Cost of Insurance and Death Benefit: Level vs Increasing

As mentioned in one of my first few posts, insurance is a very critical part of solidifying your financial foundation. Using the UL (Universal Life -- Permanent Insurance) can be a very beneficial strategy for you, if used properly.

However, a couple of the things that usually don't get talked about much are, how the insurance cost is actually broken down, and how the death benefit is calculated.

Cost of Insurance

Essentially, there are 2 ways cost of insurance is calculated; you can have Level Cost of Insurance or Increasing Cost of Insurance.

Level - Pretty straight forward; means that the cost of insurance will remain the same over the entire life of the policy

Increasing - Also pretty straight forward; means that the cost of insurance will rise every year over the life of the policy. Originally, cost of insurance will be a lot lower during the earlier years, to allow for more money to go towards the investment portion of the policy. However, over time the cost of insurance will surpass that of "level cost of insurance" and the policy will cost more to maintain.

Both strategies have their pros and cons and you should crunch the numbers for both strategies to see which one works best for you for the amount that you are contributing to your policy.

Death Benefit

Just as there is Increasing and Level Cost of insurance, there is also Increasing and Level Death Benefit.

With an Increasing Death Benefit, your insured amount stays fixed, while your death benefit increases with the accumlated savings.

Using an example of $500,000 Insured amount, plus $100,000 in the savings component, with an Increasing Death Benefit, the total payout would be $600,000 upon death. This is advantageous because you can increase your tax-free benefit to your heirs.

With a Level Death Benefit, the death benefit stays fixed and the insured amount decreases as your savings increase (thus decreasing the cost of insurance). Using the above example, the death benefit would be a total of $500,000 ($400,000 that the insurance company is giving you, and $100,000 of your own investments).

The benefit is that the overall cost of insurance is going to be lower, because as your investment amount increase, proportionally that's how much less coverage you will be paying for; therefore allowing more of your premium to go towards the investment amount.

However, once the investment amount has surpassed the face amount, the death benefit paid to your beneficiaries increases. For example, if you originally bought a policy with a face amount of $500,000, and later on in life your investment portion grows to $750,000, your beneficiary would actually receive the full $750,000, not $500,000.

Here's a great visual example that I got from the sunlife.ca website:

Level death benefit For fixed insurance needs, the level death benefit is the less expensive option. With this option, the amount of the death benefit paid to your beneficiary remains level. Here’s how it works: as the policy fund grows through contributions and earned interest, the difference between the death benefit and the policy fund value decreases. The difference is called the “net amount at risk.” The cost of insurance (COI) you must pay each month for the base insurance portion of your policy is based on the net amount at risk. By lowering the net amount at risk, you can lower the monthly COI withdrawal.		Death benefit plus policy fund With the increasing death benefit option, any amount in the policy fund is added to the death benefit and paid tax-free to the beneficiary. The policy fund is not used to reduce the net amount of risk. Because the net amount of risk stays constant, you will know at purchase exactly what the COI withdrawal for your base insurance will be over the lifetime of your policy.

(source: http://www.sunlife.ca/plan/v/index.jsp?vgnextoid=ea9775b5e1856110VgnVCM1000002dd2d09fRCRD&vgnextfmt=default&vgnLocale=en_CA)

Essentially, these graphs can also be used to show how increasing vs level cost of insurance works.

As mentioned before, both strategies have their pros and cons, and much of depends on time horizon and how much you will be contributing to the policy over that time. Make sure your advisor always crunches the numbers for both strategies and shows you how each one would work for you.

I hope this has helped! If you have any questions please do not hesitate to contact me. Please consult your financial advisor before making any decisions.