Protection

The Case of Term vs Whole Life Insurance: Chapter 4


Article Author - Christopher Tan
By Christopher Tan
Jul 13, 2016

This article is part of The Case of Term vs Whole Life Insurance: A Comprehensive Consumer Guide e-book. The following chapters will be released shortly.

To read Prologue and Chapter 1 of the e-book: Click here

Chapter 2 & 3: Click here


Chapter 4 - Which Type Of Insurance Is Suitable To Cover Our Needs?


There are 4 main types of insurance that pay out upon death, total and permanent disability (TPD) and dread disease (critical illness):


Endowment


Endowment policies are designed to help us save for the future. We contribute a regular premium for a number of years and at the end of the policy duration we receive a lump sum maturity pay out. Some Endowment policies have a "Cash Back" feature, whereby yearly cash benefits are given at specified years in addition to the maturity pay out.

As endowment plans are mainly meant for savings, a much smaller portion of our premiums are used to pay insurance charges (mortality charge) that gives us the insurance coverage. Therefore, endowments are not suitable, if we are buying it for the purpose of protection.

We have no objections if we are using it for savings, either towards our retirement fund or children’s education fund. But we are not big advocates about endowments, simply because the returns may not be sufficient for us to achieve our goals, and also because of its inflexibility. In addition, we have given many other savings and investment options in Chapter 1. So if we want to buy an endowment plan, do consider if they are enough for us to reach our goals. We might need to supplement it with other options.

To understand more about endowments, we might like to read the following educational articles:

  • Choosing the Right Endowment: Click here
  • 4 Endowment Plans Specially Designed For Your Child’s Education: Click here

Investment-Linked Policy (ILP)


ILPs are insurance policies that combine life insurance coverage with investments into unit trusts. Part of our premiums goes to pay for insurance charges that pay for the cost of insurance benefits, and part of it is used for investing. The investment value is liquid and it can be withdrawn from anytime.

For a regular premium ILP, the policyholder determines the annual premium amount, which stays level, as well as the percentage allocations to insurance charges and investments. However, ILPs are usually structured such that the insurance charges increase over time, which means that the remaining portion of the premiums that goes into investments shrinks over time.

We have written an article on why we do not advocate ILP at all. We can read more about it here.

In gist, the main reason why we do not advocate buying an ILP is that we are limited by the choice of funds (unit trusts) that are being sold by that insurer. And if we are really keen to invest in unit trusts, there are plenty of choices outside the ILP space, why do we want to tie our hands unnecessarily?

As such, we do not advocate using ILPs for the purpose of protection.



Term Plan


A term plan is one where by we only pay for pure protection. We do not give extra money to the insurance companies for them to invest it into their life fund. We also decide how long we want to cover ourselves for, using a term plan. As such, when a term plan runs its course, we no longer have any cover and also we do not get any money back.

Because of this, the premium for term plans is very low, for the same amount of coverage we would have paid for using a whole life plan or an ILP. As such, term plan is the most affordable way for us to be fully covered for our needs.


Some Advantages and Disadvantages of Term Plans

Features of Term Plan

Advantages

Pure insurance coverage with no investment component

1. Premium is low and very affordable. We can afford full coverage of our needs
2. We only pay what we need - insurance
But that is what insurance should be for - protection, not savings or investments.

We decide the term of coverage

We can decide how many years of coverage we need and we pay for what we need. No money wasted and premium is affordable.

No cash value

As there is no investment component in term plans, there is no cash value, simply protection. But that is what insurance is for - protection, not savings or investments. And because there is no cash value, we can terminate this plan anytime when we don’t need it, or there is a better plan out there. There is no fear of not being able to breakeven our premium paid.

Table 4.1: Advantages of term plans

Features of Term Plan

Disadvantages

Remarks

No more coverage after term ends

We may be afraid that when the term plan ends, we might have miscalculated in that we have yet to retire or our retirement has been delayed, due to unforeseen circumstances. We might still need the coverage but now we have none.

This can be easily solved by giving ourselves a buffer in our planning. Instead of buying a term till 60 or 65, we can stretch it until aged 70. If we retire earlier than 70, we can always terminate it earlier without fear of losing cash value, etc. It is simple, no complications.

No cash values - cannot do automatic premium loan (APL)

An APL is an insurance policy provision that allows the insurer to deduct the outstanding premium amount from the cash value if the insured does not pay it after the grace period (30 days). This ensures that the policy will not lapse if the premium is not paid. Because term plans have no cash value, if we forget to pay premium, after 30 days, a term plan may lapse.

While having an APL feature is useful, to buy a high premium whole life plan, just to hedge against forgetfulness to pay insurance premium does not make sense. One can easily prevent it from happening by setting up a direct debit facility with the bank to do regular premium deduction.

No cash values - After term ends, no money back

There is no investment component in term plan. As such, when we terminate your plan or after the end of the term, we do not have “savings” to take back.

The primary purpose of insurance is for protection, not savings or investment. For if we want to save or invest, there are many other options available as described in Chapter 1. Furthermore, having no cash value makes terminating a policy when we need to, easier. No fear of not breaking even our premium paid.

Table 4.2: Disadvantages of term plans

In our experience working with clients over the past almost 2 decades, many have told us that they bought whole life plans because they get some returns on the premiums they paid from whole life insurance whereas from term plans, they get nothing back at the end of say, 20 years. But this is a misunderstanding because the only reason why they get something back from whole life plan is because they gave the insurance company extra money above the insurance cost to invest. The insurance cost they paid for their protection portion of whole life plans has no return. It is an expense, just like term insurance.



Whole Life Policy and Whole Life Hybrid Policy


A whole life plan is one where we get permanent coverage - meaning that the insurance policy will continue for as long as we live. It used to be that we will also need to pay our premiums for as long as we live as well. However, nowadays, insurers are coming out mostly with limited pay whole life plans where we only pay for a limited period of your life, for example, till age 70 years old but the coverage is for as long as we live. So it seems like a steal, isn’t it? Well, we all know there is no free lunch. What this means is that the insurance companies have already calculated the amount that we didn’t have to pay from, say aged 70 and brought forward so that we pay more premium per year, till aged 65.

The premium for whole life plan is high because for every dollar that we pay, a small proportion of it is taken to pay for insurance cost (mortality charge) and the rest is invested into the insurance companies' life fund. The life fund return is currently projected between 3.25% - 4.75% p.a. This is of course not guaranteed. What that means is that even if the life fund can return 4.75% p.a., we will only get 4.75% p.a return on the portion of the premium that is invested into the life fund. The portion of the premium that is paid for insurance cost is an expense. There is no return.

Increasingly, we see insurance companies launching what are known as “Whole Life Hybrid” products. These are packaged products that put a whole life plan and a term plan together. How a hybrid can be structured might be like this: A $50,000 whole life plan is packaged together with a $100,000 term plan that run till aged 70. So we get covered say $150K plus cash values for death, total and permanent disability, if it happens before say aged 70. If death, total and permanent disability happens after aged 70, we only get covered $50,000 plus cash value.

Hybrid plans are cheaper than pure whole life plans for the same coverage because of the embedded term component. But the premium is still much higher relative to a term plan.



Some Advantages & Disadvantages of Whole Life Plans

Features of Whole Life Plan

Advantages

Remarks

Automatic Premium Loan - APL

An APL is an insurance policy provision that allows the insurer to deduct the outstanding premium amount from the cash value if the insured does not pay it after the grace period (30 days). This ensures that the policy will not lapse if the premium are not paid. When the insurer deducts from our cash value, we are effectively taking a loan from the insurer. If we want to pay back the premium amount back into the cash value, we have to pay the insurer an interest.

While having an APL feature is useful, to buy a high premium whole life plan, just to hedge against forgetfulness to pay insurance premium does not make sense. One can easily prevent it from happening by setting up a direct debit facility with the bank to do regular premium deduction. In addition, we have to pay an interest to the insurer for the loan taken.

Paid-up Policy

If we do not wish to continue paying the premium or, if we cannot afford the premium, we can request the insurer to lower our sum assured to a level whereby they estimate that the cash value of our insurance policy is sufficient to pay our monthly premium for our new lowered sum assured, until we probably pass away.

While this gives us some flexibility if we can no longer afford our premium, our sum assured is reduced and we may not be sufficiently covered. Also, if we surrender this policy subsequently, we won’t have much cash value to take back.

Has cash value

When we surrender the policy, we get back some money. Whether the amount we get back will be more than the premium paid depends on how well the life fund has done and when we surrender it. Early surrender usually mean inability to breakeven our premium paid.

The primary purpose of insurance is for protection, not savings or investment. For if we want to save or invest, there are many other options available as described in Chapter 1. Furthermore, having cash value makes terminating a policy when we need to, complicated. There is a fear of not breaking even our premium paid if we terminate early.

Higher death benefit pay out than the amount we initially bought

Due to the policy bonus that is declared regularly, the protection value may increase over time as bonus is declared when the insurance companies' life fund performance is good. This may help to mitigate the effects of inflation

While mitigating the effects of inflation is important, the high premium of whole life plans may only afford us a much lower coverage than what we actually need. Buying a low cost term plan with a slightly higher coverage than what we need will easily solve the problem of hedging against inflation.

Table 4.3: Advantages of whole life plans

Disadvantages of Whole Life Plan

Remarks

Paying for what you don’t need

When we buy a whole life plan, we are paying for insurance coverage for as long as we live. However, as we have discussed above, in most situations, we only need coverage for a period of time. As such, we are paying premiums for what we don’t need.

Returns

The primary purpose of insurance is for protection, not savings or investment. For if we want to save or invest, there are many other options available as described in Chapter 1. Furthermore, having cash value makes terminating a policy when we need to, complicated. There is a fear of not breaking-even. That if we terminate early, we may have paid more premium than the cash value we would receive. If we are depending on this “return” for the purpose of saving towards retirement, the return might not be enough to reach our goals.

Inflexible

Having cash value makes terminating a policy when we need to, complicated. If we terminate early, there is a fear of not breaking-even. Over the years, insurers are coming out with good term plans with very competitive premium. But even if we are healthy enough to switch plans, we might find it hard to do it because of this consideration.

High premium

The biggest disadvantage of whole life plan is that the premium is so high that we might not be able to afford the cost to provide full coverage of our needs. This defeats the primary purpose of insurance, which is to give us sufficient protection against our risks.

Table 4.4: Disadvantages of whole life plans

Many people buy whole life plans for dual purpose: coverage and saving for retirement. The problem with this approach is that because whole life’s premium is too high for us to afford ourselves full cover, and the return is probably too low for us to reach our retirement goal, we end up not achieving both objectives. We are stuck in the middle.

So whilst whole life plans are meant for protection purpose, the premium is expensive because:

  1. There is an investment component
  2. The protection is for the entire life

As we have said the primary purpose of insurance is for protection and not saving or investment, the question really is: Should we use term or whole life plan to meet our insurance needs? To answer this question, let’s put all our discussion in the previous chapters together


Higher Priority Needs How Long Do You Need Insurance? How Much Coverage? *Whole Life Plan Premiums (p.a.) *Whole Life Hybrid Premiums (p.a.) *Term Plan Premiums (p.a.) Recommended Plan

1. Income replacement due to death and TPD

2. Repayment of all liabilities

3. Funding of children’s tertiary education need upon demise

Temporary - You only need it for a period of time

Tony - $500K

==========

Peter: $1 mil

Tony - $14,320
===========
Peter -$28,640

Tony - $5,761
========
Peter -$11,189

Tony - $1,922

=============
Peter - $2,913

Term Plan

Income replacement due to critical illness

Temporary - You only need it for a period of time

Tony - $130K

==========

Peter - $360K

Tony - $4,650
===========

Peter - $12,877

Tony - $2,269
=========
Peter - $6,242

Tony - $1,699

============

Peter - $3,810

Term Plan

Income replacement due to critical illness +

Alternative medicine and care

Temporary for Income Replacement & Permanent (due to the desire to have the option for alternative medicine and care)

Tony - $130K (Temp) + $50k (Perm) = $180k
==========

Peter - $360K (Temp) + $50k (Perm) = $410k

Tony - $6,439 ($180K coverage)
=========

Peter- $14,666
($410K coverage)

Tony - $3,061
($180K coverage)

=======

Peter - $6,782
($410K coverage)

Tony - $1,699 (Term) + $1,814 (Whole life) = $3,513
============

Peter - $3,810 (Term) + $1,814 (Whole life) = $5,624

Tony: Whole life Hybrid

Peter: Term + Whole Life

Table 4.5: Term or whole life?

*We used the lowest premiums based on the 5 insurers we compared. Please go to appendix 1- 4 (Table A) for a detailed breakdown of the various insurance companies’ premiums. The premium for the whole life and whole life hybrid is over a limited period of 25 years.


Conclusion


Based on our discussion so far, we can safely conclude that term plans are the most suitable plans for most people with higher priority needs. It is the most suitable because all of our higher priority needs are temporary needs. Secondly, as our need for coverage is quite high, it will simply be too expensive to use whole life plan to cover ourselves fully.

However, if we want the option of providing a lifetime of alternative medicine and care, then a whole life or a whole life hybrid insurance plan may be more appropriate.

Many a times, when we advocate the use of term plan for insurance planning purpose, people often question whether we are too broad stroke, too presumptuous to assume that all clients’ need are the same. Many have commented that we should not be one size fit all in our approach. The truth is, we agree that we should customise recommendations based on clients’ needs.

But the customisation is based on how much coverage one needs, based on the different factors which we have described above. After calculating the coverage amount needed, we can see that term plan is the most suitable, because all of our higher priority needs are temporary needs and the amount of coverage needed is usually too large to use a whole life plan to cover cost effectively.

Can someone insist on using whole life plan to cover that amount? The answer is obviously yes. But not many people can afford the premium and this person must have so much financial resources that after buying all the insurance he needs, he still has enough to plan for other areas of his life.

Because of the above, we strongly advocate term plan as the insurance plan of choice, once the amount of coverage is established.

To read Chapter 5 of The Case of Term Insurance vs Whole Life: Click here



Download The Case of Term vs Whole Life Insurance: A Comprehensive Consumer Guide entire e-book free for a limited time

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