Insurance

Buy term invest the difference? Not if you look at the numbers

August 14, 2012

49 comments

Today’s guest post is by Glenn Cooke, a life insurance broker and president of LifeInsuranceCanada.com who believes in an educational approach to life insurance rather than a product sales approach. In the post he urges readers to take a closer look at the numbers behind the conventional wisdom of buy term and invest the difference.

Proponents of buy term invest the difference advocate strongly against purchasing whole life insurance. For those unfamiliar with the idea, it suggests that buying cheaper term life insurance and investing the difference in a mutual fund is a better financial option than purchasing a whole life policy and cancelling it at age 65 for the cash values. The strategy itself is rooted back in the 1980’s when the life insurance industry was promoting whole life insurance to consumers as some type of savings vehicle. The strategy often provokes a strong emotional reaction against life insurance companies. What many people may not realize that the biggest promoters of this concept even today are actually life insurance companies who use it to sell term life insurance and mutual funds.

Nevertheless, back in the 1980’s with interest rates where they were and with the products we had available back then, a pretty strong ‘numbers’ case could be made. But that was like 25-30 years ago. Things change. Is this emotional argument that got foisted onto consumers by the insurance industry still valid? Let’s have a look at the numbers today.

Before I do so, let me just state clearly – I have no preference either way. I do however believe in looking at the actual numbers once in a while, rather than just blithely continuing to parrot what everyone else has been repeating for 20 odd years without ever checking their facts.

It’s also important to appreciate that the buy term invest the difference argument is NOT a numbers game. It depends on your assumptions. What do you think is the correct long term interest rate over the next 15-20 years? 8%? or 3%? Or somewhere in between?

OK, lets get to the numbers. I’m using the Compulife® database for my premium information, the database used commonly by insurance brokers as well as what powers the quotes on my website. And we’re going to look at a male, nonsmoker age 45 purchasing $100,000 of life insurance. For the term policy I’m going to use Equitable Life’s 20 year term at $286 per year. For the whole life I’m going to use a whole life policy from BMO Life with premiums of $1276 per year.

Case 1: (Assume 8% rate of return, no taxes on earnings.)

  • Term Case: If they buy the term and invest the difference at 8%, at age 65 they cancel the insurance and have $48,928 saved.
  • Whole Life Case: If they buy the whole life and cancel at age 65, they will have a cash value of $27,160 (less a minimal amount of tax).

The term is $20 G’s better than the whole life. Case closed – it’s a win for buy term invest the difference.

But wait. All is not as it appears. Back in the 80’s one could convince consumers that 8% was a nice conservative rate of return and lead into both a term insurance and a mutual fund sale. Today? Clearly not all consumers are going to buy into the idea of an 8% rate of return over the long term.

So lets try the same numbers at 3% rate of return.

Case 2:(Assume 3% rate of return, no taxes on earnings.)

  • Term Case: Buy term and invest the different at 3% and cancel their policy at age 65, they’ll have $27,399.72 saved.
  • Whole Life Case: If they buy whole life and cancel at age 65, they’ll have a cash value of $27,160 (less a minimal amount of tax).

Really? At 3% rate of return the two products are almost identical! Actually, it turns out that they’re not identical. At this crossover point, the whole life actually has substantial benefits over the term policy.

  1. First, the 3% we just assumed you’d earn with your term and invest strategy? Not guaranteed. The cash value on that whole life policy? Guaranteed. We’re comparing a non-guaranteed rate of return with a guaranteed cash value. Win for the whole life policy. Clearly in today’s environment some Canadian consumers are going to be interested in the equivalent of a guaranteed 3% rate of return – even when compared a higher non-guaranteed rate of return.
  2. Secondly, what if we change our mind and don’t cancel the policy? If you bought the whole life, your premiums remain at $1276 for the rest of your life. If you bough the term life insurance, you now have to take a medical exam and buy a new whole life at age 65, for premiums of about $3500. Win for the whole life policy of over $2000 a year for the rest of your life.
  3. But there’s a third option. The whole life policy allows you to stop paying premiums and take a smaller policy of $46,500 for the rest of your life, no further premiums due. By comparison with the term policy, if you took your $27,000 in savings from your term policy, you could buy a 10 pay whole life policy of $25,000 for about $2500 per year for 10 years – which roughly burns down the money you just saved. Stop paying premiums and keep the coverage, the whole life policy will provide you $46,000 of lifetime coverage, the term option, about $25,000. Win for the whole life policy of $20,000 when you pass.

So now the ‘numbers’ seem like the whole policy is actually a better buy. But there’s some downside to this as well. With the term policy, despite the drawbacks mentioned above, the cash is liquid whereas it’s not easily accessible inside the whole life policy. Does that matter? Maybe it does, then again, for some folks maybe it doesn’t. And for many consumers, paying the higher premiums of whole life simply may not be feasible.

As you can see, it’s not as clear cut as it’s often made out to be. What product is ‘best’ often lies in the underlying assumptions. High interest rate or low? Guarantees vs. non guarantees? Higher premiums or lower premiums? As different people have different preferences and tolerances, so to do we have different solutions for different people. It’s not nearly as simple as buy term invest the difference and believe you’ll be better off financially in the future.

Some Good News on Auto Insurance Premiums for 2012

February 28, 2012

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Auto insurance premiums have skyrocketed in Ontario in the past few years. According to the Financial Services Commission of Ontario (FSCO), auto insurance premiums in the province increased by an average of 5.6 percent in 2008, 8.8 percent in 2009 and 6.2 percent in 2010. Since the reported rate changes are averages, your rate change may be higher or lower than average. As I reported here and here, the auto premiums for our household went up 22 percent in 2010 followed by another increase of 7.6 percent in 2011. Note that since most drivers renew their auto insurance annually, it may take up to a year for the rate changes approved by FSCO to take effect.

Our auto insurance renewal notice for 2012 arrived in the mail recently. The good news is that our auto insurance premium for the exact same coverage and driving record as last year is lower by 8 percent. I count myself lucky because Nordic Insurance Company, which is the underwriter of our policy increased rates by an average of 7 percent in 2011.

According to FSCO, auto insurance premiums went up by an average of 5 percent in 2011, a lower increase than previous years. It appears that new regulations capping accident benefits implemented by the Ontario Government in September 2010 are taking effect. The bad news is that you may still be hit with a hefty increase. Some insurance companies have received approvals for rate hikes of as much as 13 percent. If you are among the unlucky ones, be sure to shop around, review your insurance coverage, consider increasing the deductible and make sure you are getting all the discounts you are eligible for.

Home Insurance Premiums Increasing Sharply

March 8, 2011

36 comments

Our auto and home insurance renewal documents arrived in the mail the other day. Last year, the cost to insure our two automobiles went up by 22 per cent and the cost to insure our home went up by 14 per cent. And when I replaced our rusty old 1992 Accord with a shiny new (relatively speaking) 2004 Accord, our auto premiums went up another 31 per cent (a part of this increase was due to the addition of comprehensive coverage). So, when our auto and home insurance renewal documents arrived in the mail the other day, I opened the envelope with some trepidation. I was hoping that 2011 wouldn’t see a repeat performance. Unfortunately, I wasn’t so lucky.

The news isn’t so bad on the auto insurance front. The changes to new and renewing auto insurance policies implemented in Ontario beginning September 1, 2010 meant that our auto premiums went up by just 7.6 per cent. The smaller increase is a direct result of a decrease in benefits for car owners who are injured in an auto accident. For example, medical and rehabilitation benefits for non-catastrophic injuries have been reduced from $100,000 to $50,000. The good news is that I was quickly able to eliminate the premium increase by boosting the deductible on direct compensation.

Home insurance turned out to be a different story. The premiums went up by 28 per cent for exactly the same coverage and same situation (no claims in the past year). I was able to get a 6 per cent discount for running what Belair Direct calls a home diagnostic (once again, showing that there is real money in some of the bill insets, so at least take a glance before chucking them away), which still means a premium increase of 20 per cent. Insurance companies are blaming increased payouts for wind and water damage due to climate change for the increase in home insurance premiums.