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Breaking Down Permanent Life Insurance Policies
In this article, we are going to shed some light on the different types of permanent life insurance products and what you should look out for.
What are the different types of permanent life insurance and who is it suitable for?
Whole life - created in 1940’s
- Fixed premium and death benefit - one amount of premium for a guaranteed death benefit
- Growth - On average 3.5% annually
Whole life policies are most suitable for conservative individuals who prefer a fixed payment and guarantees in growth and death benefit. These policies tend to be the most expensive of permanent life insurance policies.
Universal life - created in 1980’s
- Flexible premium and death benefit - you can adjust your monthly premium (between a minimum and maximum) and adjust your death benefit coverage throughout your life
- Growth - On average 3.5% annually
Universal life policies are the oldest version of “flexible premium, adjustable life products”. Although they allow for flexibility for payments and customization, they generally have very low growth rates for cash value.
Variable universal life - created in the 1980s
- Investment subaccounts - Cash value is invested in subaccounts that are managed by the insurance company. The investment value can fluctuate with market performance and 100% of the investment risk is taken on by the policy owner
- Growth - Rate depends on the market
Variable universal life policies allow for the individual to invest, grow their money tax-free, and access the cash value tax-free all within their life insurance policy. However, the downside is that if the market doesn’t perform and their premiums cannot cover the cost of insurance, their death benefit may decrease.
Index universal life - created in late 1990s
- Indexed strategy - Cash value grows based on an index (such as the SP500) but within a cap and floor, meaning the growth will not exceed a maximum growth or drop below a minimum growth level. For example, a market growth of 30% may be capped at 15% but a market drop of -10% may equate to a floor of 0% (no loss)
- Growth - Rate depends on the market, but often equates to 6-8% on average
Index universal life policies are the most recent form of permanent life insurance. After the 2008 mortgage crisis when the markets came crashing down, and a lot of policy owners lost their insurance policies due to the cash value not being able to cover their cost of insurance. A new product started gaining popularity in the market that allows policy holders to lower downside risk while still capturing upside potential when the market is performing well.
What should I look out for when choosing what kind of perm life I should get?
Cost - Not all permanent life insurance is created equal, especially when it comes to cost. Each insurance carrier has different cost structures and rates at which they cover various ages and health statuses. For example, some carriers front load their costs while others spread out the cost; therefore, some policies are more suitable for younger applicants and others older. It is best to shop around to find the best value for your dollar.
Health - Occasionally you may obtain a great illustration/projection for a policy but realize the premiums are very different than the initial projection due to health. If you have previous health issues, it is best to get a pre-approval from multiple insurance companies by sending in your medical records and results without submitting a formal application, since once you submit a formal application and obtain a rating (or even worse, a decline), it may likely lower your chances of getting a better rating with other insurance carriers when they look at your previous application history.
Riders - When it comes to permanent life insurance, there are a plethora of riders that can significantly increase the use cases for your permanent life insurance policy. Some of the most popular ones include adding a term rider for temporarily higher liability, long term care, critical illness, and terminal illness. These riders often increase the monthly premium by tens of dollars but can allow for your death benefit to act as a living benefit and fill the gap between your health insurance and severe or long term illnesses.
Return - Life insurance cash value returns can vary widely depending on the type and structure. The higher the return the more flexibility you have in terms of how long you have to pay into the policy for in order to obtain lifetime coverage and how much tax-free cash value you will have access to later in life. Like any investment, the best strategy is to front-load the policy to maximize long term returns. Unlike investment securities, there is usually a cap of how much you are able to invest in any given year (before creating a Modified Endowment Contract and being subject to income taxes for your investments). The benefit of investing in a life insurance policy is that your cash value will grow tax-free and can be accessed tax-free after a certain number of years.
Fees - If you are using the policy for investment purposes, it is important to take note of the fees involved. Some examples include premium expense charge (a percentage of how much you put into the policy, such as 5%), your cost of insurance, and an investment management fee (such as 0.5-0.9% of AUM).
Loan interest rates - Very important to note if you are using permanent life insurance as a cash accumulation vehicle, high loan interest rates that are charged on your death benefit based on how much cash value you retrieve from your policy can significantly eat up your death benefit. Many permanent life insurance policies can offer very low or 0% net loan interest rates on the cash value that you take out of your policy.
Segment value - When a life insurance policy shows extremely high or unlimited caps (and a 0% floor), it is likely that they will put a segment value limitation to the growth. This means that they will only credit you interest based on the difference (or delta) between one point of the market and another point after a given period of time and credit you that interest. This significantly lowers the frequency of interest being credited to your account and therefore lowers your compounding interest overall. For example, a 5-year point to point strategy means that you will only be credited once during the 5 years and if you started in January 2015, you will receive the difference in the index between January 2015 and January 2020 and receive the difference as interest.
How safe/guaranteed are permanent life insurance policies?
Established life insurance companies are very safe places to put your money, even more so than the bank nonetheless other investment vehicles. Often, they’ve been around for hundreds of years and have a “guaranty association” in place whereas other life insurance companies will reinsure their risk.
That being said, it is important to understand what you can and cannot do when purchasing a permanent life policy. We would recommend reading the details of your policy, not just listening to your agent, including understanding what the minimum mandatory payment is per month/year and never going below that. The permanent life policy is designed for the minimum payment to grow enough so that when your cost of insurance jumps up as you grow older, your premiums will not skyrocket. That also means that you are limited in how much you can take out in cash value and if you take out too much cash value then you will need to pay additional premiums to cover the cost of insurance later on in life. In addition, if the market does not perform well for an extended period of time, you also run the risk of having to pay additional premiums later on in life.
Overall, permanent life insurance is a very safe place to put your money as long as you are following the guidelines of how you should pay, how long you should pay for, and how you should be taking out your cash value. Illustrations provided by insurance companies often use the average returns of the last 20 years and if you want to be extra conservative, you can ask for them to be run assuming 50% less returns compared to the last 20 years. In addition, we would recommend that if you are paying minimum or target premiums per month, you should wait at least 20 years before removing cash value and you should only remove around 5-10% of your cash value in any given year.