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Permanent Life Insurance Series: How Term Life Insurance Works

My friend Brandon is a very big advocate of Permanent Life Insurance. Him and I have gone the rounds on many occasions about permanent versus term. I decided that to be fair, I would present his argument in a series of posts here in Rabbit Funds. The series begins with a post about challenging the pre-conceptions about permanent life insurance. You can find links to the other posts in the series at the bottom.

Whole Life Insurance

Think of it this way

Let’s say you have a machine in your basement, a special machine, the only one of its kind in the entire world. When you use it, you turn a handle and it spits out money. You can do this as often as you like, as long as you like. And the best part is that the older the machine gets, the more efficient it is: it spits out even more money per turn as it ages.

Now if you had a machine like this, what would you do to protect it? Armed guards? Fancy security system? Would you buy insurance on it? How much? I bet as much as you could get. Would you have it spit out a few hundred thousand dollars and then get rid of it, because that’s all you need? Of course you wouldn’t, that would be crazy.

Well, you do have a machine like this. It is you, and your ability to work and provide an income.

So why would you not want to do everything you possibly can to protect the most valuable asset you will ever have? Why would you want a temporary life insurance policy, one that is designed to expire before you do? Because the reality is that 99% of term life insurance policies never pay a claim.

Why so many? It’s because of the way they are structured.

Term life insurance really is designed to expire before you do

When a term life insurance policy is priced, the issuing company will take a lot of health information about you. They will compare it to an incredible amount of data about how long people of a given height, weight, age, gender, and health status will live. Then they will put you into a particular risk classification. They might not know which of their clients will die in a given year, but they know exactly how many.

For an average 30 year old, it’s about 1 in 1000 that die every year

If each of these people wants $1,000,000 of protection, and the company knows that at the end of the year they will need to pay out 1 claim of $1,000,000, the company knows that it needs to bring in enough in premiums from this group of 1000 to cover the claim, profits, and expenses.

So the price of a $1,000,000 life insurance policy for an average 30 year old starts at about $1,000 a year (1000 people paying $1,000 each is $1,000,000). Once you factor in that the company can invest the money and get growth, you see the actual price go down depending on company performance.

With term life insurance, you are paying only for what is called the mortality risk, or the risk that you might die prematurely. This risk is relatively cheap for young healthy individuals, because you are sharing the risk with many others.

The down side to this, though, is that since you only pay for mortality cost, and you are sharing that risk with others in a similar situation, the cost of a term life insurance policy goes up significantly as you age.

Many people think they can simply renew a policy for as long as they like, but this is not the case. By the time you reach average life expectancy in the above example, your total premiums will be roughly $740,000, and your bill that year will be about $150,000. If you live 8 years past that, you will have paid roughly $2,190,000 and your bill that year is about $250,000 for a $1,000,000 policy.

Of course, the only people willing to pay that are the ones who have been told by a doctor they only have a few months to live.

Buying a term life policy is really a one shot deal

When you do it, you better hope you can actually save up enough money to self insure by the time that initial 20 year period is up, or you could be in trouble.

True, you might be able to get a new policy in 20 years but that is no guarantee. If you can’t get a new policy, your price skyrockets. I mean that within 5 years of your locked in rate expiring, your premiums have gone up over 10 times the original amount. Give it another 10 years, and the premiums have increased by another factor of 10.

Your affordable $500 per year policy now costs $50,000 per year when you are 65. And even if you do manage to qualify for another policy, your new 20 year rate will be about 7 times higher than it was initially.

Again, making this decision early on really forces you to stick with it. And if you haven’t self insured by then, you could be in a world of hurt.

Consider this example, which has happened to many families

The decision was made to buy term and invest the difference, with the goal to self-insure. Twenty years later, the breadwinner has become un-insurable and cannot get a new policy. The premiums on the original policy are growing too much, so the family is forced to go without life insurance, but they have invested a good chunk of money so they don’t feel too bad about giving up the coverage.

But all of a sudden, the market crashes and the self-insurance fund has lost half of its value. To top it all off, the breadwinner dies suddenly. After paying for funeral expenses and taxes, the survivors are left with less than $50,000.

Now you might be saying something such as, “Well that’s just too many things to go wrong all at once, how likely is that really?” But anyone who lost a breadwinner within the last two years could easily have faced that situation.

When you consider that you automatically lose about 1/3 of the total value in taxes, then pay $15,000 for final expenses, and top it off with a massive market loss…it becomes easy to see how that scenario could play out.

Here are all of the posts in this series:

  1. Challenging Pre-conceptions
  2. How Term Life Insurance Works
  3. Is 12% Realistic when “Investing the Difference”
  4. Returns, taxes, death benefit and debt
  5. Achieving Financial and Spending Freedom

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