By Joel Dansby* on Aug 25, 2020
You’ve spent hours figuring out your life insurance needs, researching products and speaking with agents. You’ve been provided with several premium quotes, and now, you’re scratching your head wondering why they’re so different from one another. Your thoughts then turn to the more penetrating issue of how premiums are calculated and life insurance costs in general, a question few people really want to contemplate but would love to have answered. Many people would probably not give it a second thought, but others, such as yourself, would like to know how your premium dollars are actually spent. Here’s your primer on life insurance costs:
Also referred to as the cost of insurance, this is the cost that the life insurer charges to cover its risk of providing you with life insurance protection. Life insurers employ armies of actuaries to study statistics and devise formulas for determining mortality costs, but, fundamentally, these costs are based on mortality, or life expectancy tables expressed in terms of the number of years a person is expected to live based on their age, health condition, and medical history. The insurance costs for a young person, in good health and with no adverse medical history are less than someone who is older, or who has experienced some health problems.
Each year the cost of insurance increases and the life insurer applies these increased costs to your premium. This is best illustrated in a yearly renewable term policy in which the annual premium increased each year in response to the increasing insurance costs. In a permanent, or cash value policy, the life insurer levels the premium by charging more in the early stages of the policy in order to offset the higher costs during the later stages of the policy.
If a health condition presents a risk that is not factored into any of the standard mortality rates, the insurer will assign a special rating that with an additional insurance charge. Sometimes the rating is only temporary, so when it expires so does the additional charge.
Policy and Administrative Fees
Most policies include fees associated with the administration of the policies to cover the expenses for marketing and policy underwriting, issue and maintenance. Expressed as a percentage, these costs can be low, or even non-existent in some term policies to as much as 1% or 2% in some cash value policies. Administrative fees tend to be higher in policies that offer more options or flexibility for the policyholder such as with universal life policies.
Although these are not fees that are paid from your premium, they do need to be factored in to determine the overall cost of your life insurance. In universal and variable universal life insuarnce policies, where a portion of your premium is deposited into an accumulation account, you have withdrawal privileges. The life insurer wants to discourage early withdrawals so it will charge a surrender fee on the amount of a withdrawal made in the first five to ten years of the policy. Most policies allow for a withdrawal of 10% of your withdrawal before it applies the fee which could amount to as much 12% of the excess withdrawal. These fees usually decrease as the policy matures over the first seven to ten years until they disappear altogether.
Management fees are typically associated with variable life policies that include separate accounts in which your cash values are invested in managed stock or bond portfolios. These annual fees can range from .75% to 2.5%.
Life insurers that market their products through agents or brokers pay a commission on product sales. In addition to paying a sales commission, they also pay a renewal commission each as premiums are paid. Some products include an upfront sales charge which is a percentage of your initial premium that is paid to the broker. Many times you will hear that there is no upfront sales charge, rather, the life insurer directly compensates the broker. It’s important to keep in mind that the life insurer needs to recover its sales costs from somewhere, so it could be built into your ongoing premium payments. While there are low-load or no-load products available, it’s always a good idea to ask specifically how the sales costs are paid.
Option and Riders
Riders are optional provisions that can be added to a life insurance policy to enhance the benefits of the policy or cover additional risks. One example is an accidental death benefit option which provides additional protection in the event death occurs as a result of an accident. Some cash value policies today are offering long term care riders that will apply a portion of the death benefit to the cost of nursing home care. The costs associated with options and riders are not a part of the base policy and are enumerated separately in the contract.
Life insurance policies are complex financial instruments which, some people would say, only an actuary can understand (mainly because they are designed by actuaries). This should not preclude or discourage anyone from fully understanding the costs of their life insurance policy. The policy statement should list all expenses, and include an analysis of the total cost of ownership. Life insurers today are under much stricter regulations and requirements to ensure transparency and full disclosure, so if something isn’t clear, don’t be afraid to ask.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2023 Advisor Websites.