Introduction
In this article I’m gonna explain the differences between term life insurance whole life insurance and universal life insurance. We are gonna start with a concept that underpins prices for insurance which is directly related to explaining the differences between types of life insurance policies available and that concept is this mortality rates increase exponentially.
In plain English what that means is the likelihood of you dying increases the older you are but that rate of increase increases. Looking at the United States in 2016 the odds of a 40-year old man dying within the next year were zero point two four two percent which means for 40 year-old men two point four two out of 1,000 would be expected to die in a given year. For 41 year old men that rate increases to two point five three out of 1,000 and for 42 year old men it increases again to two point six six three out of 1,000.
What you’ll note is that the increase increases. The increase in the odds between 40 and 41 year-olds is zero point one one but the increase in odds between 41 and 42 year olds is zero point 1 3 3. So conceptually if we were to plot the likelihood of dying in the next year on the y-axis and age on the x-axis we would get a curve that looks something like this.
If every year you were to buy a new one-year life insurance policy you could use this same graph and replace the likelihood of dying with the insurance premium in dollars which remember is just the fancy word for the cost of the insurance. So what this means is that if you were repeatedly buying a 1-year life insurance policy the price would go up every single year and later in life it would become unaffordable.
This change in cost doesn’t really get dramatic until later on in life. So for example the same amount of coverage or death benefit that costs say 10 dollars per month for a 20 year old might cost $20 per month for a forty-year-old, $100 per month for a 60 year old but might shoot up to $1,000 per month for an 80 year old.
Term Life Insurance
Now in reality people don’t buy one year life insurance policies. This brings us to our first type of life insurance term life insurance.
If we take our graph and we separate it into ten year intervals an insurance company might say instead of just increasing the price every year we’ll set a static cost for the entire ten-year period or term. This fixed cost during the term would be a bit higher than the one year cost earlier on in that term but a bit lower than the one year cost later on in that ten-year term. So essentially they’re averaging it out.
For this ten year term life policy the monthly premium would stay the same for that entire ten-year period. After that ten years is up there would be a higher monthly premium for the next ten year term and the same for the third 10-year term.
Let’s look at an example policy. Let’s say that we had a 30 year old with a term 10 life insurance policy with a coverage amount or death benefit of $250,000. That initial premium the cost of the policy might be 15 dollars per month. What that would mean is they would pay 15 dollars every month for the next 10 years for the same $250,000 death benefit should he die.
In year 11 which would be the beginning of the second 10-year term the premiums would increase to maybe $100 per month. If they kept their policy they would still have the $250,000 coverage amount and in the third 10-year term the premiums might again jump up again to something like $300 per month.
Another option available is a 20-year term life insurance policy. In this case the monthly premium would remain the same for a 20-year period. As you can see the costs start out really low but soon escalates to the point of being very very expensive.
It’s relatively cheap to get lots of insurance coverage when you’re young and healthy but very expensive when you are older. For many people this might be all the type of insurance that they ever need or want. Over time as your assets grow your need for protection decreases and term life insurance is synonymous with temporary life insurance.
Permanent Life Insurance
Permanent life insurance is quite a different beast compared to term insurance. Most insurance companies don’t even offer term life insurance if you’re 80 years old because it’s insanely expensive.
Some people may still want some coverage at that age for reasons like paying for funerals, covering a tax liability on real estate or a business, creating an inheritance, or using life insurance in specific financial planning strategies for more than just the death benefit.
As the name implies the permanence of these policies means you really need to research them. They can be complex, involve long term trade-offs, and many people make a lot of money selling you permanent or temporary insurance so you have to be mindful of sales incentives.
Whole Life Insurance
Let’s explain what is called whole life insurance. Again take a 30 year old who wants $250,000 in coverage. If they wanted a 20-year term life policy the initial monthly premium might be 20 bucks. For a whole life policy the monthly premium might be closer to 200 bucks.
Why the massive difference?
You can think of a whole life policy as like a term life policy except instead of a series of ten year or twenty year terms there’s only one term which is your whole life.
If we created a level premium over the course of your entire life we would maybe get a premium that looks something like this. The concept is that you overpay early on in exchange for under paying later on but the early overpayment is much more pronounced.
The insurance company invests the difference between the premiums you pay and the cost to provide the pure insurance. This amount is referred to as reserves or cash value and this excess is invested and grows over time.
Let’s say we have a whole life insurance policy with a death benefit of $100,000 and the person gets this policy when they’re 30 years old. If they die and their policy is in force their beneficiaries get the $100,000 as promised. But the cash value or reserves build up over time.
The difference between the death benefit and the reserves is the amount that the insurance company has at risk. Over a very long period of time the reserves may eventually equal the death benefit.
Participating vs Non-Participating Whole Life Insurance
This is the perfect point to talk about the difference between non-participating whole life insurance and participating whole life insurance.
In a non-participating whole life policy everything is guaranteed. Your premium, death benefit, and cash values are guaranteed on your policy illustration.
If the insurance company assumptions are conservative it basically means you’ll end up paying more than you had to and the insurance company makes more profit.
A participating whole life policy is different because you participate in the profits of the insurance company with respect to these reserves.
If fewer people die than expected and the reserve fund grows faster than expected due to investment performance the insurance company will pay out part of these profits to you every year in what’s called either a dividend or a bonus.
You generally have the option of taking it in cash, using it to reduce premiums, purchasing additional insurance, or putting it into an interest earning account with the insurer.
All other things being equal the initial premiums for a participating policy are going to be higher than a non-participating policy but over long periods of time the participating whole life policy may or may not work out to be less expensive.
Buy Term and Invest the Rest
Back in the 1970s and early 1980s interest rates were very high and many people were losing their jobs. Insurance companies were making huge profits because the rates of return they used to calculate premiums were much lower than the actual returns they were earning on reserves.
At the same time many people with expensive whole life policies were looking for ways to reduce expenses while keeping insurance coverage.
This led to the strategy known as buy term and invest the rest.
This strategy refers to buying a term life insurance policy which is much cheaper than whole life insurance and investing the difference between the two premiums yourself. Over time your own investment account could grow enough that you no longer need life insurance because you become effectively self insured.
Universal Life Insurance
To counteract this insurance companies started heavily pushing a different type of permanent insurance which allowed people to choose how the cash value of their policy was invested.
A variable life insurance policy is one where you can select how the reserves are invested. Instead of relying on conservative investments from the insurance company you can choose investment funds with more potential return but also more risk.
A universal life insurance policy refers to a policy that has a number of parts that you can tinker with. You can adjust your death benefit up or down over time and also adjust your premiums.
In some countries like Canada people mostly associate universal life insurance with the ability to pick investments for the reserves. In the United States there are four main types of universal life insurance policies:
- Guaranteed Universal Life
- Universal Life
- Indexed Universal Life
- Variable Universal Life
Guaranteed universal life policies are not designed to build cash values so premiums are lower.
Regular universal life puts reserves into conservative interest bearing investments.
Indexed universal life exposes reserves to stock market indexes but with guardrails where upside is capped and downside exposure is limited.
Variable universal life policies allow you to choose from different mutual funds with different risk and return profiles.
Final Thoughts
There are two main types of life insurance temporary and permanent.
Term life insurance is temporary insurance. It’s relatively cheap when you’re young and becomes unaffordable in old age.
Permanent insurance is designed to stay with you for life. To achieve that you pay more upfront and those extra premiums are invested into reserves or cash values that grow over time.
Whole life insurance is a type of permanent insurance. Participating whole life allows you to participate in the profits of the insurance company through dividends or bonuses while non-participating whole life does not.
Universal life insurance gives you more flexibility and more control over how reserves are invested and how your policy is structured.
Always remember that terminology and policy structures can vary depending on the country you live in, so it’s important to research the specifics carefully before making any decisions.