The Perm / Term Squirm: Deciding Between Permanent and Term Life Insurance Policies Part 1 – Term Life Insurance
Just so you know, I’m a big fan of life insurance, both permanent (“perm”) and temporary (“term”) policies. On the other hand, it is also important to pick the right policy for the report; sometimes a perm policy with lots of bells and whistles is the perfect solution but in others, buying a simple, inexpensive term policy is the way to go. In the end, it’s about figuring out what policy fits your needs and budget, rather than your advisor’s. Just don’t automatically assume that your insurance agent is on the take if she sings the praises of universal life or he extolls the merits of a participating whole life policy.
This article will (hopefully) begin the process of helping you picking the right type of life insurance for your situation, whether it is a stripped down, boring term policy or a super deluxe permanent policy with a 100 page user manual (I jest not!) As I don’t have the heart to attempt summarizing perm policy intricacies with first providing fair warning, I’ll do us both a favour and focus primarily on term coverage today.
Assuming you know how much insurance you need, the next decision you must make when staring into your insurance advisor’s eyes across your kitchen table is term or perm (or a little bit of both.) Yes, there is also group life insurance from the bank or credit union against your mortgage or coverage through your group benefits at work, but I’ll have to save that discussion for another day other than this; I always recommend personally owned life insurance, especially when compared to group mortgage coverage.
What’s the difference between term and perm coverage, you may ask? Insurance advisors often describe it as the difference between renting and owning. A term policy is like renting in the following ways:
• You never build up any equity in your policy. Unless you die while covered, you will not get any cash from your insurance policy (except in rare situations, such as when selling or donating a policy when in poor health). On the other hand, perhaps you have been able to build up more equity in other assets from all the money you may have saved along the way by only paying rent.
• Your coverage only lasts for a set period or term. Like renting, you can renew when your term expires, but the rates are usually substantially higher. It also means that you are stuck paying for as long as you own the product. Moreover, also like renting, term coverage doesn’t last forever; no matter how good a renter you have been, if you live long enough, you will eventually lose your right to renew your policy. This can mean paying in for decades and having nothing to show for it.
• You don’t have all the flexibility that comes with owning as detailed below.
On the other hand, a perm policy is like owning because:
• You can build up equity in some policies, which is something you can borrow against, or convert into cash if you surrender or sell your policy. A lot, however, depends on the terms of the policy, how long you’ve owned it, how much you’re paying into it and, perhaps, whether or not the investment gods have smiled in your general direction. (As an aside, it is actually possible for both term or perm policies without cash values to be worth something, but this usually only matters if you’re donating the policy to charity or ‘selling’ the policy to a company you already own in whole or in part.
• You have coverage for life that the insurance company cannot take away (except for things like fraud or failure to pay premiums.) This means your heirs getting a big cheque when you die or you getting a smaller cheque or cheques during your life if you surrender your policy or borrow against to fund your retirement dreams.
• You have a lot more flexibility in terms of payment options. Some policies can be paid up for life at a set age or after paying in for a predetermined number of years (like paying down mortgage.) Other policies allow you to take “premium holidays” where you can skip payments into the policy and use the equity already to pay them. Other policies generate income that you can use to pay premiums, generate cash for your retirement or buy additional life insurance. Finally, you can make extra payments into many policies to accelerate the time when the policy is officially “paid up” or, if this isn’t possible, to generate enough income inside the policy to pay these premiums for life even if the policy isn’t officially paid up.
Advantages of Term Life Insurance
In a nutshell, the big advantage of term insurance is price. Term premiums are priced differently than permanent policies and are often a fraction of what you’d pay for permanent insurance, at least in the short term. The insurance company only needs to assess the chance of something happening to you within the current term of the policy. In other words, if you take out a 10 year term policy when you’re 38, the insurer only needs to assess the chances of you dying before turning 48. If you’re healthy enough to get approved in the first place, there is a very good change that you’ll outlive that term and the insurer won’t have to write a large cheque to your grieving family.
As this type of policy is a lot less risky to the insurance company, since they will only have to pay out on a fraction of the policies issued to people in a similar age bracket, they can charge you lower premiums. Although the insurers may lose out if you die before the policy does, they are betting that there will be enough other clients of a similar age with similar policies that will survive for 10 years. The premiums from these other clients and the investment profits the insurer has hopefully made on the premiums it receives from all of you should be more than enough to pay out the occasional death claim and still leave them with a healthy profit. In some ways, insurance companies are like casinos, they make sure that the odds are stacked in their favour and measure success by looking at large scale results rather than focusing on whether they are ahead or behind on any single client.
Assuming that you haven’t reached the ultimate expiry age indicated in your policy, you generally will have the opportunity to renew the coverage with any further ado for another term of the same length or until that ultimate expiry age. Your original policy will actually provide you with a list of each set of new premiums so you will know in advance what your cost will be. Unfortunately, your new pricing will take into account that you’re 10 years older and steadily shoot upwards with each renewal. This is also because the insurance companies take a worst possible case scenario approach to renewal pricing; they assume that if you were healthy, you would be willing to go through the application process from scratch in order to qualify for better rates rather than renew an existing policy. Accordingly, if you don’t take this extra step, your premiums for the next term will be based on the assumption that you’re two steps removed from the grave.
Over time, the extremely cheap term monthly insurance premiums that were so attractive in your 30’s may cost more than a family vacation. Typically, term policyholders do one or more of the following things at some point:
• Cancel their coverage because they can’t afford to pay the premiums any more if they actually want to retire someday, even if they still need the coverage.
• Cancel the policy because it has already served its purpose. If the children are done medical school, the house is mortgage free and the balance of the investment portfolio is 7 or 8 digits long, policyholders might no longer worry about their family’s financial future if they don’t survive their next 10 km run.
• Reduce their amount of coverage to either fit their budget or because their life insurance needs have reduced but not disappeared.
• Convert from term to perm insurance (which usually must be done before a set age like 65 or 70 if allowed at all under that policy) if they feel they have a permanent insurance need. Interestingly, is not unusual for policyholders to have a different insurance need when they decide to keep and convert than the one they had when they took out coverage in the first place. For example, instead of paying down the mortgage, maybe the policy is now being used to provide pay the tax bill on the family cottage on death. Be warned about waiting too late to convert; the rates for the perm policy will be based on your age at the time of conversion, which can lead to a potentially terminal case of sticker shock. In such cases, if health permits, I suggest apply for a fresh policy before converting in the hope of qualifying for lower premium and also so you can pick the exact type of permanent coverage that best suits your situation, as your options when converting may be limited.
• Keep renewing their term policy for a same or lower amount even though they have a permanent insurance need. I compare this to renters in a place like Vancouver getting priced out of the market by waiting too long to buy. Although they may need permanent coverage, this is no longer affordable, so they make do with term insurance, even though they know that they won’t get a payout if the insured dies after the policy expires for good. This means that it is important to ‘keep on top of the market’ if you may have a permanent life insurance need so you can convert before it either becomes unaffordable, you lose the ability to convert your term insurance or your health no longer allows you to qualify for a fresh perm policy.
Features of Term Life Insurance
If you are shopping for term insurance, although it doesn’t have all the bells and whistles of permanent insurance, you’ll soon find out that it does have a few special features and options. Some of your choices are as follows:
• Length of term: I have seen the following term lengths, expressed in years: 25, 10, 5 and 1, although I suspect that this list isn’t all-inclusive. There are even “term to 100” policies that stay in effect for life (although the insurers don’t make you pay premiums past age 100). Technically, I consider this to be a permanent policy, which is why I haven’t said more about this earlier. Generally, the premiums remain level (i.e. the same) for the life of the term. For example, if one 37 year-old twin took out a 20 year term policy, she would pay the same amount every month or year until her policy came up for renewal when she turned 57. On the other hand, if her sister took out a comparable 5 year policy that she kept renewing every 5 years, she would pay a lot less early on but would eventually pay a higher premium that her sis and would pay more in total premiums over the life of the policy. What makes more sense? It completely depends on the situation and factors like budget, current and anticipated future insurance needs.
• Who is Covered. Most term insurance policy insure only one life only but that is not the only game in town. A “joint-and-first survivor” policy pays out when the first of two or more insured people die, while a “joint-and-last-survivor” policy waits until the last person has departed this mortal coil. The first policy might be for a couple of yuppies with no other dependants or for insuring a mortgage, while a last-to-die policy is usually used for tax purposes, such as to pay the often enormous tax bills that usually coincide with the last spouse’s death.
• Living Benefit Option. In some cases, the insurer will pay you a set amount of the death benefit while you are still alive, like 50%, if you are suffering from a terminal illness.
• Surviving Spouse Option: Some policies allow you to purchase a policy on the surviving spouse after payout of a joint-first-to-die policy has paid a claim on the first death without any additional questions if done within a set time period of the first death, such as 30 days.
• Riders: this is a fancy insurance term for add-on benefits that cost a little bit more. Just like you’ll need to pay a bit more to trick your car out with the deluxe audio package or bum warmers, you’ll need to pay a bit more for special features like (but not limited to):
o Waiver of premium on disability. This means that you don’t have to pay your premiums when you’re disabled.
o Childhood Term Coverage. This gives you coverage on your kids up to a set age without making them jump through any hoops. This feature may also allow the kids to purchase additional coverage up to a set age in the future and convert it to permanent insurance.
o Guaranteed Insurability. This allows you to purchase additional coverage in the future without any tests or questionnaires. Usually, this rider requires you to exercise this option while you’re still fairly young.
o Critical Illness Coverage. Rather than getting a separate policy, you can buy a rider that will pay out a set lump sum if you are diagnosed with a covered illness or condition and survive for a set period afterwards. I generally recommend getting a separate critical illness policy that you can tailor it to your situation but it is nice to have choices.
Uses of Term Insurance
To paraphrase my earlier comments, it’s really important to use the right tool for the job. Here are some of the situations where term insurance is commonly used:
• Replacing future earnings / covering future educational expenses/ providing childcare and household services. These types of needs won’t be around forever so your insurance doesn’t have to be, either. As you put more in the bank or make more tuition payments, the need to use life insurance to create a pool of money to care for your dependants decreases .For younger people, the amount of money needed to address these issues is rather daunting. Accordingly, term insurance is often the only insurance solution that is affordable, based on the amounts involved. For needs like these, the amount of insurance coverage is usually more important than the type.
• Debt Protection. If you have a mortgage or took out a new business loan, you, your family or the bank (in the latter case) might want you to have life insurance in place in case anything happens to you. Assuming that you aren’t just paying interest-only on your debts, this insurance need is temporary and term insurance for the life of the expected loan is the way to go.
• Buy-Sell Purposes. If you have business partners and don’t love the idea of going into business with each other’s spouses if one of you dies before your time, buy-sell insurance makes a ton of sense. It can create a cash injection to pay out the deceased’s estate in a tax-efficient way so that the widow or widower can get on with life and the other owners can get on with business. Term insurance can be perfect for this need especially for new businesses with limited cash flow or if there is a plan to sell the business in 5 or 10 years and no one is too old to qualify for term coverage. In some situations, such as if there is no plan to ever sell or if the owners have a permanent insurance need such as paying tax at death, permanent insurance will make more sense.
• Key Person Insurance. Although it is important to have cash on hand to buy out a deceased business partner’s spouse, this might not be the only money problem for your company if a partner or a key employee passes on to the great widget factory in the sky. Perhaps banks will get nervous and start calling in loans, maybe there will be a lot of disruption and loss for the business while you hunt for a new widget maker, train her up and win back lost clients. Although this is an important need, it isn’t a permanent one, so term insurance is usually the preferred solution.
• Spousal and Child Support Replacement. I estimate that about 1 in 3 of the separation agreements or divorce orders I have seen include insurance provisions. If you are relying on spousal or child support payments, it makes to have life insurance protection to top up your or the kids’ bank accounts until the kids have received their honours English degrees and you have found that dream job upon re-entry to the workforce. Assuming that this extra coverage doesn’t motivate you cut the brakes on your ex’s car, this coverage is actually a benefit for him or her, too. If the insurance can partially or fully fund these obligations, he doesn’t have to worry about court challenges when his new Will leaves everything to his trophy wife and second batch of kids. Fortunately, many child or spousal support obligations don’t last forever. Perhaps, your insurance coverage shouldn’t, either.
Today, I have just given you a brief glimpse rather than showing you a complete picture of life insurance. Although I think that is beyond any one person’s capabilities, I promise to flesh in a few more of the details, particularly on the permanent insurance front, in future articles. Although I have today sung the praises of term coverage, permanent insurance also needs its own day in the
Before I leave you to stumble through the confusing maze of life insurance on your own until next time, I do want to give you a few breadcrumbs or balls of yarn to use when trying to find the way out. They are:
• The perm / term choice isn’t an all-or-nothing decision. Sometimes you might get some term coverage for short-term needs and permanent coverage for things like final taxes or a charitable bequest rather than a single one-size-fits all policy.
• Consider a blend of term policies if you expect diminishing insurance needs going forward. For example, you might need a 10 year term policy for your shorter term needs and a 20 year term policy for the rest. If you aren’t too old, you will generally have the option to renew your 10 year policy when the first term is almost up if you haven’t quite paid down the mortgage. On the other hand, if you are on schedule, you can cancel the 10 year policy as planned, knowing that you have also saved a lot of money in premiums along the way by not sticking exclusively to a 20 year product.
• Although group mortgage insurance through the bank is easy to apply and may seem like a no-brainer, just say no. I’ll write more about this in later, but there are many advantages to a privately owned term policy instead. A word of caution, however: don’t cancel your group coverage until your personally owned one is signed, sealed and delivered.
• You can generally reduce your term coverage along the way without cancelling the whole policy, which results in paying lower premiums. Accordingly, I suggest revisiting the amount of coverage you need every few years and reducing your insurance if appropriate. In many cases, I see clients with tons of life insurance and little health protection. Consider using some of the savings to pay for these so-called “living benefits.” Making extra payments into RRSPs or against the mortgage aren’t a bad idea, either.
• If you are insuring something like a mortgage or even for things like income-replacement, look into a joint first-to-die policy rather than two individual policies, as this will reduce your costs. You will get half the money if you both die, but perhaps that’s all you need, especially if you have additional policies on your individual lives in place anyway or no other dependants.
As always, I welcome questions, comments and future article suggestions!