While life insurance is an integral part of a comprehensive financial plan, we’d all like to pay as little as possible for the protection. Life insurance premiums are often much lower on the priority list than bills, groceries and other mandatory expenses, so people skimp on the coverage to fit it in their budget. But coverage should be the last thing you reduce when trying to save on life insurance, since having enough coverage is the main objective for purchasing life insurance in the first place.
For those of you who are looking for other ways to save on life insurance, layering your life insurance may be a strategy you can use. Here we’ll introduce the concept of layering your life insurance, and how it saves you money long term.
Traditional method of serving your life insurance need
Traditionally, when you purchase life insurance, you calculate your needs at that moment in time to determine the amount of coverage that you require. The problem with this method is your insurance needs change over time, and they are likely to decrease as your assets grow, your debt load decreases, and there are less years to provide income replacement for your dependents. Therefore, the amount you calculated at this moment likely isn’t accurate 10 or 20 years down the road. Because you are over-insured, your insurance premiums will be higher than if you were insured for the correct amount. In the figure below, you can see how much of the life insurance bought was wasted from age 35 to 65. Of course, your beneficiaries wouldn’t complain, but life insurance is for protection first and foremost, so why should you pay for insurance that you don’t need?
If a 35 year old non-smoking male bought term-10 insurance for the amount shown above ($1,800,000), he would pay $72.54/month for the first 10 years, $532.62/month for years 11-20, and $1,188.72/month for years 21-30, for a total of $215,265.60 over the 30 years (1).
If instead he used term-30 to fund his insurance needs, he would pay $253.98/month for the 30 years for a total of $91,432.80. This is a significant amount of savings over using term-10, but is still shy of the amount that can be saved by layering your life insurance.
Layering life insurance
Since we already identified that our life insurance needs decrease as we age, we can design an insurance policy that matches the decline. Within this policy is term-10, term-20, term-30 and permanent insurance (universal life). The idea behind layering your life insurance is that you drop the coverage for term-10 when it’s up for renewal after 10 years, drop the coverage for term-20 after 20 years, and do the same for term-30 after 30 years, leaving you with permanent insurance to cover final expenses in retirement. Dropping the term coverage as they are up for renewal ensures your coverage closely mimics your need. It also limits your exposure to increased renewal premium, which is where the greatest cost of term insurance appears. By combining all of these coverages under a single policy, you save by paying a single policy fee instead of multiple ones.
This method isn’t perfect, and as you can see from the figure, there are gaps in coverage where term insurance is dropped. But there are also points where coverage is higher than the necessary amount. Over the life of the policy, the over-insured and under-insured amounts should cancel out.
To do a proper comparison with the traditional method, we will match the premium payment period of 30 years. The same 35 year old non-smoking male using the layering strategy will pay $23.44/month for 10 years for $625,000 of term-10 coverage, $41.18/month for 20 years for 610,000 of term-20 coverage, $33.2/month for 30 years for $240,000 of term-30 coverage, and owns $25,000 of universal life that increases in cost annually until age 100. In total, he is insured for $1,500,000. Since the comparison is based on 30 years of premium payment, the insured can pay an amount greater than the minimum so that the universal life portion of the policy can draw on the reserve to continue in force past age 65. The reserve in a universal life policy is usually invested, but in this case, we will set the return to 0%. The minimum payment until age 65 that is required to keep the policy in force is $171.16/month, or $61,617.60 over 30 years.
By layering his life insurance, the person in this example matched his coverage with his need, plus he saved close to $30,000 over 30 years! If we applied a return of 5-6% for the reserve fund within the policy, which is easily possible given the long timeframe, the savings would have been even greater.
The drawback of layering is that an untimely death can result in an insufficient death benefit. This can be avoided by purchasing a higher amount of life insurance, but it will increase your premiums. Overall, a comparison shows that it has more advantages over the traditional method. Also keep in mind that using the traditional method, there is a permanent need with final expenses that would not be satisfied with term insurance.
1. Quote from Transamerica Life Canada. Rates are current as of November, 2014.
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