I feel like I downplay the importance of life insurance all too often, but the reality is that life insurance is an extremely important component to financial planning. Getting the insurance component correct can be the difference in a plan’s success in the event of an unknown disaster; however, far too often insurance policies have been misunderstood by a buyer, misled by an insurance salesperson, or both. I’ve unfortunately seen many insurance policies that are way out of line with what’s appropriate and suitable. To reach a good insurance decision, it’s important to understand some of the bad decisions that occur far too often. As such, let’s talk about one such what-not-to-do-scenario with your term life insurance policy to be aware of what’s out there.
Term life insurance is essentially comparable renting life insurance. With “Level” term life insurance, there is a guaranteed number of years when the premium remains fixed in exchange for the death benefit to be available to your beneficiaries. An instance of such is a 20-year level term. For example, a relatively healthy 40-year-old may pay $70 per month for a $1,000,000 for 20 years. This means both the premium and death benefit are stable for 20 years, as long as the premium is paid.
In contrast, an annually renewable term policy is a one-year term life insurance policy that automatically renews until a defined age. Some policies renew until age 80, some renew until age 120 (or until the insured passes away). Like a level term life insurance policy, an annually renewable term policy has a level death benefit. Where the two life insurance policies differ is the premium structure.
The annually renewable policy generally begins marginally lower than a level term life insurance policy because the premiums are calculated to cover the risk of premature death of one year, instead of averaging that risk over 20 years. Where a $1,000,000 20-year level term policy might cost a healthy 40-year-old around $70 per month for 20 years, a similar annually renewable term life insurance policy might begin with a monthly premium of $39. If you own the annually renewable term life insurance policy for 20 years, the monthly premium will scale up to an estimated $600 per month. Furthermore, the premiums illustrated in these policies are not always guaranteed. There is an illustrated premium and a guaranteed premium. The guaranteed premium in an annually renewable term policy is the highest amount an insurance company is allowed to charge, so if the insurance company experiences financially difficulty or decides to enforce the maximum premium for any reason, then the premiums could skyrocket. For example the maximum premium could be as high as $1,000 per month in the 20th year in this case. Thus, the real issue in annually renewable term policies is the lack of guaranteed premiums and the increasing expense. These policies are inefficient to own insurance for long periods of time.
Calculating the total 20-year costs of the level term policy is simple. A 20-year level term policy costing $70 per month, as described above has a total 20-year cost of $16,800 ($70/month x 12 months = $840 per year x 12 years = $16,800). This premium schedule is contractually guaranteed, assuming the insured received the favorable health rating during underwriting (based on the second-best health rating).
The annually renewable term policies vary from insurance company to insurance company, so I got a hold of a real insurance proposal for usage (the insurance company will remain unnamed). The aggregate premiums would add up to just over $56,000. If the insurance decided to charge the maximum premium, the aggregate cumulative premiums over the 20-year timeframe would be about $133,440.
There are several differences to point out here. First, and the most obvious, is the 20-year cumulative premium difference is $39,200 ($56,000 - $16,800 = $39,200), or an average of about $163 per month difference. This means the total average cost of annually renewable term policy would have been about $233 per month, instead of the $39 introductory monthly premium. As a contrast, the level term policy cost $70 per month.
The second difference is that the 20-year level term policy, once the policy survives at least one day beyond the 20-year timeframe, loses its death benefit, and the policy lapses. As was discussed above, the term policies are simply death-benefit-rental-agreements. If the $70 per month is paid, the policy survives each year until the 20-year timeframe has ended. The annually renewable term policy, on the other hand, continues past 20-year frame, albeit with a higher premium. It could be reframed this way: the total cost of the 20-year level term policy is the cost of the policy plus the loss of the death benefit, since that death benefit was purchased for a purpose and was subsequently allowed to lapse. If the death benefit of the level term life insurance policy had a place on a person’s cash flow statement, the 20-year cost of the level term policy would be $16,800, and the 21-year cost would be $1,016,800. The 21-year cost of the annually renewable term is $47,570. Does this make the annually renewable term policy cheaper?
How can you account for the loss of the death benefit? What can be done to make up the lack of insurance? I typically recommend that you set up a goal for each insurance policy you own and understand how the insurance policies work. In the example of the level term policy above, the death benefit is $1,000,000. It’s important to understand that in a term policy, you do not own the death benefit, and there’s not a chance for ownership equity in the policy; it’s rented insurance. To accumulate similar equity, you can save some money. In this case, if you save $50,000 per year in a bank account yielding 0%, you will achieve $1,000,000 in replacement assets over 20 years. If you do happen to get a return on your savings, say 6%, then saving $2,000 per month will do. If you have a term premium that constantly increases, this change in cost will decrease your savings rate each year.
So do you own the death benefit in an annually renewable term policy? Nope. It’s just that the timeline on these policies is generally more flexible, yet the increased cost makes owning these kinds of policies virtually impossible given a long enough timeframe.
What if you decide to keep the annually renewable term policy beyond 20 years? If this policy was kept for an additional 20 years (to age 80), the accumulated premium would add up to $444,000, but the guaranteed premium – or the maximum the insurance company could charge – could be as high as $791,000. Assuming you’re still healthy, you can get a $1,000,000 20-year level term policy for about $450 per month at age 60 (same health rating – second-best rate). The total cost of the 20-year level term policy beginning at age 60 is about $108,000. This puts the total 40-year cost of the level term policies at $124,800. After age 80, additional life insurance is likely not an option. Thus, any kind of term insurance is likely not a suitable option to satisfy long-term life insurance goals.
This leaves us with a new calculation for the insurance policy: net death benefit. It’s simply the death benefit minus the cumulative premiums paid. For a 20-year study, the net death benefit for a level term is $983,200 ($1,000,000 death benefit - $16,800 total premium for the level term policy). The 20-year net death benefit study for the annually renewable premium would leave us with a range, since the initial premium is not guaranteed. Remember the insurance company could charge a higher premium than what was quoted, so the net death benefit range would be $944,000 to $866,560. If the 20-year term policy was owned for all twenty years and subsequently repurchased (assuming good health as a 60-year-old), the 40-year net death benefit would be approximately $875,200 (the first 20-year term cost $16,800 and the second 20-year term cost $108,000, yet the death benefit remained at $1,000,000). The 40-year net death benefit range for the annually renewable term policy would be $556,000 to $209,000. This shows that the longer an annually renewable term policy is owned, the worse it is. There even becomes a point at which the net death benefit becomes negative, meaning there was more premiums paid to the insurance company than death benefit received.
The purpose of the annually renewable term policies is twofold: one, to hold the life insurance policy for a very short period of time before cancelling it or converting it to a permanent policy, and two, for life insurance agents to have term policies that eventually appear to be expensive, and not so different in premium from permanent policies, thus allowing the life insurance agents the ability to “relieve” you of the increasing premium and sell you more permanent life insurance policies. The purpose is to make the increasing premium so uncomfortable that purchasing more permanent life insurance looks like a reasonable alternative. This is unfortunately a real sales tactic. It’s equally unfortunate that these salespeople call themselves “advisors.”
Getting your plan on track and setting up your life insurance policies correctly shouldn’t be a zero-sum game. No one should get tricked or trapped into purchasing insurance, or anything, for that matter. Making insurance decisions can be difficult, so make sure you’re able to make your own independent decisions on each financial decision. If you have a trusted advisor, it’s worth it to get a second opinion. Additionally, it’s important to understand the goal established for each insurance policy.
Whether it be for estate planning, cash accumulation, or establishing a legacy, there are some people who set up a goal for their insurance policies to last their entire lives, and this is OK, as long that goal has been thoughtfully crafted. If having insurance last a lifetime is a goal, utilizing term life insurance may not be the right policy fit for the entire insurance portfolio; however, if you have a policy with an increasing premium, you should be careful about the long-term implications of owning these policies.
Life insurance is a vital component of a financial plan. It alleviates the plan of unforeseen and drastic circumstances. The reality is that death is a part of life. In fact, death gives life meaning, otherwise, life would just be being. Making sure your dependents can survive beyond your life is a noble action. It’s unfortunate that sales quotas can hamper the outcomes of our lives and livelihood, so it’s important to review your insurance policies, accounts, and financial decisions on a regular basis. If you don’t understand something, seek a trusted advisor who doesn’t have a sales quota.