20 Year Term and 30 Year Term
We’ve seen how 10 year term just takes the 1 year term premiums and levels them out for 10 years. 20 and 30 year term (and all the other variations of term insurance) are the same thing, just over different periods of time. A 20 year term takes the 1 year term costs and averages them out over 20 years – giving you life insurance that has premiums level for 20 years. At the end of 20 years, the premiums increase and are level for another 20 years.
Term Life Insurance
Lets put all this together now to get a definition of the first class of life insurance – Term Life Insurance.
Term Life insurance is
- Pure life insurance in that it simply pays a death benefit in exchange for a premium.
- Premiums are level for the defined term of the policy.
- At the end of the term, premiums increase and are level for another term. This is called a renewal.
- Term policies have an end date known as the expiry.
There are two other attributres of term life insurance that you should be aware of – renewable and convertible.
The term ‘Renewable’ means that at the end of the first term duration (10,20 or 30 years depending on the policy) the policy doesn’t stop. Instead the premiums increase for another term and the coverage continues. Years ago this was an important feature but cost structures changed so that now the premiums are renewal are exhorbitant. Thus, you should expect that you would not ever renew a term policy (keep it past the first term) and would instead cancel it at that time. If you need insurance for a longer period, consider purchasing a longer term policy upfront.
Conversion is an extremely important feature – so important that you should never purchase a term policy that doesn’t have conversion as a feature. Conversion lets you exchange your term life insurance policy for a permanent policy but without taking a medical exam. This is crucial if you become uninsurable. If you do, you’ll likely want to have permanent life insurance instead of term (nothing like having a heart attack to convince people that they do in fact want life insurance forever). But if you’ve become uninsurable – well, by definition you can’t get any more life insurance. Except with conversion, you can – you can trade in your term policy for a permanent policy, at standard premiums, and without a medical question of any kind. Yep, you can do this even if you’ve had a heart attack.
Permanent Life Insurance
Lets extend that averaging/leveling process of premiums out over your lifetime. Instead of premiums that go up every 10,20 or 30 years, we’re going to take the average cost over your expected lifetime, giving us level premiums for life. This type of life insurance is called permanent life insurance. At it’s core it’s exactly the same as term – premiums are simply level for life instead of a defined period.
The result of the lifetime averaging is that there’s a couple of new attributes that get introduced. These give us three types of permanent life insurance; term to 100, universal life, and whole life. These additional attributes often get used to promote one type over another, but remember not to get distracted by these features – they are secondary and are not the primary purpose of the life insurance.
Term to 100
This is the purest form of permanent life insurance; it consists entirely of level premiums for life – no cash values,no investments, and generally the least expensive type of permanent life insurance.
For technical reasons however Term to 100 is not generally available as a standalone insurance policy in Canada any longer. (see the universal life section to find out how you can duplicate the benefits of Term to 100). Again, the definition of Term to 100 is level premiums for life, no cash values or investments.
Whole life is the second type of permanent life insurance. It has level premiums for life. However it also has an attribute called cash surrender values. Lets look at what these values are.
Recall the 1 year term policy, where premiums go up every year. These are the baseline annual insurance costs that must be paid. With permanent life insurance, premiums are generally much higher than term insurance in the early years. So what do the companies do with each year’s ‘overpayment’ above the cost of insurance? For most companies that would be profit, but not so with life insurance companies.
With a whole life policy there is eventually going to have to be a death benefit paid. Life insurance companies know this, and when you die they don’t act surprised. There’s no “we weren’t prepared for this, now where are we going to come up with that $500,000?”.
The companies know that a death claim is coming and plan accordingly. In the early years of your policy they take the excess premiums and save them conservatively (it does not go to profit). This investment, called a reserve, is internal to the company and not exposed directly to policy owners.
The goal is to build those savings so that when you pass, they have 100% of the death benefit in the bank. Now when you die and your beneficiaries ask for their six or seven figure cheque, the life company doesn’t need to find the money – they have it. They respond with ‘we were expecting this, and have been saving your premiums for 50 years, the death benefit money’s in the bank, here’s your death benefit’. In summary, in the early years the insurance company is taking the excess premiums over the cost of insurance, and investing them over the long term with the intention of having exactly your death benefit saved up when you die.
Now, what happens if you cancel your whole life policy early? The insurance company no longer has to pay a death benefit, so it doesn’t need those invested reserves. They cash out those reservers and split it two ways – some of it they give back to you, some of it goes to profit. The amount that they give to you is known as a cash surrender value. It’s a partial refund of their savings towards your death benefit. Importantly, you’re in most cases cancelling your policy to get these values – it’s cash surrender value OR death benefit, not both (because of course, the cash value is the early stages of your death benefit).
That’s the definition of whole life – level premiums for life and a cash value if you cancel.
There are some variations on whole life that are not guaranteed. In most cases consumers should stay away from these types of policies. For our purposes, we are going to treat whole life as guaranteed level premiums for life, with cash values if you cancel. (Whole life has enough variations that I’ve addressed them in a seperate appendix).