The Surprising Way Level-Premium Term Life Insurance Works

By Zeke Anders on September 27, 2023

Level premium term insurance is so ubiquitous that we take it for granted. But some people may notice that after their level term period ends the premiums to maintain the policy increase exponentially. Annually renewable term used to be more common, but the premiums would increase dramatically in later years, which often surprised policyholders who would generally drop the policy. The way level premium term life insurance works is similar to saving for retirement, the insurance company builds up assets in the beginning which it invests to cover costs later on, though with one key difference which is unique to insurance: risk pooling.

Insurance works because of risk pooling. The insurance company spreads risk over thousands of policyholders and can apply the law of large numbers. It is impossible to predict whether one individual will get sick, or pass away, or their house will burn down. With a large number of people, however, the number of these perils that occur each year is fairly predictable. By grouping thousands of people together, the insurance company is able to provide large payouts for the people that need them at a much lower cost to the people that don’t. Insurance works best for risks that are severe but infrequent.

With life insurance specifically, the risk we face is dying early. When you are young, the odds of dying are low, so the required premium from every policyholder for that year is low. As you get older, the risk of dying increases, so the cost for each year increases. The increase is exponential in nature, it rises slowly at first, but then dramatically later. To offer level premium term, the insurance company raises premiums in the early years and invests the excess, called surplus, primarily in corporate bonds and mortgages. This surplus grows over time through additional premiums and the interest earned on investments. As you get older, the premiums you pay cover less than the true, full cost of insurance each year, so the insurance company starts drawing from the surplus. When the level premium period is over, the surplus is depleted, and to keep the policy the insurer will charge the full cost of insurance each year. At that point, most people stop paying the premiums and cancel the policy as the premiums are exorbitant. Permanent life insurance works in a similar way, the difference is the insurer is guaranteed to pay a death benefit as long as the policy doesn’t lapse. Therefore, they must charge higher premiums since there is no pool of premiums from other policies that did not pay out a death benefit.

The insurer can make money if fewer policies pay a death benefit than expected, or if investment returns are better than expected. The insurance company doesn’t necessarily make a profit just because your policy expired, since those premiums might have been paid out to someone else. Insurers can also make money when a policy is canceled, also known as lapsing, sooner than expected.

In saving for retirement, you build a surplus during your working years. When you start saving early, the “premium” or annual savings you need to set aside is lower, since those savings have longer to grow. If you start saving very late, the amount you need to save each year increases rapidly. The key difference between saving for retirement and life insurance, from a consumer’s perspective, is that your investment returns and human capital can’t be accelerated because you need them sooner. Insurance, through risk pooling, allows for an insurance company to pay large death benefits even after only a single premium has been paid. By building and investing a surplus, insurers can offer level-premiums for decades rather than exponentially increasing premiums over time. While it can feel silly to pay for a product you hope to never need, insurance is an invaluable planning tool for protecting your human capital, providing for your loved ones, and creating estate liquidity.

Zeke Anders – Planning Specialist | zanders@twickenhamadvisors.com

Disclaimer

Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.