Once you decide to buy life insurance, the next step is to determine what premium you can afford to pay to obtain the coverage and benefits you want.Premiums vary based on a number of factors, beginning with the type of policy you plan to buy. While some policies always charge the same premium, others allow you to change over time. It's important to understand how this works so you can budget appropriately and make sure you get the best insurance value out of your premiums.
Key Takeaways
- If you want life insurance, you should figure out how much of a premium you can afford to pay.
- The premium for a policy depends on the type of life insurance.
- Term life insurance usually provides the least expensive premium but it eventually expires.
- Universal life insurance provides the most flexibility of permanent life insurance premiums whereas whole life insurance always charges the same premium.
- A policy illustration shows how your premiums would change throughout your policy.
How the Premium for Insurance Is Calculated
Life insurance companies use a variety of factors to determine how much premium they will charge for a life insurance policy.These variables include your age, sex, health rating, the assumed rate of return, payment mode, additional riders, and whether the death benefit is level or increasing.
Some life insurance policies offer high-benefit payouts, but these higher payouts come at the cost of higher premiums. Policyholders might be tempted to use premium financing to pay the higher premiums. The financing is not risk-free.
The premium is also based on how long the policy is designed to last. Longer-lasting policies cost more. A 20-year term policy costs more than a 5-year term policy, while a permanent policy that never expires costs the most.
Permanent policies also build cash value, which grows over time. The performance and growth of your cash value can significantly affect the premium. If your cash value grows by more than expected, you might be able to reduce your premium. Poor cash value growth could increase your future premium.
Insurance agents use illustration software provided by the carrier to model a policy's future performance.When you receive a hypothetical illustration for permanent life insurance, it will predict your cash value growth and the cost of your life insurance over time. That way, you can plan your budget and premium payments accordingly.
Premiums and the Type of Life Insurance
The type of life insurance makes a big difference for the premiums as well. Term policies charge a lower premium because they provide only temporary coverage. The premium usually stays the same during the entire term as well. Permanent policies do not expire and cost more. There are different types of permanent policies.
Whole life insurance policies charge a set premium that does not change. Universal life insurance 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.
If you pay too little premium in the early years, your policy could run short of cash value to cover the insurance costs. Then you would need to pay much higher premiums or you'd risk losing coverage. A universal life insurance policy will give you recommendations for how much to pay with a planned premium, no-lapse premium, and minimum premium.
Planned (Target) Premium
The planned (or target) premium is a suggested premium that indicates the amount of premium that should keep a given universal life policy in force in the coming years. The planned premium is based on conservative financial assumptions.
The illustration software will model the target premium. The amount is based on variables the insurance broker enters into the program, including an assumed rate of return. The assumed rate of return is important, since a higher non-guaranteed return results in a lower premium (and vice versa). However, maintaining the planned premium does not guarantee the policy will remain in force if the rate of return falls short of projected returns.
Some policies are calculated to last to expected mortality or age 90, while others may be modeled to last until age 121.
No-Lapse Guarantee Premium
The no-lapse guarantee premium is the amount that must be paid to ensure that the policy will stay in force for a set number of years, regardless of actual policy performance. During the no-lapse period, the insurer guarantees the coverage will continue, even if the cash value drops to zero. However, once the guarantee period ends, the policy could lapse unless a significantly higher premium is paid. The no-lapse period can be as few as five years or last to age 121.
In exchange for the no-lapse guarantee, contracts with longer guarantee periods tend to build significantly less cash value than does the same contract using the target or another non-guaranteed premium.
Minimum Premium
The minimum premium is the amount that must be paid to put the policy in force. This amount is usually insufficient to keep the coverage in force for life (unless the insured person is very young). This premium may be used, for example, when a 1035 exchangefrom another policy is pending. It may also be used if the policy is owned in a trust when issued, and gifts will be made to provide additional funding.
Premiums and Cash Value
Cash value builds in permanent policies on a tax-deferred basis. You can also tap into your gains tax-free through loans. In the past, investors abused this tax break. They paid very high premiums into policies relative to the death benefit to use life insurance mainly as an investment. In response, the government created rules for how much premium you can pay into these policies.
Regulatory Compliance Tests
The guideline premium test and the Cash Value Accumulation test provide an IRS-approved way to determine the tax treatment of a life insurance policy. The guideline premium test requires a policy to have at least a minimum amount of at-risk 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 policy's corridor amount: the difference between the policy's death benefit and its cash value. The acceptable size of the corridor varies by the type of test administered.
The corridor amount is greater when the policyholder is young, It decreases as a percentage of the total death benefit atan individual age until it eventually drops to zero by age 95. If the premium exceeds these guidelines, thenthe policy could be taxed as an investment rather than as insurance.
Modified Endowment Premium
The modified endowment premium is the amount that makes an insurance policy a Modified Endowment Contract (MEC). Under the Technical and Miscellaneous Revenue Act of 1988, distributions from a policy determined to be a MEC, such as loans or cash surrenders, are potentially taxable and could be subject to an IRS 10% penalty tax. However, the death benefit remains income-tax-free.
A policy can become an MEC when the combined premiums paid during the first seven years that the policy is in force exceed the seven-pay test premium. The insurance company's illustration software automatically calculates the seven-pay premium amounts.
The IRS has established these measures to help curb abuses that occur when insurers sell policies with a nominal amount of insurance designed to build a large amount of tax-free cash value.The seven-pay amount varies by age and type of policy.
Your insurance company can tell you the maximum premium you can pay into your policy relative to the death benefit so you avoid breaking these rules and losing the tax benefits on your cash value.
Which Policy and Premium Amount Should You Pick?
The amount of premium you should pay depends on how you design the coverage and how much you can afford.
Term policies have the lowest premiums but do not accumulate any cash value and eventually expire. Whole life policies build have cash value and carry a higher premium that doesn't change. Universal life policieshave flexible premiums and assume fixed interest rates of return.Variable universal life policies, in contrast,offer the greatest risk-reward potential, allowing the cash value to be invested in mutual fund sub-accounts.
To build the most cash value in a policy, you want to pay the maximum allowed premium and select a level death benefitthat helps minimize the amount of pure insurance you are buying. You want to overfund the policy as much as policy without pushing past the rules that would turn it into a MEC.
If you want to maximize your death benefit, universal and variable policies illustrated with a high rate of return and increasing death benefit provide the highest payout at death.A policy with a level death benefit, for example, $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 an Insurance Premium?
An insurance premium is the amount of money you regularly pay to keep your policy in force, Some policies have higher premiums than others, while others policies (like universal life) have flexible premiums.
How Is Life Insurance Premium Determined?
Your insurance company sets your premium based on such factors as your age, health, the type of policy purchased, your death benefit amount, and whether you buy any extra benefits through riders.
How Do Premiums Work?
Life insurance premiums pay for your life insurance policy on a periodic basis (usually monthly or annually). Premiums keep your policy active; if you skip payments, your insurance company may cancel your policy. Term policies have lower premiums, as they do not accumulate value beyond the policy's face amount. Permanent policies have higher premiums, which are used to pay for the policy and are invested in a cash-value account.
The Bottom Line
When designing life insurance coverage, the right premium really comes down to why you are buying the coverage. Is it for temporary or permanent protection? Do you prioritize cash value accumulation, the death benefit, or both? A life insurance agent can explain all your different options to design a plan with the premium that best fits your needs.
