Benjamin Franklin famously proclaims – In this world, nothing can be said to be certain except for death and taxes. Since death is an absolute certainty, we should always ensure that we are sufficiently insured for that unfortunate event one day.
In today’s market, there are many types of insurance coverage. I am going to compare and analyse two common types of insurance: Life insurance vs Term insurance. There is a traditional saying “Buy term and invest the rest” How true is this statement? Let’s find out below:
Life Insurance
Life insurance is used to protect the life insured in the event of death. The premium that you paid is split into two portions. A small portion of your premium will go to the participating fund of the insurer and the remaining portion will be used to pay the insurance protection cost.
Life insurance is a small savings and high protection insurance. Because there is a savings element in life insurance, it will have a certain cash value which is declared yearly as reversionary bonus by the insurer.
The death benefit will then have a guaranteed portion which is the sum assured of the policy plus a non-guaranteed portion of reversionary bonus. The amount of reversionary bonus is based on the performance of participating fund. Life insurance, as the name imply, covers one for the whole life.
For new life insurers, the premium you need to pay is usually fixed, ranging from 5 years to 25 years. This means that you only need to pay for 5 years or up to 25 years and get life time cover.
Term Insurance
Term insurance is a rather simple product. Term insurance is pure protection and nothing else. The entire premium paid goes towards insurance protection cost. Therefore, there is no cash value for term insurance. Term insurance can be used to cover for temporary needs. The premium payment term is the same as the coverage term. This means that you will need to pay the premium for the entire time you are covered.
Here is a summary of life insurance and term insurance:
| Features | Life Insurance | Term Insurance |
|---|---|---|
| Coverage Term | Life Time Death Coverage | Temporary Death Coverage |
| Objective | Savings + Protection | Pure Protection |
| Premium Term | 5 to 25 years | Same as coverage term |
| Cash Value | Yes, depending on the performance of participating fund | No. |
Life vs Term
In order to compare these two forms of insurance, I have done an analysis by using Company A Life and Term insurance products. I prepared for coverage up to age 99, even though technically speaking life insurance covers up to 125 years old! The maximum coverage for term insurance is only up to 99 years old.
The analysis is done for a male, non-smoker, $100,000 death coverage, 85 years old life span. Because the life insurance premium payment terms and term insurance premium payment terms is not similar, we cannot compare by just looking at the face value of premium, the best way to measure the “return” of these two insurance is by using Internal Rate of Return (IRR). You can think it as yearly investment return.
There are a few outcomes we can glean from the chart above.
- For most of the time, term insurance outperforms life insurance. One should buy term insurance as protection rather than using life insurance.
- For newborn, buying a life insurance policy is actually better than buying term insurance.
- Life insurance IRR decreases if you buy at a later age.
- Best time to buy term insurance is at around 20 years of age.
Limitations of the Analysis
This analysis may not be perfect due to the following:
- The data is based on Company A, it may not be the cheapest in the market.
- The non-guaranteed portion of life insurance is assuming 3.25% projected participating fund return.
- Usually life and term insurance come with riders, examples are critical illness and Total permanent disability rider. This analysis did not factor in the cost of these two riders.
- The 85 years old life span is just an assumption. Different life span will change the result drastically. For example, if a person lives until 100 years old, IRR for term insurance is 0%.
Qualitatively assessing your insurance needs
This analysis is done purely based on quantitative analysis. Qualitative analysis as below should be considered before you decide which is the better plan for you:
- Premium affordability is not considered in this case. The pros for life insurance is you can pay off the premium during the early age of life which most likely when you have the capability to pay the premium.
- Buy term and invest the rest. This statement has two parts. “Buy term” analysis is done in this post. You will save some cost by buying term insurance. The second part of this statement is “Invest the rest”. You need to invest the rest. If you are a spender that spends the amount that you save from buying term insurance, then I would rather prefer you go get a life insurance.
- Some life insurance allows you to add early critical illness that cover for life time. This type of life policy may be a better option if you are looking for protection against early stage critical illness.
Disclaimer, this analysis is not to advise you to surrender your life policy and switch to a term policy. Surrendering a life insurance policy always comes with a cost, you should check with your financial advisor before you make any decision.
Personal Finance Fundamentals
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Alternatively, you can let me know here. I am happy to help you review your existing policies.
I have also compared the returns of ‘Term’ and ‘Life’ insurance previously.
I am no financial expert, as a lay man i thought whole life insurance is much worth due to the cash value return with guarantee and non-guarantee fee. If you could tahan it the cash value will offset the premium you give. According to my search it is 3 to 5 times more expensive for the same sum assure though. However with the time term of 10, 15, 25, if individual choose the shortest, the cheaper it is and you won’t have to worry for the rest of your life. However, with term, you need to keep giving until you can’t or to certain age, and it is time sensitive, later you buy, the expensive it is, and in some cases it increase with age (Correct me if i am wrong). That is what most financial adviser had told me, please do advise if i am wrong.
Hi Ja,
Thank you for your comment. In my analysis, I have included the non-guaranteed cash value for life insurance. The “return” which is measured by IRR shows that term insurance is still higher than life insurance. Even though you get some cash value for life insurance, because you are paying more premium for life insurance, end up your “return” is lower.
You are right that life insurance has fixed premium payment term, which allow you to pay upfront during your working age. I agree with you and has mentioned in this post.
Yes. Insurance premium is time sensitive. The premium will be higher if you buy at a later age. This is proven by looking at the decreasing IRR in the chart. Other than avoid higher premium, you should get insurance when you are healthy.
Another angle to look at this is to consider the coverage period of critical illness riders.
For a rider attached on a term plan, once the basic plan expires, the rider coverage will stop. This is usually capped at around 60 to 70s of the Life Assured’s age.
One may consider to attach critical illness riders with lifetime coverage to ensure they remain covered in their 70s and beyond.
Granted, one usual strategy is to peg the premium payable period close to a specific age or year. For e.g. 25 years to be in line with 50 years when one would prefer to channel more cash flow towards retirement.
Hi Jeremy,
Thank you for your comment. The Critical illness rider can cover up to age 99 too and not only cover up to age 60 or 70.
Yes. I do agree with you. Need to consider to have CI cover up to age 99.
Yes and No. If you know how to invest, your income generated from investment should be more than sufficient to pay for the premium in your retirement age. I should write another post on how much return you need to generate to pay for term insurance.
Thanks
Regards
Louis
Since more than 10 years ago, Providend has been drawing brickbats from many in the industry for advocating term instead of whole life plans. While I believe that buying term and investing the rest has its merits, the biggest reason for buying term is because it is the only way you can afford to cover your needs fully.
Hi Christopher,
Yes. I do agree with you. One should not pay too much premium on protection.
Thanks.
Regards
Louis