All insurance policies fall into two types of categories (term insurance, and whole life insurance). Within each category are numerous variations, however, this article will discuss the foundations for both.
Term Insurance
Term insurance is temporary insurance that provides coverage for a limited period of time without any buildup of cash value. It is also the least expensive type of insurance when young, but increases in cost as you grow older upon renewals
Term insurance is typically the most sensitive type of insurance in relation to an insurance company’s economic well-being. An insurance company could increase premiums on a yearly basis to reflect changes in its operational success (e.g. issuing policies that have a low lapse rate, exceed investment expectations, and accurately estimate mortality rates). If insurance companies do not meet financial expectations, premiums will likely be raised to the maximum guaranteed premium, which is usually much higher than what an insurance agent illustrates to you when selling a policy.
Whole Life Insurance
Whole life insurance has fixed premiums rather than ones that rise with age. As a general rule, you will either pay premiums for the insured’s life or until the policy “endows” (meaning the policy is designed to pay a certain amount after death or at the end of the contract period).
The non-fluctuating premium system results in insurance companies collecting more than it needs to pay off claims in the early years, and less than it needs to pay out claims in later years caused by increased mortality. This system works because excess premiums earned in early years (which are invested) cover the shortfall of earnings in the later years.
Whole life premium payments provide two benefits: insurance protection (or a death benefit) and an investment account. The risk portion is essentially term insurance, and the investment portion acts as a savings account inside the policy (commonly known as cash value). Cash value is a liquid asset that builds up over time, and is available to the policy owner who can borrow against the policy. The cash value is usually free from current income taxes while the policy is in force, however, when the policy is surrendered for its cash value, income taxes will be due.
In standard whole life insurance, premiums will not increase (or adjust) to reflect actual mortality experience. However, the illustrated premium structure usually assumes that the policy will offset future premiums with interest or dividends earned from the policy’s cash value (cash value gets re-invested into the policy), thereby reducing the number of years that you have to pay the premium. This concept is typically referred to as a “vanishing” premium.
However, the vanish date shown in the illustrations is not guaranteed, and will take longer if the insurance company was unable to achieve its risk projections are off. This highlights why it is critical to purchase a policy from a highly rated insurance carrier.
