Tuesday, January 3, 2023

Term, Universal and Whole Life Insurance: Price is What You Pay, Value is What You Get

Here’s a simple explanation of life insurance in order of product history with some anecdotes sprinkled in from my life experience.




1. Term is the oldest.  No cash value.  Death benefit has a level cost (premium) for a “term” period.  After the term period (common example: 10, 20, or 30 years), the premium increases annually at an ever-increasing cost.  Hypothetically, one could pay the rising annual premiums to age 95 or 100 (per the contract) but effectively no one ever does because premiums become too outrageous.  Benefit is the temporary cheap death benefit.


2. Whole Life was introduced after Term around 150 years ago because customers wanted a permanent death benefit.  Whole life covers the “whole” or entirety of one’s life up to age 121, if you live that long.  There is cash value.  Premiums are guaranteed level for the life of the contract.  Overage of premium is returned to the policy holder as a dividend.  Cash values guaranteed to increase because cash values must eventually equal the death benefit on the last day of the contract in year 121.  This is called endowment.  Only a Whole Life policy can guarantee endowment.  Benefits (short list): level premiums for life, guaranteed cash values which can be accessed while living for any reason, guaranteed death benefit for life.


3. Universal was introduced about 40 years ago.  It separates the cost of insurance from the interest component so that the cost of insurance adjusts once a year for the life of the contract.  This is known as Annual Renewable Term. Universal policies has the illusion of being cheaper than Whole Life because the cost of insurance at time of policy issue is very inexpensive.  But as the insured ages, the cost of insurance increases annually to better price the mortality risk (closer to dying).  What was once very cheap becomes extremely expensive by late 60’s getting exponentially more expensive into 70s, 80’s and beyond if there is still enough cash value to support the rising costs internally without the policy owner having to come out of pocket to offset the cost of rising premium.  Benefit:  cheap at first, “permanent” death benefit.



Universal is “Permanent” much like how a term policy could be considered permanent.  Technically, if a person were willing to pay the increasing cost of premium every year to age 95 (or the end of the contract), both a term and universal policy would be permanent, indeed.  


The reality is altogether different.  Because only a Whole Life policy locks in a guaranteed level premium, it is the only life insurance contract that is in effect permanent.


Hucksters (Dave Ramsey) and life insurance salesman with limited training will recommend Universal making the common mistake of thinking it is cheaper than the Whole Life but the reality is, like term insurance, being cheap is temporary.  Eventually, the price of the insurance policy will catch up to its true cost.



Having worked at Nordstrom in my college years selling expensive but high quality men’s dress shoes I learned a valuable lesson:  Price is what you pay, value is what you get.


I learned it was easy to buy the $80 dress shoes that would hold up for maybe 6 months but it was smarter to spend $220 on shoes that would last 4-5 years or longer. 


I approach life insurance the same way.  Term insurance certainly has a place.  For my money, I want a guaranteed convertible term policy so I always have the option to covert to a Whole Life policy.  But when purchasing permanent life insurance, I want the best value I can get.  That only applies with Whole Life because I know the guarantees with Whole Life make sure the premiums are locked in.  I’m transferring the risk of ever being unable to afford the policy as I age and I have cash values that won’t be cannabalized by rising mortality costs like with Universal policies.



I think of Whole Life as similar to a 30 year fixed mortgage.  When I’m shopping for a home, I’m going to choose the financing option that will provide a level payment until the home is paid for.  It’s common sense if you’re going to live in the home for a longer time.  Sort of like shopping for a life insurance plan and planning to be alive for as long as possible… I’d never choose a 1 year adjustable mortgage when buying my home.  In mortgage terms, that’s essentially a Universal Life policy.


We all know what happened in the Great Financial Crisis from 2007-09.  The movie The Big Short chronicles it extremely well.  A few individuals saw the writing on the wall with all gimmicky artificially low interest rates that were set to adjust much higher after the initial term expired and they bet against the housing market making millions, even billions, in the process.


Why do you think life insurance companies love to sell term and Universal policies?  They know they are going to be let off the hook of paying a death benefit because people will either outlive the term policy and won’t be able to keep up with the rising cost of insurance.  Like a home going into foreclosure where the bank repossesses all equity and the house, the life insurance company will keep all the premium (term) paid or in the case of Universal, surrender what’s left of the cash value.  The death benefit is temporary is both cases.


Takeaway: a death benefit can only be guaranteed if the policy owner can afford to pay the premiums or there is enough cash value and/or built up death benefit to pay up the remaining policy premiums to achieve endowment.  Only Whole Life makes this possible because the premium is calculated and guaranteed by the underwriters to cover a level cost of insurance for the life of the policy.  


Price is what you pay.  Value is what you get.



Additional note:



Since Universal policies subject the interest credited to either money market like rates (Universal), or mutual fund like securities (Variable Universal), or even ETF like funds with caps and participation rates (Indexed Universal), there does exist for the possibility for the excess premium (cash values) above the rising cost of insurance premium to accumulate and stay ahead of future mortality expenses.  However, as noted, because the rising cost of insurance is never locked in beyond a year at a time with Universal policies, the risk of the policy performing as one hopes for when making the purchase always resides with the policy owner, never the life insurance company.  The insurance company bears no risk for non-performance because the interest component is unbundled from the cost of insurance.  The risk of the universal life policy performing, because cash values aren’t guaranteed to increase to eventually equal the death benefit like with Whole Life, is left to uncertainty.



 Thank you,

John Montoya

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