BEST TYPE OF LIFE INSURANCE
The immediate question most consumers have is ‘what’s the best type of life insurance?’ Then they’re overwhelmed by trying to sort out all the conflicting information.
It turns out there is no best type of life insurance because there’s only ONE type of life insurance. It’s the type that pays a death benefit in the event of your premature death. That cheque to your beneficiaries upon your passing is the ‘product’ that you’re purchasing. And all polices pay the same cheque. A $1MM cheque from policy one cashes the same as a $1MM cheque from policy two. They’re identical.
So it’s not the death benefit that seperates insurance policies. Yet clearly there are different classes of insurance policies – what differentiates them?
Premiums Over Time
The answer is the premiums. And not just the premiums, but the premiums over time. We can generate most of the different classes of life insurance policies by simply tinkering with how we pay our insurance costs across the years. That’s right – we can generate all the different classes of life insurance policies simply by changing how you pay your insurance premiums over years. All the different classes you/ve read about – Term, Whole Life, Universal Life – all pay the same basic death benefit. The primary difference between them is how you pay the insurance premiums over time.
We still have the same problem – which of these classes is ‘best’ for us. And the answer is, the best policy is
the cheapest policy over the timeframe that we need the insurance for. All we need to do is determine your timeframe and we can find a matching policy class that’s least expensive over that timeframe.
Before we provide examples for the five scenarios we saw in the previous section, let’s look at how we get the different policy classes by changing the premium structure.
Types (Classes) of Life Insurance
1 Year Term
We’re going to start with the purest form of life insurance, as it’s what all the other types are ultimately based upon.
Insurance premiums are based on our risk. If you’re a higher risk it’s going to cost more – that’s clear to most of us. But remember, our life insurance premiums are over time, not just a one year period.
With car, house, and many other types of insurance, our risk doesn’t change much. Last year our house insurance was maybe $1000, next year it’ll be $1000, because the risk of our house burning down hasn’t changed.
But life insurance has a different problem – with life insurance our risk DOES get higher every year. Every year we’re a year older, we’re a year closer to dying and thus a claim. Every year our risk increases, therefore every year our cost – and thus our premiums – need to go up. So your premiums would look like this:
Eventually the insurance becomes unaffordable. Further, nobody really wants life insurance where the premiums go up every single year. However if we did purchase such a policy, it would be called 1 year term. It’s term because it’s pure life insurance, and it’s 1 year because the prices go up every ‘one’ year.
1 year term isn’t easily available in Canada because there’s no real market. However it is the underpinning of all life insurance in Canada – those annually increasing costs have to come from somewhere.
10 Year Term
Assume we want life insurance for 10 years, after which point we no longer want the insurance. We could technically purchase a 1 year term and cancel after 10 years. However, there’s an insurance policy that is designed expressely for this purpose.
Remember our 1 year term, prices go up every year. Lets say the insurance company takes the average premium over that 10 years and charges you the average each year. The total premiums over 10 years will be the same if you purchase a 1 year term or a 10 year term, but with the 10 year term the premiums are now level. Here’s an example:
1 Year Term 10 Year Term 1 $25 $50 2 $30 $50 3 $35 $50 4 $40 $50 5 $40 $50 6 $50 $50 7 $55 $50 8 $60 $50 9 $65 $50 10 $75 $50 Total: $500 $500
There you have 10 year term – it’s a term policy with level premiums for 10 years. Compared to 1 year term, the premiums are higher in the early years of the policy, and lower in the later year.
At the end of the 10 years, the premiums will increase (because you’re 10 years older) and be level for another 10 years. This is called a ‘renewal’ and there’s more details in the Renewal section. However the short answer is that you would not normally want to keep a term life insurance policy after a renewal as premiums will be too high.