Fifty years ago, most life insurance policies sold were guaranteed and offered by mutual fund companies. Choices were limited to term, endowment or whole life policies. It was simple, you paid a high, set premium and the insurance company guaranteed the death benefit. All of that changed in the 1980s. Interest rates soared, and policy owners surrendered their coverage to invest the cash value in higher interest paying non-insurance products. To compete, insurers began offering interest-sensitive non-guaranteed policies.
Guaranteed Versus Non-Guaranteed Policies
Today, companies offer a broad range of guaranteed and non-guaranteed life insurance policies. A guaranteed policy is one in which the insurer assumes all the risk and contractually guarantees the death benefit in exchange for a set premium payment. If investments underperform or expenses go up, the insurer has to absorb the loss. With a non-guaranteed policy the owner, in exchange for a lower premium and possibly better return, is assuming much of the investment risk as well as giving the insurer the right to increase policy fees. If things don’t work out as planned, the policy owner has to absorb the cost and pay a higher premium.
Term life insurance is guaranteed. The premium is set at issue and clearly stated right in the policy. An annual renewable term policy has a premium that goes up every year. A level term policy has an initially higher premium that does not change for a set period, usually 10, 20 or 30 years, and then becomes an annual renewable term with a premium based on your attained age.
Permanent coverage: whole, universal and variable life is more confusing since the same policy, depending on how it is issued, can often be either guaranteed or non-guaranteed.
All permanent life insurance policy illustrations are hypothetical and include ledgers that show how the policy could perform under both guaranteed and non-guaranteed assumptions. The rates of return and policy fees are usually shown at the top of each ledger column and some policies, such as variable or index life, are sometimes illustrated assuming very optimistic 7%-8% annual returns. (For related insight, read more about permanent life insurance.)
Non-guaranteed policies are typically illustrated with a premium that is calculated based on a favorable assumed rate of return and policy fees that could change. The lower premium payment is great as long as the performance of the policy meets or exceeds the assumptions in the illustration. However, if the policy does not meet expectations, the owner would have to pay a higher premium and/or reduce the death benefit, or the coverage may lapse prematurely.
Some permanent policies offer a rider for an additional cost that is part of the contract and guarantees the policy will not lapse. The policy is guaranteed, even if the cash value drops to zero, as long as the planned premium is paid as scheduled. Depending on how the policy and the premium are calculated, the no-lapse guarantee can range from a few years out to age 121. However, in exchange for transferring the risk back to the insurer, these policies typically have a higher premium and build little cash value.
How to Decide
Whether you should buy guaranteed or non-guaranteed life insurance coverage depends on many factors. Here are some factors to consider:
If necessary, will you be able to pay higher premiums?
Most people who bought universal life policies 10 to 20 years ago, when 5%-7% fixed interest rates were the norm, never envisioned the financial collapse in 2008 or the extended low-interest rates that we are currently experiencing. Those policies are now only earning 2%-3% and the owners, often retirees, are faced with paying significantly higher premiums or losing the coverage.
Why are you buying life insurance?
Insurance is unique because it allows you to time liquidity to certain events and to transfer large risks that you cannot otherwise afford to pay out of pocket. If, like most people, you are buying life insurance for the leverage (small premium/large death benefit), you may prefer not having to worry about the policy staying in force.
Do you want to invest the premium and grow the cash value?
Many insurers promote the ‘living benefits’ of permanent life insurance that include the tax-free growth of the cash value, the ability to invest in mutual fund sub-accounts or index products, and taking loans against the cash value or surrender a portion of the cash value. If these benefits are important to you, then guaranteed coverage may not be the best choice.
How long do you need the coverage for?
For many people, a 20- or 30-year level term policy may be adequate to pay off a mortgage or provide funds for your children’s education. And some term insurance can be converted. (Read more about convertible insurance policies.) However, if you need coverage for your entire life, for example as part of an estate plan, then you need a policy that will stay in force until at least age 95 or 100.
The Bottom Line
It is critical to think about why you are buying life insurance and how it fits into your financial picture. If the primary reason for having insurance is to help transfer risk, adding risk to the insurance may not make sense.