Once you’ve decided to buy life insurance, the next step is to determine what premiums you can afford to pay to get the coverage and benefits you want. Premiums vary depending on a number of factors, starting with the type of policy you plan to buy. While some policies always charge the same premium, others allow for change over time. It’s important to understand how this works so you can budget appropriately and make sure you get the best value for your premium.
Key Things
- If you want life insurance, you should figure out how much premium you can afford to pay.
- The amount of the premium depends on the type of life insurance.
- Term life insurance usually provides the cheapest premiums, but it eventually lapses.
- Universal life insurance provides the greatest flexibility of insurable permanent life insurance, while whole life insurance always charges the same premium.
- The policy illustration shows how your premium would change over the course of your policy.
How Is the Insurance Premium Calculated?
Life insurance companies use various factors to determine how much premium they will charge for life insurance. These variables include your age, gender, health rating, expected rate of return, payment method, other riders and whether the death benefit is flat or increasing.
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Some life insurance policies offer payouts with high benefits, but these higher payouts come at the cost of higher premiums. Policyholders could be tempted to use insurance financing to pay higher premiums. Financing is not risk-free.
The premium is also based on how long the policy is designed to last. Longer term policies are more expensive. A 20-year policy costs more than a 5-year policy, while a permanent policy that never expires costs the most.
Permanent policies also create cash value that grows over time.
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The performance and growth of your cash value can greatly affect premiums. If your cash value increases more than expected, you may be able to lower your premiums. Poor cash value growth could increase your future premiums.
Insurance agents use illustration software provided by the carrier to model the future performance of the policy. When you receive a hypothetical permanent life insurance illustration, it will predict the growth of your cash value and the cost of your life insurance over time.
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This way, you can plan your budget and premium payments accordingly.
Premiums and type of life insurance
The type of life insurance makes a big difference to premiums as well. Term contracts charge lower premiums because they only provide temporary coverage. The premium usually remains the same throughout the term. Permanent policies do not expire and cost more. There are different types of permanent policies.
Whole life insurance charges fixed premiums that do not change. Universal life policies allow you to adjust the policy up and down each year. While this budget flexibility is nice, it also means you need to plan properly.
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If you pay too little premiums in the early years, your policy may not have enough cash value to cover the cost of the insurance. You would then have to pay much higher premiums or risk losing your coverage. Universal life insurance will give you a recommendation on how much to pay with a scheduled premium, no forfeiture and minimum premium.
Planned (target) premium
A planned (or target) premium is a proposed premium that indicates the amount of premium that should keep a given universal life policy in force for years to come. The planned premium is based on conservative financial assumptions.
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The illustration software will model the target premium. The amount is based on variables that the insurance broker enters into the program, including the expected rate of return. The expected rate of return is important because a higher non-guaranteed return results in lower premiums (and vice versa). However, maintaining the planned premium does not guarantee that the policy will remain in force if the rate of return does not reach the planned return
Some policies are calculated to last until expected mortality or age 90, while others can be modeled to last until age 121.
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Hassle-free Premium Warranty
A lapsed guarantee fee is an amount that must be paid to ensure that the policy remains in force for a specified number of years, regardless of the actual performance of the policy. During the grace period, the insurer guarantees that coverage will continue even if the cash value drops to zero. However, once the warranty period ends, the policy may lapse unless significantly higher premiums are paid.
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The non-statutory period can be as little as five years or last until the age of 121.
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In exchange for an unexpired warranty, contracts with longer warranty periods tend to generate significantly less cash value than the same contract using a target or other non-guaranteed premium.
Minimum premium
The minimum premium is the amount that must be paid for the policy to take effect.
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This amount is usually insufficient to keep the insurance in force for a lifetime (unless the insured is very young). This premium can be used, for example, when a 1035 exchange from another policy is pending. It can also be used if the policy is held in trust at the time of issue and donations will be made to provide additional funding.
Premium and cash value
Cash value is built into permanent policies on a tax-deferred basis. You can also use your profits tax-free through loans. In the past, investors abused this tax break. They paid very high policy premiums relative to the death benefit to use life insurance mainly as an investment. In response, the government created rules on how much premium you can pay into these policies.
Regulatory compliance tests
The recommended premium test and the cash value accumulation test provide an IRS approved way to determine the tax treatment of life insurance. The indicative premium test requires the policy to have at least a minimum death benefit (insurance that exceeds the cash value), while the cash value test compares the death benefit to the cash value. Both tests determine the amount of the policy corridor: the difference between the death benefit and its cash value. Acceptable corridor size varies according to the type of test being performed.
The corridor amount is higher when the policyholder is young. It decreases as a percentage of the total death benefit at each age until it finally drops to zero at age 95. If premiums exceed these guidelines, then the policy could be taxed as an investment rather than insurance.
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Adjusted foundation premium
The adjusted capital premium is the amount that makes the insurance a modified endowment contract (MEC). Under the Technical and Miscellaneous Income Act of 1988, distributions from a policy designated as MEC, such as loans or cash redemptions, are potentially taxable and could be subject to a 10% IRS penalty tax.
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However, the death benefit remains exempt from income tax.
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A policy can become MEC when the combined premiums paid during the first seven years of the policy exceed the seven-payment trial premium.
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The insurance company’s illustration software automatically calculates the sums of the seven-payment insurance premium.
The IRS put these measures in place to help curb the abuse that occurs when insurers sell face value policies designed to build large amounts of tax-free cash value. The amount of the seven payments varies by age and policy type.
Your insurance company can tell you the maximum premium you can pay into your policy in relation to the death premium to avoid breaking these rules and losing the tax benefits of your cash value.
Which policy and premium amount should you choose?
The amount of premium you should pay depends on how you design your coverage and how much you can afford.
Term policies have the lowest premiums but do not accumulate any cash value and will eventually expire. Whole life insurance has a cash value and carries a higher premium that does not change. Universal life policies have flexible premiums and assume a fixed interest rate of return. In contrast, variable universal life insurance offers the greatest potential for risk and reward, allowing cash value to be invested in mutual fund sub-accounts.
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To get the most cash value in your policy, you want to pay the maximum allowable premium and choose a death benefit level that helps minimize the amount of net insurance you’re buying. You want to overfund the policy as is the policy without going over the rules to turn it into a MEC.
If you want to maximize your death benefit, universal and variable policies illustrated with high rates of return and increasing death benefits provide the highest death payout. A policy with a death benefit level, such as $500,000, includes your cash value as part of the death benefit. A policy with increasing death benefits would pay $500,000 plus any cash value.
What Is the Premium?
The premium is the amount you pay regularly to keep your policy in force. Some policies have higher premiums than others, while other policies (like universal life insurance) have flexible premiums.
How Are Life Insurance Premiums Determined?
Your insurance company sets your premiums based on factors such as your age, health, the type of policy purchased, the amount of your death benefit and whether you purchase any additional benefits through supplemental insurance.
How Do Premiums Work?
Life insurance premiums are paid regularly (usually monthly or annually) for your life insurance policy. Premiums keep your policy active; if you miss payments, your insurance company may cancel your policy. Term policies have lower premiums because they do not accumulate value above the face amount of the policy. Permanent policies have higher premiums that are used to pay for the policy and are invested in a cash value account.
Bottom Line
When designing life insurance coverage, the right premium depends on why you are buying the insurance. Is it for temporary or permanent protection? Do you prefer cash value accumulation, death benefits, or both? A life insurance agent can explain all of your different options to design a plan with a premium that best suits your needs.
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