Choosing a life insurance policy can be confusing. There are so many different policies to consider. You have to think about the premiums and benefits that come with the policies, as well as the companies them. Then there's the type of policy. Which one is right for you—a term life or a permanent life? Both have their advantages and disadvantages, depending on your personal situation.
If you're mulling over a permanent life insurance policy, there are a few things you'll need to consider. The illustrations are hard to decipher, and every company’s products have different fees, which makes it difficult to compare policies directly. Here's a guide for comparing life insurance policies.
- Permanent life insurance policies don't expire, and offer death benefits as well as a savings portion.
- To compare different permanent life polices, use the internal rate of return of the death benefit as an evaluation tool.
- Generally speaking, the policy with the highest IRR is probably the best one to choose.
What Is Permanent Life Insurance?
Before we look at how to compare policies, it's important to understand what permanent life insurance is. Permanent life insurance is a type of insurance policy that doesn't have an expiration date, which is a characteristic of term life insurance—a contract that expires if the insured party is still alive after a certain age.
Permanent life insurance generally has two components or benefits. The first is the death benefit, or the amount paid out to the insured's beneficiaries after death. The second is the cash value, which builds up over time. The policyholder can borrow against this amount or even withdraw from the savings after a certain point.
Types of Permanent Life Insurance
There are primarily two different kinds of permanent life insurance policies available on the market. Both offer a death benefit as well as a savings portion. But there's a subtle difference between the two. The savings portion for a whole life insurance policy is usually guaranteed, while the one offered by a universal life policy fluctuates based on how the market performs. Universal policies also offer policyholders flexible premium options. One caveat with both of them: You must pay your premiums or risk losing your policy.
So how do you choose a policy that's right for you? Try using the internal rate of return (IRR)—a common measure used to evaluate investments or projects.
Internal Rate of Return
Most people look at two factors when deciding on which permanent life insurance policy they want to take out—premiums and the death benefit. The goal is to objectively measure and evaluate the return on the dollars allocated to the insurance premium. Sounds hard, right? Not really. Fortunately, there is a way to cut through the confusion by using the IRR of the death benefit as an evaluation tool. It measures the interest rate at which the net present value (NPV) of the premium paid equals the net present value of the death benefit. The general consensus is that policies that have the same premiums and a high IRR are much more desirable.
Life insurance has a very high IRR in the early years of policy—often more than 1,000%. It then decreases over time. This IRR is very high during the early days of the policy because if you made only one monthly premium payment, and then suddenly died your beneficiaries would still get a lump sum benefit.
The best way to truly evaluate a policy is to request an optional report that shows the IRR of a policy.
Other Considerations for Your Policy
When buying coverage, it’s best to work with an independent broker who can offer guidance about underwriting and provide scenarios from different companies. Here are some issues to consider when buying coverage:
An independent broker can walk you through the underwriting process and give you projections from different insurers.
How much death benefit is needed? This depends on your financial situation and what you need to leave behind to your beneficiaries. Consider your debt load, your annual income, and any other factors at play in your financial life. Generally speaking, you should take out a policy with a death benefit that equals four to five times your annual salary.
Another question to ask yourself: When the death benefit is needed—at the first death, second death or at both deaths? In many cases, a survivorship policy that insures two lives has a lower premium and higher IRR than an individual policy.
Your Age and Health
Insurers have different preferred client profiles and rate health issues differently which affects the cost of insurance. The younger you are, the lower the premiums. That's because insurance companies are betting that you'll live longer. So, older people tend to be more expensive to insure. If you're a smoker or have a terminal illness, your premiums will also be higher.
The Insurance Company
The financial rating and stability of the insurance company. This is simple. If you pick a company that's on the rocks, you may not get the benefits you paid for, so it's worth doing a little digging into the insurer's financials.
Who Takes the Risk?
Policies with a no-lapse guarantee have set premiums and costs but build little cash value. As long as the premium is paid on time the death benefit is guaranteed by the insurer to remain in force until a defined age. With non-guaranteed policies, the risk is shared. The premium is determined in part by an assumed rate of return. Thus, the higher the assumed rate of return the lower the illustrated premium. However, if the assumed return is not achieved, or the insurer increases fees in the policy than additional premium payments may be required, or the policy will lapse.
What to Do Next?
The next step is to select a list of companies and request illustrations. Illustrations are projections that give you an outlook of your policy over its lifetime. To be consistent all illustrations should:
- Have either the same level premium or death benefit
- Last until a specified age
- Use the same premium payment mode—monthly, quarterly, or annual
- Use a consistent assumed interest rate for nonguaranteed policies
- Exclude any riders that have an additional cost
- Include the IRR report
Here's how to evaluate the illustrations:
- Decide on a guaranteed or nonguaranteed death benefit
- Review the financial ratings of the insurer
- Determine, which policy, offers the highest IRR at the lowest premium
The Bottom Line
Assuming all other factors are equal such as premium, death benefit, financial ratings for the insurance company, etc, the policy with the highest IRR on the death benefit over time is probably be the better choice. Once you make your selection, you need to submit an application and go through underwriting. In some cases, the offer from the insurer may have a different rating. If this occurs your broker can help shop the case to other companies to see if a more favorable offer is available.