do not need to be sick or dying to sell your policy. Most life settlement options are only open to individuals who are very advanced in age… like 75 or 80 years old. However, some life settlement companies will buy your life insurance policy from you if you’re in your 60s.
In most cases, you will receive between 50% and 80% of the death benefit of your insurance policy as cash payment. The policy ownership is when transferred to the investor who then changes the beneficiary designation so that they receive your death benefit when you die.
On Death Benefits
Normally, your beneficiaries or heirs are not going to pay income tax on death benefit (the principal amount). However, if your beneficiaries choose an income option, they will pay income tax on any interest generated from the death benefit.
Your heirs might pay estate taxes on death benefits though if the death benefit exceeds the estate tax exemption limit. However, this can generally be avoided by placing a life insurance policy in an irrevocable trust before you die.
In rare cases, something called the “transfer for value rule” will kick in. This only happens when you sell your policy to an investor (as in the case of a viatical or life settlement). In these cases, the investor pays tax on the gains made from the transaction.
On Cash Values
Cash values in life insurance policies are generally not taxed as long as the policy remains in-force.
If you surrender a policy with cash values, however, you will be taxed on any gains in the policy. A cash value gain is the difference between the total premiums you’ve paid to-date and the net cash surrender value at the time you cancel and surrender the policy.
For example, if you’ve paid $5,000 in premiums and your cash surrender value is $6,000, then your gain in the policy is $1,000. This ($1,000) is the amount that will be subject to income tax.
Another way cash values can be taxed in a life insurance policy is if the policy is redefined as a modified endowment contract (MEC) by the IRS. The IRS defines what a life insurance policy is by applying special tax rules to the premium payments and cash value buildup of a life insurance policy.
A modified endowment contract (MEC) is a special tax qualification for all cash value life insurance policies which arises when the cumulative premiums paid to the insurer exceeds the federal (IRS) tax law limits for that policy. Every whole life policy, universal life policy, and variable life policy is subject to these limits.
Specifically, certain aspects of the modified endowment contract become taxable whereas they were not taxable under the original life insurance policy arrangement.
For example, in a MEC, any gains in the policy (cash values in excess of the premiums you paid) are taxable at ordinary income tax rates when you withdraw them or take on policy loans. This money is assumed to be withdrawn or borrowed first, meaning there is no way to avoid taxation on gains if you tap your policy cash values.
In addition to the tax, withdrawals prior to age of 59 1/2 are assessed an early withdrawal penalty of 10% (similar to the penalty applied to retirement accounts for early withdrawal).
As you might imagine, most of the time, this is undesirable.
This MEC classification is permanent and cannot be undone (not even by skipping premiums in later years).
In other words, once you go tax, you can never go back.
Death benefits for MEC policies aren’t subject to income tax, however. Some people do intentionally buy modified endowment policies. These folks intend to use them as endowments and do not plan on using the cash values while they are alive so the taxation of the cash values is a non-issue for them.
With that said, while it is usually undesirable to have a MEC, it is not always undesirable.
Out Of Pocket Payments vs Annual Internal Costs
Out of pocket payments are exactly what they sound like. They are the out of pocket premiums you pay to the life insurance company.
Out of pocket premiums do not necessarily represent the cost of insurance or the total expenses of the policy.
With term life insurance, most of the time, the premium is equal to (or pretty close to) the cost for pure insurance. With whole life, universal life, and variable life, the premium is not the same thing as “cost.” Part of the premium goes toward building the cash value and part of the premium goes toward various policy expenses.
This is why looking at cost and payment indices is important as is having your agent or financial advisor calculate the internal costs of the policy you’re thinking of buying.
Net Internal Policy Costs
Net internal policy cost is usually calculated by subtracting any cash value, guaranteed interest, and dividend payments from the premium you’ve paid. Whatever is left over is, by definition, the net internal cost of the policy.
These costs include the cost for pure insurance, costs for managing the investments in the life insurance company’s general investment account, the life insurance agent or broker’s commission, and other miscellaneous fees.
Even when you pay no premiums, there are policy charges. These charges are usually deducted from the investment earnings on your cash value.
The net cash value you see on policy illustrations and your policy contract, however, will always show the net cash value amount after all fees, commissions, and other expenses have been deducted. In other words, it is the actual amount of money you have to spend or use. This is done for your convenience so that you do not have to calculate these costs yourself (and also to avoid confusion about how much money you have built up in your policy) .
Once you have the net internal costs, you can compare them to other policy types which have a savings component. If you compare a whole life policy to term insurance, however, make sure you include the cost of term insurance as well as costs for a hypothetical investment since whole life is not just insurance… it is insurance and savings and includes costs for both.
When you compare the out of pocket payments or net internal policy costs, you should also always make your comparison over the same time periods and use the same cash outlay in both scenarios.
For example, if you are comparing term life to whole life, the only accurate way to compare the two is to assume you pay the same premium to both strategies.
If you are comparing a $1,000,000 whole life policy where you pay $10,000 in annual premium, you should compare it to a $1,000,000 term policy where you pay the cost of term insurance and then invest the remainder in an investment fund of the same or similar risk class over the same period of time, say 30 years.
In effect, you will be comparing $10,000 going into whole life insurance to $10,000 going into a term insurance and investment plan over 30 years. Then, you observe which plan seems to perform better given the costs, benefits, and risks you’re taking with both strategies and… you make a decision about which way you want to go based on that information.
Speaking of costs, there is a great big misunderstanding when it comes to how life insurance is priced, what you pay, and what the internal costs of a policy are.
Knowing how life insurance is priced will take some time to learn, but it will save you a lot of time and frustration later on…
Cost Indices And Advanced Cost Discovery Methods For Comparing Policies
Listen to me now and hear me later: Premiums do not equal cost.
As I mentioned early on in this section, premiums are payments you make in exchange for a bunch of promises from the insurance company.
But… there are costs. Always costs… and those costs are often tucked underneath the “surface” of the insurance policy.
Term. Whole life. Universal life. They all have internal or embedded costs.
The way to see those costs is to look at the cost index for the policy as well as a few other cost discovery calculations.
Cost indices are numbers that insurance companies use to tell you how much an insurance policy costs —both now and into the future. It does this by moving costs between various time periods so you have a better understanding of how a life insurance policy distributes costs and how much the policy will cost you over time.
Lots of pretend financial experts like to say that you should just go with the lowest premium. But… lowest premium does not equal the lowest cost. That’s because a lot of things go into a premium that do not include costs… like refundable premium amounts (premium credits on term and whole life) and cash values (which is equity of a permanent life insurance policy).
Enter, the cost indices.
A cost index lets you strip out some of the complexity of both term insurance and whole life (and universal life) to see the underlying costs. And, it’s printed in every illustration you get from an insurance company.
There are two primary cost indices: the interest-adjusted surrender cost index and the net payment cost index. Another method that’s commonly used is the net cost index or net cost method.
Net Cost Index
I don’t want to spend a lot of time on this one since it is rarely used anymore and, when it is, it gives almost no useable information to you as a buyer.
The net cost method is essentially the premiums you’ve paid in, less any accrued dividends and net cash surrender value. It does not take into account the effect of interest over time, so it doesn’t give you a very meaningful number.
In fact, it can give you a meaningless number since it’s possible to calculate a negative net cost. This is absurd, since life insurance always has a cost.
Why does this happen, then?
The net cost method ignores the time value of money. Time value of money is the value of money over time, usually expressed as an interest rate. Without adjusting for this interest factor, you can’t get any kind of sense for what the insurance is really costing you over time.
For this reason, we usually use an interest-adjusted surrender cost index or net payment index in combination with other cost-discovery methods.
Interest-Adjusted Surrender Cost Index
This number helps you figure out the relative cost of life insurance with cash values, where your primary concern is the implied cost for having those cash values.
It assumes you will surrender the policy at some point in the future.
The “quick and dirty” formula for calculating the index number is to take the total premium you pay to the insurance company, and subtract any dividends you receive as well as the net cash surrender value. The result is the “net cost.”
From there, the insurance company calculates the “cost per $1,000” (which is sort of like the “unit price” or “unit cost” of life insurance) by dividing the face amount of insurance (the death benefit) by 1,000. Then, the net cost is divided by that dollar amount.
This gives a total net cost per $1,000 of insurance, which is then adjusted by an annuity factor so that you can better understand those costs as annual costs instead of cumulative costs. The annuity factor is essentially discounting the cost per $1,000 so that you see those costs in today’s dollars (which is simple to understand) as opposed to future dollars (which is much more difficult to understand).
The insurer then publishes this cost in your life insurance policy illustration. It will look something like: $12.54 or $5.75. The dollar amounts correspond to specific policy years.
These dollar amounts are the cost per $1,000 of insurance assuming you surrender the policy for its cash value in the year listed by the dollar amount. For example, if you see “$12.54” in year 10, it means you would pay $12.54 per $1,000 of insurance if you surrendered the policy in year 10. This figure takes into account the effect the cash value has on your cost of insurance.
If you see a figure like $5.75 at policy year 20, then (in this example) it means your surrender cost at year 10 was $12.54, but at year 20 it dropped to $5.75, indicating that the policy got cheaper over time and less of your premium dollars and interest earnings went toward paying for insurance over the course of 20 years.
Interest-Adjusted Net Payment Cost Index
The net payment cost index uses the same calculation as the surrender cost index except… it does not assume you will surrender the life insurance policy.
Because of this, it tells you what the cost of the policy is if you just keep paying premiums forever (until the policy matures and no more premiums are payable). In essence, it is telling you the cost per $1,000 of death benefit, ignoring the impact of the cash value of a policy.
For term insurance policies, this is the only index used, since term policies do not have cash values.
How To Use Cost Indices
Fortunately, you don’t need to know any math to use cost indices. The insurance company publishes them for you in your life insurance policy illustration.
It’s really very simple: if your primary concern is cost, then choose the lowest index number when comparing two similar policies (e.g. whole life vs whole life, term vs term, universal life vs universal life).
The Disadvantage Of Using Cost Indices
There’s always a catch, right?
The disadvantage of using cost indices is that you cannot accurately compare two dissimilar policies (e.g. you cannot accurately compare term against whole life insurance) and… you cannot get a sense for how each policy performs.
Cost indices also do not tell you anything about the value of any policy riders or other benefits. A more expensive policy might be more expensive because it comes with a chronic illness or long-term care insurance rider, which pays a cash benefit if you need skilled nursing care.
How much you value this kind of benefit should be part of your decision-making process.
Finally, cost indices are based on current policy charges and rates of return and might not actually predict future costs. This is not a problem unique to the life insurance industry. Cost indices and similar methods used in the investment industry have the same problems. Still, it’s worth knowing.
Other Cost Discovery Methods
There are probably as many ways to tease costs out of a life insurance policy as there are flavors of ice cream. Some methods are more useful than others.
A few of these methods include:
- The Benchmark Method
- The Linton Yield Method
- The Fechtel Method
- The IRR Method
Each of these has its strengths and weaknesses.
For example, the benchmark method calculates costs of a cash value life insurance policy by dividing total charges under the policy by the amount of pure life insurance (pure insurance).
This method was devised by Professor Joseph M Belth to figure out whether an investment-focused policy was a worthwhile purchase. Belth’s formula is:
YPT = (P + CVP)(1+i)-(CV + D) / (DB – CV)((0.001)
YPT = Yearly price per $1,000 of insurance
P = Annual premium
CVP = Cash value at the end of the preceding year
i = The assumed interest rate paid to cash values
CV = The cash value at the end of the year
D = The annual dividend paid, if any
DB = Death benefit at the end of the year
The Linton Yield method uses a slightly different approach.
The cash surrender value of a policy is subtracted from its face amount (the death benefit, in most cases). The result is the net amount at risk (which, as you will recall, is the difference between the cash value and the death benefit, also called “pure insurance” or “pure insurance protection”). This (the net amount at risk) is considered the term insurance portion of the policy and used as such in the calculation.
Based on the insured person’s age, gender, and health, a second calculation is done to figure out what the insured person would have to spend to buy term insurance equal to the net amount at risk.
This cost, along with the projected annual dividend, is then subtracted from the policy’s annual premium.
The next step is to run the Linton Yield calculation, which is complex enough that it requires a computer and some spreadsheet skills. The final result takes into account the hypothetical cost of term insurance plus an investment, which is then used to compare dissimilar life insurance policies to come up with an answer to the one great mystery in the life insurance industry: which policy should I buy?
The Linton Yield calculates what amounts to a hypothetical rate of return, which is used to compare rates of return of other life insurance policies and could conceivably be used to compare non-insurance savings strategies.
The strength of this method is that it tries to compare rates of return, which most calculations don’t even attempt.
The downside is that is uses hypothetical costs for the pure insurance instead of trying to directly calculate the actual cost of insurance of the policy being analyzed. It basically avoids the question of “what does this thing cost” in favor of answering, “this is what a hypothetical policy similar to this one might cost.”
Finally, the Fechtel Method uses a calculation similar to what life insurance companies use to calculate cash value increase in permanent life insurance policies like whole life, universal life, and variable life.
The calculation is:
Annual Illustrated Costs = (Prior Year-End Cash-Value + Premium Paid) – ( Current Year-End Cash-Value / (1+illustration’s compounding rate) )
From here, the agent or advisor (or you) can calculate a hypothetical cost per $1,000 using this calculation:
Annual Cost per thousand Dollars of Coverage = Annual Illustrated Costs / Annual At-Risk Amount In Thousands
One thing to mention about the Fechtel method is that the annual cost per $1,000 is assumed to be a cost of insurance. It is not.
The annual stream of costs calculated by the Fechtel Method includes all policy costs, not just the cost of insurance. So, the costs calculated include cost of insurance, policy fees, agent commissions, and other miscellaneous fees.
This is actually a good thing since it provides a comprehensive view of all internal policy costs.
However, when calculating the cost per $1,000 of insurance, Fechtel’s formula squeezes those annual calculated costs into the net amount at risk (pure insurance) and assumes the cost of insurance is higher than it really is.
In other words, it assumes the annual illustrated costs represent the cost for net amount at risk or the pure insurance amount (which, again, is death benefit less cash value). In reality, those annual illustrated costs are for the entire death benefit amount.
So, when I calculate costs for clients, my general approach is to use a modified version of this calculation, which shows the costs for the entire death benefit amount.
In addition to this calculation, I use the final method, which is an IRR Method.
IRR stands for “Internal Rate Of Return,” and is an iterative calculation (which requires a spreadsheet program capable of running iterative calculations, like Excel, and a spreadsheet user that’s savvy enough to overcome Excel’s IRR formula bug). Iterative means it’s a “trial and error” calculation that has to be run over and over again, with slight changes in the assumptions being used, until the correct answer is found.
IRR shows the effective compound annual return on policy cash values from the perspective of the policyowner. If done correctly, it will reverse-engineer the compound annual growth rate on cash values.
If done incorrectly, however, it shows the incorrect return. Excel’s IRR function contains a known software bug which generates more than one answer. But… when doing iterative calculations, there can be only one, Highlander!
Thus, if you attempt to calculate the IRR for your own life insurance policy, you need to force Excel to show you the correct value. To do this, you must calculate IRR for each year and then string those years together to get a true dollar-weighted (investor) return on cash values.
The IRR function, if used correctly, shows you the real compound annual return on your money, net of all fees, taxes (there are usually no taxes on cash values), and commissions.
Seeing both the costs and projected return on cash values gives you a very good idea about the cost and benefit of a life insurance policy, which is something you can compare to just about anything… whether it’s another life insurance policy or… some other non-insurance savings strategy.
Factors That Affect Your Premium Rates And Cost Of Insurance
Now that you know what these cost index thingies are, and how to calculate the internal costs on life insurance, what else is there to know?
Much, young Padawan. Much.
For, even if you know how to calculate the cost of your insurance policy, and even if you know what the cost index is and even if you know what the internal rate of return on policy cash values are… you are still missing one thing.
And that one thing is…
What affects your premium rates and cost of insurance in the first place?
Ideally, you want a low cost of insurance, and a premium rate that gives you a high return on your policy. For example, you would ideally like a low cost of insurance and a high premium refund or conversion credit for term life insurance.
Or… you ideally want a low cost of insurance and high cash value on whole life or universal life insurance.
To get into that sweet spot, you want as much control as possible over the three basic factors that go into premium pricing:
- Mortality Factor
- Interest Factor
- Expense Factor
The Mortality Factor
Of these, the mortality factor has the biggest impact on the cost of insurance. Both the expense and interest factors are generally the same for all policyowners.
But, how do you control the mortality factor?
Well, on an individual level, you make sure you live a reasonably healthy lifestyle. Generally, this means maintaining a good Body Mass Index (BMI) and an appropriate waist circumference for your age and sex.
BMI is calculated using your height and weight. When BMI is combined with a waist circumference measurement, it becomes a very good predictor of general health as well as a predictor of potential chronic illness over the long-term.
Life insurance companies use either BMI or both BMI and waist circumference in underwriting.
In general, waist circumference should be less than 40 inches for males and less than 35 inches for females.
But… it’s more than just BMI and waist circumference. Life insurers also take blood and urine samples to test for kidney and liver function, HbA1c, and cholesterol, among other things.
Along with your general health, your lifestyle is also a predictor of mortality. If you’re a base jumper or sky diver, you’re a higher risk than someone who jogs and goes to the gym 3 days a week.
If you smoke and have a glove box full of speeding tickets for street racing, you’re a higher risk than someone who does not smoke and doesn’t have a history of reckless driving.
I cover this in more detail in The Underwriting Process section of this guide if you want to know more (link is below at the end of this section).
Aside from keeping your own house in order, you want to know the general mortality risk of other policyholders you plan on jumping into the pond with.
You see, when you buy life insurance, you are casting your money into a big pool with other people who are also buying insurance. The insurance company has to manage this risk for everyone. Some insurers take on more risk than others and some insurers are better at managing certain risks than others.
In case I haven’t beat this suggestion to death, it pays to get an insurance broker to help you navigate the insurance landscape to find an insurer that is really good at managing risks similar to the ones you personally represent to the insurer.
So, for example, if you are reasonably healthy, you want an insurer who has lots of other healthy folks and tightly controls the high risk folks it lets into its fold…
… if you have health problems, you want an insurer that is good at managing those risks too… usually through reinsurance.
… if you need a large life insurance policy, your insurer should have a high retention limit and the ability to keep costs under control. Otherwise, you will end up overpaying for insurance over the long-term.
Moving right along…
The Interest Factor
The interest factor is arguably the second-most important factor in determining premium rates. All life insurance policies which are not annually-renewable term (which is basically every policy, both term and permanent) contain an investment function.
The investment function can be used to help offset the cost of insurance. For example, if your cost of insurance is $5, the insurance company would normally charge you $5 (makes sense, right?). But, if it can earn $3 from your premium payments, it only needs to charge you $2 in premium to pay the full cost of insurance ($2 in premium + $3 investment earnings = $5).
If the insurer can only earn $1 in investment income, then it must charge you $4 in premium. Either way, you pay less than the full cost of insurance. This method is used for term, whole life, and universal life insurance.
Investments also help an insurer pay for the future death benefit of a policy and help reduce its outstanding liabilities.
With term life insurance, you do not see this investment function unless you purchase a term policy with a return of premium option (where premiums are refunded to you after the term policy’s level premium period ends). But, all level term policies have low, but non-zero, policy reserves. These reserves are a function of the fact that most term policies have a level premium. The insurer charges more than what’s actually necessary to pay for the cost of insurance. More on this in the Term Life Insurance section of this guide.
With whole life and universal life, the investment function is clear and obvious: the cash value.
Life insurance companies collect premiums and invest them to help pay for the rising cost of insurance (thus keeping your premiums level), or to help pay for the future death benefit (as is the case with permanent insurance), or both.
How do life insurers invest your premium dollars?
According to the 2017 Life Insurers Fact Book, life insurance companies primarily invest in 4 different assets:
- Mortgage and real estate holdings, and;
- Policy loans
Bonds, including both corporate and government bonds (though most life insurers do not invest a substantial amount of money in U.S. Treasuries). Roughly 68% or 2/3rds of the bonds in a life insurer’s general account (where premium dollars end up) are invested in what are called “unaffiliated securities.” Usually, these are high-quality corporate bonds, both foreign and domestic.
Because insurers have incredible buying power, they’re able to buy bond issues which are generally not available to the general public.
These bond issues are primarily what secure the guarantees of their policies.
Stocks make up the second-largest holding for many life insurers, at 30% of total assets in the general investment account. Stocks are usually purchased for their ability to generate income and appreciation.
Mortgages and Real Estate
Mortgages are a bit more risky than bonds, so insurers tend to hold fewer mortgages and less overall mortgage debt than their other investments. Still, mortgages represent about 7% or so of insurance company holdings.
Most of these are commercial mortgages on hospitals, retail stores, shopping centers, office buildings, factories, and commercial apartment buildings. Residential mortgages comprise just 3.5% of total mortgage holdings.
Life insurance companies also hold real estate directly. But, direct property ownership is small — just 0.7% of total general account assets. Most properties are income-producing.
Finally, there are policy loans. Life insurance companies lend money to policyowners who own the company’s whole life and universal life insurance.
Because the insurer has to make good on its guarantees and promises, it must charge interest on all policy loans. Instead of investing money elsewhere, the insurer is essentially investing in its own policyowners. This loan interest becomes profit to the insurer like any other investment and represents a very low-risk investment for the insurance company (most people are protective of their own policy’s cash values).
Policy loans represent roughly 2% of investment holdings in the general account.
Net Rate Of Return
Life insurers realized a net return of 4.86% on the general account. This excludes the insurer’s separate account which is comprised of mostly stocks and other investments. Total net return on all invested assets was 4.5%.
These are industry averages. Some insurers earn more on their general account assets and total invested assets, some earn less.
The discrepancy between insurance companies often comes down to the investment philosophy of the life insurance company, the skill possessed by the investment managers, the amount of premium the insurer is collecting, and the insurer’s unique competitive advantage in the marketplace.
For example, some life insurers have access to rare investment opportunities through venture capital deals and are thus able to consistently edge out their peers year-after-year.
Other insurers have more buying power than their peers and thus generate higher yield on assets. Still others own numerous other businesses, like investment advisory firms and brokerages which they use to generate more income.
And, some insurers use a combination of tactics and advantages to earn above-average returns.
How To Get The Most Out Of An Insurer’s Investment Returns
Some whole life insurance policies aren’t just life insurance. They also represent partial ownership or membership in the life insurance companies. Typically, these types of policies are sold by mutual life insurance companies.
Mutual life insurers (discussed later in this guide) have no outside stockholders and are instead owned by their policyholders and must, by contract and by law, return profits to their owners. Profit is, of course, generated by expense savings and by investment gains.
This results in a dividend payment each and every year the insurance company is profitable and earns money above what is necessary to pay the basic guarantees of the policy and fund the insurer’s policy reserves.
While dividends are obviously never guaranteed (as profits can’t be guaranteed), most mutual life insurers have paid healthy (and generally increasing) dividends for over 100 years, with the oldest mutuals paying dividends for over 150-170 consecutive years.
The Expense Factor
The third, and final, factor that impacts your premium is expenses. Life insurance companies have expenses, just like any other business.
Most of these expenses are operating expenses, like labor costs (personnel costs, costs to hire, train, and pay salespeople, etc), supplies, rent, utilities, local, state, and federal income (and other) taxes, and so on.
The premium of a life insurance policy must include a share of all these expenses, sometimes called “loading” or “loading charge.”
Net Premium vs Gross Premium Calculations
While mortality, interest, and expense are the most basic factors affecting premiums, they are not the only factors.
Life insurance actuaries (professional mathematicians who design life insurance contracts) also include various calculations and make assumptions about these basic factors.
These assumptions include calculations for net single premium, net level premium, and gross premium.
Net single premium is basically just a hypothetical single premium amount needed today which, when combined with interest from the general account investment earnings, would be enough to pay for all future benefits of the policy. It’s like as if you paid a single one-time premium today, and the insurer invested that money today… how much would that premium have to be to pay for the death benefit and all other policy benefits?
The net annual premium is equal to the net single premium spread out over “X” number of years, where “X” is equal to the number of years you would ordinarily pay premiums for your life insurance policy. The interest factor is adjusted to account for the fact that premiums are spread out over many years.
From there, the actuary calculates the gross premium. Gross premium is the net premium, minus the interest the insurer expects to earn on your premium dollars, plus the loading factor or expense charge. The final amount is what you, as a policyowner, pay for your policy.
There are, of course, other factors that affect your premium (which are discussed in more detail in The Underwriting Process section of this guide), including:
- Your age,
- Your sex,
- Your health,
- Your occupation and;
- Your habits, hobbies, and general lifestyle.
Each of these factors can have a dramatic impact on your premium.
Now… controlling for these factors can help you get a great deal on your life insurance policy.
For example, maintaining good health, minimizing the cost of insurance, and buying a participating policy (which gives you ownership rights in the insurer), and making sure your insurance company tightly controls the risk it’s taking when insuring other policyholders can result in a very good (and high-performing) whole life policy.
Or… maintaining good health, minimizing the cost of insurance for your age and sex, getting a flexible conversion or premium refund option, and buying from a company that targets your age range for lower-than-average premiums can result in an excellent deal on a term life policy.
So… this naturally raises a question in lots of peoples’ minds. With all this information at your fingertips…
“How do I make comparisons between insurance companies?“
The Practicality Of Comparing Costs Across The Industry
Knowing what you’re paying is all well and good. Knowing what can affect your premium rates — also good.
But… how do you actually use this information?
I never said it was going to be easy.
Doing a good job never is.
There are over 5,000 life insurance companies in the U.S. How can you compare costs, benefits, and risk to make sure you get a “good deal”?
The “simple” way is to hire a damn good insurance advisor who has spent hours and hours and hours and years and years and years beating on his craft and knows it, cold.
A general guideline for you, as a customer and client, is to look for excellence in the financial professional you choose to work with. Alternatively, you can attempt to calculate various costs yourself and then make your own comparisons. More on that later.
For term life insurance and guaranteed universal life, where cash value accumulation is not a major concern, most agents and brokers will comb the marketplace for the lowest premium. If you’re not worried about the financial health of the company, and you never plan on converting your term policy to a permanent policy, lowest premium usually wins.
Keep this in mind though… those premiums, however low, have an impact on your savings plan. Any premiums you pay represent money diverted away from a savings plan.
Listen to me now and hear me later: If the insurance you buy doesn’t do its job, or if you’re unable to save up enough money for your future needs, then the life insurance policy you bought, no matter how low the premium, was an expensive policy.
Most people, most of the time, need an insurance advisor who spends time analyzing the financials of the insurers in the marketplace to determine which one is most likely to make good on its long-term promises.
For term and guaranteed universal life, a agents tend to gravitate toward a few companies:
- American General Life Insurance Company
- The Penn Mutual Life Insurance Company
- North American Company for Life and Health
- Nationwide Life and Annuity Insurance Company
- Pruco Life Insurance Company
- Lincoln National Life Insurance Company
- John Hancock Life Insurance Company
- Banner Life Insurance Company
Of those, Penn Mutual has the distinction of never having raised the cost of insurance on existing policyowners in over 170 of doing business, even when times were extremely tough for the company and even when it would have been very profitable for them to do so.
The other company of note here is American General, which has wedged itself into a nice little niche, selling a guaranteed universal life insurance policy you can liquidate for retirement — converting the death benefit into 10 equal annual income payments after age 85.
For whole life insurance, most agents choose to do business with mutual life insurance companies.
There aren’t nearly as many mutual (privately-owned) life insurers (which are the companies that typically sell the best-performing whole life insurance contracts) as there are stock (publicly-traded) companies. And, of the mutual insurers in the marketplace, agents and brokers tend to gravitate to just 7 of the major mutuals in the industry:
- Penn Mutual
- New York Life
- Guardian Life
- Ohio National
- One America
- Northwestern Mutual
Of these, MassMutual, Penn Mutual, and New York Life set the standard for what whole life insurance ought to be. That doesn’t mean other whole life carriers don’t provide good value or that you should only buy whole life from a carrier in this list.
It just means that these are the carriers most life insurance agents gravitate to when they want to design a high cash value policy for their client.
Agents and brokers who believe in the promise of indexed universal life tend to gravitate toward these insurance carriers:
- Midland National/North American
- Lincoln National
- Minnesota Life
- Penn Mutual
- Pacific Life
Again, as with the whole life carriers, this list is not meant to be a recommendation but rather a list of companies that have set the standard for indexed universal life insurance in the marketplace. And, they are the companies most agents gravitate toward when looking to design a high cash value indexed life product for their clients.
One More Thing…
I know there’s someone out there, right now, in Internet land, who has read this far, and is already scheming and plotting ways to “cut out the middleman,” and save themselves some money, as they say on the Tell-Lie-Vision.
On the off-chance that you happen to be one of these folks, let me disabuse you of that notion: it won’t work.
Someone always gets paid by selling you life insurance and the best policies on the market are commission-based.
Now… there are several “no-load” insurers who do advertise the fact that they do not employ commissioned salespeople and thus do not have the same sales loads found in commissionable life insurance products, but… their policy performance, premium rates, and company ratings and financial strength don’t rank anywhere near the top 5% (or even top 10%) of the industry.
Meaning… no load insurers don’t have any special advantage in the industry. The reasons for this are not so intuitive. Commissioned salespeople dramatically lower the cost of advertising, sales, and distribution, which the insurer then uses to show a more competitive premium rate (on term insurance products) or a more competitive return on cash value (in whole life and universal life products).
Without commissioned salespeople, those costs are born entirely by the insurance company, which it then passes on to policyholders.
There is an old saying, which I think explains it perfectly: There are no deals in the insurance industry.
This is a difficult pill for some folks to swallow but… it’s the way it is.
The commission and fee structure incentivizes many agents to sell well-designed products. Sometimes, it incentivizes agents to sell expensive and crappy products with low cash value growth or expensive riders. This is a problem the industry doesn’t like to admit exists, but it does in fact exist and it is a very real problem. And, I think a lot of people have experienced the sting of a dishonest or self-serving insurance agent at one time or another.
However, this problem is not the epidemic that critics claim it is because… products that build low cash value don’t sell as well simply for the fact that you can’t hide cash value growth from consumers. It’s right there in the policy illustration.
This is why the big mutual life insurers, with high cash value products, outrank everyone in whole life sales, for example, while smaller (and less competitive) mutual insurers can’t capture any significant market share.
The same is true on the term insurance side of the business. The best rates tend to be with large companies that employ a large commissioned salesforce.
But… even if you do business with a major mutual life insurer, or a major stock insurer, it doesn’t guarantee stellar policy performance or cheap rates.
And here is where a good life insurance advisor can make all the difference.
Most companies offer at least one product which can be customized (sometimes extensively). Some companies sell products which must be customized in order for them to perform correctly.
DIY’ers and cheapskates who are always out to save a buck are always disappointed by the fact that they have to pay a professional to get a professional job.
And that’s really what it comes down: are you willing to pay a professional to give you superior results? If so, then life insurance can be an extremely powerful tool (even “simple” term insurance). You’ll probably be very satisfied with the end-result.
On the other hand… if you are always hunting for the best “deal,” hate commissionable life insurance products, and believe you can be your own insurance professional because you read a few books and scour the personal finance forums on the Interwebs, then prepare to be underwhelmed by life insurance.
Should You Do Business With An Agent Or A Broker?
This brings me to an important point that’s not discussed very much in the insurance business.
Should you do business with a life insurance agent or a life insurance broker?
There are basically two different ways you can go about buying life insurance.
You either buy it from a life insurance agent or a life insurance broker.
Some brokers or agents who are more advanced in their education and training, and have a lot of experience, will hold themselves out as life insurance advisors.
An advisor’s job is to provide a somewhat more comprehensive approach to life insurance planning.
However, legally speaking, there are only two different classifications of advisors.
A life insurance agent, sometimes called a “captive agent,” or “direct writer,” works directly for a life insurance company and usually only sells its products. They also carry the legal authority to bind insurance on behalf of the insurance company. For example, a New York Life agent works exclusively for New York Life Insurance Company and will generally only sell you a policy from New York Life.
This is fine if you already know which life insurance company you want to do business with.
Most of the time, most people will be better off working with a broker. Brokers legally represent you (the buyer) and not the insurance company. Because they work for you, they do not have any legal authority to bind the insurance company to any sort of business. They can, however, make offers on your behalf, negotiate, and place business with an insurance company for you.
Where Do You Go From Here?
If you haven’t read the Human Life Value section of this guide, go there next.
If you’ve already figured out your Human Life Value, and you understand the basic concept, then it’s time to venture into weird, wild, world of life insurance policies…
Want To Learn More?
If you’re ready to learn more about life insurance and how it can improve your financial plan, then click the link below and explore more sections of this guide.