Permanent life insurance is a lot tougher to sell than the much cheaper term life. Agents often use the “vanishing premium” concept as a way to make permanent insurance more palatable to potential clients.
“These premiums may look high today,” an agent might say, “but they’ll disappear after a few years and the policy will pay for itself.”
Such sales pitches sold permanent life insurance policies like hotcakes over the past two decades, but in many cases the vanishing premiums have failed to disappear. As a result, insurers were besieged by class-action lawsuits.
Technically, there’s nothing wrong or dishonest about the vanishing premium technique. It’s a simple concept: The cash surplus from premiums paid in the early years earns enough in later years to pay the premiums. The policy becomes “self-supporting” at that point.
There’s only a problem if the assumed rate of return is unrealistically high. That’s when your vanishing life insurance premium doesn’t vanish as expected.
For example, suppose you had purchased a permanent life insurance policy in 1994 with the understanding that you would not owe premiums after the tenth year. You might have received an illustration showing a 10% rate of interest and your premiums vanishing in 2004.
But interest rates have dropped substantially since 1994, meaning that the dividend rate (for whole life) and interest rate (for universal life) have dropped substantially, as well. Instead of 10%, your policy may be earning as little as 6%, depending upon the company and type of policy you purchased. So instead of paying premiums for 10 years, you may still be paying — and will keep on paying for years to come.
Take action now
If you bought a policy assuming your premiums would vanish at a certain point, chances are you will have to pay longer than you expected. What should you do?
First, phone your insurance company to find out if there is a class-action lawsuit pending or that has been settled. You should have been notified of the suit and your options, but it doesn’t hurt to check. You can also call your state insurance department to get a list of the companies targeted in class-action suits.
Second, call your agent or insurance company and ask them to provide “in-force illustrations” that assume you do one of the following four options, with the first option clearly your best:
1. Continue to pay premiums until the premium vanishes.
When you receive the illustrations, look at what year the premium vanishes under current rates and 1% lower. Could you afford to keep paying for those additional years?
If not, consider the other three options:
2. Borrow from cash value to pay the premiums.
You can always borrow the premium from the cash value, if there is enough, at an interest rate that is usually well below 10%. This way, you keep the death benefit (although your policy loan is subtracted from it) and the cash value continues to increase each year.
- Advantage: You can keep the policy in force with little or no out-of-pocket cost.
- Disadvantage: If you continue borrowing to pay the premiums, all of your cash value probably will be used to pay premiums in a few years. Your policy will lapse and you will end up with no life insurance coverage at all.
- Questions to ask: How long will the insurance stay in force, assuming current rates and 1% less? Will you need insurance coverage beyond that point? Would you prefer to keep paying for this policy or try to buy a new one? (Consider your health before you assume you can get a new policy.)
3. Change the policy to extended term.
With this technique, your permanent life insurance policy becomes a term insurance policy, and the cash value is slowly used up over time to pay the term insurance premiums. The more cash value you have, the longer you can keep the policy in force. Another factor is your age; the younger you are, the lower your term insurance premiums will be.
- Advantage: You’ll have insurance for more years than if you use up the cash value to keep the permanent policy in force because the term life premiums probably are lower than those for the permanent insurance.
- Disadvantage: At some point, the extended term coverage will lapse and you will end up with no death benefit. Any premiums you paid on the permanent policy are essentially wasted.
- Questions to ask: What year does the coverage lapse under current rates and 1% lower? Will you need insurance beyond that point, keeping your health and age in mind?
4. Rewrite the policy with a lower death benefit.
The insurance company takes your existing permanent life insurance policy and uses the cash value in it to buy a “paid-up” policy instead. A paid-up policy is one that is guaranteed to remain in force for your lifetime, and it guarantees that you will never owe premiums on it. It differs from a “self-supporting” policy in that self-supporting policies don’t guarantee that premiums will never be due on them.
- Advantage: You have life insurance coverage without any out-of-pocket cost.
- Disadvantage: You’re going to end up with a substantially lower death benefit than you currently have.
- Questions to ask: What is the death benefit under current rates and 1% lower? Is the amount of insurance under the paid-up policy enough for your needs, and if not, how expensive would it be to buy additional term insurance?