Understanding Life Insurance Premiums

Once you have made a decision to buy permanent insurance, you then need to determine what kind of policy to purchase and what amount of premium to pay. Unlike term life insurance, which has a set premium based on the amount and duration of coverage, the premium for a permanent policy depends on how the coverage is designed and what assumptions are used to prepare the hypothetical illustration. Premiums also differ depending on the kind of permanent coverage. For example, whole life has less flexibility than universal life. Additionally, the premium can change over the time you own the coverage. 

The premium for a life insurance policy is calculated using illustration software provided by the insurance company. The premium amount is determined by a number of variables including your age, sex, health rating, the assumed rate of return, payment mode, additional riders, and whether the death benefit is level or increasing. How long the policy is designed to last, as well as the assumed non-guaranteed rate of return, can have a significant effect on the premium. Some policies are calculated to last to expected mortality or age 90, while others may be modeled to last until age 121. (See also: Understand Permanent Life Insurance Illustrations)

When you receive a hypothetical illustration all of the following premiums, along with some explanations, will be included. You will have to read through the illustration to locate them since the ledgers in the illustration will be based on the planned premium.

The Planned or Target premium is the amount modeled by the software and is based on the 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.

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 range from as few as 5 years even up to age 121. In exchange for the 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.

The Guideline Premium and the Cash Value Accumulation tests were devised to 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). The corridor amount is greater when the policyholder is young and decreases as a percentage of the total death benefit as one ages, eventually dropping to zero by age 95. If the premium exceeds these guidelines, then the policy could be taxed as an investment rather than as insurance.

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 a MEC when the combined premiums paid during the first seven years that the policy is in force exceeds the seven pay test premium. The illustration software automatically calculates the seven pay premium amount. The IRS has established these measures to help curb abuses where insurers sold policies with a nominal amount of insurance that were really designed to build a large amount of tax-free cash value. The seven pay amount varies by age and kind of policy.

The minimum premium is the amount that must be paid to put the policy in force. This amount is usually not sufficient to keep the coverage in force for life unless the insured is very young. This premium may be used, for example, when a 1035 exchange from another policy is pending or the policy is owned in a trust and when issued gifts will be made to provide additional funding.

The amount of premium you should pay really depends on how you design the coverage.

Whole life policies build a large cash value and tend to have a higher set premium. Current assumption universal life policies have 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 benefit that helps minimize the amount of insurance you are buying. If you want leverage (death benefit), universal and variable policies illustrated with a high rate of return, increasing death benefit and low premium 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.  

Whole life and no-lapse universal policies offer guaranteed death benefits. However, the policies will have a higher premium offering less leverage.

When designing permanent life insurance coverage, the right premium really comes down to why you are buying the coverage. Is it for protection, cash value accumulation or both?