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So, you’ve made the decision to apply for life insurance as the next important step in your financial and estate planning. You know what kind you’d like to purchase and what the provider’s process looks like, but you may not know how much it will cost long-term.
You need to know that the cost of life insurance will be dependent on many factors. However, when comparing life insurance policies, the variables to examine will include the annual premiums, cash values, and dividends with the time value of money applied to each variable.
This article will discuss the different methods to compare the cost for life insurance which includes the cost method, surrender cost index, net payment cost index, and the internal rate of return on yield method. The four methods will each have their own advantages and disadvantages. There is no one method that will be superior in all situations.
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Net Cost Method
Using the net cost method, a time period is selected of either 10, 20 or 30 years. Then, the total premiums are added for the period selected and deducted by dividends from the periods and the cash value at the end of the selected period. The net cost per year is calculated by dividing the insurance cost by the term selected.
The disadvantage of using the net cost method is that it does not take the time value of money into account. The method bases calculations on projected premiums, dividends, and cash values are not guaranteed. In addition, it assumes that the policy is kept until expiration.
The method also yields a cost per $1,000 that is less than the true cost of the insurance. The method is dependent upon the insurer's illustration. The insurer could use an unreasonable dividends and earnings rate assumption in later years which can reduce the cost per $1,000 because it ignores the time value of money. Therefore, this method is not effective for comparing policies.
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The Interest-Adjusted Methods
The Surrender Cost Index
The surrender cost index measures the cost of insurance if the policy is surrendered after a selected term. The method calculates the value of all premiums inflated at a selected fixed interest rate for the selected term. Then the value of all dividends inflated at a fixed interest rate for the term is also calculated and subtracted from the amount of premium inflated. The cash value at the end is then subtracted for the selected term. Afterward, the annual payment is calculated along with the cost per $1,000 per year.
The Net Payment Cost Index
The new payment cost index measures the relative net payment of a policy for a given term by assuming that there will be no surrender of the policy during the term. Using the previous method, we would eliminate the cash value step.
The results of the cost per $1,000 is dependent on the insurer’s assumptions concerning policy values and the selected term and interest rates chosen by the insured. The advantage of these methods is that they take into account the time value of money.
Both interest adjusted methods are more useful than the traditional cost method, but the problem arises if the cash outlays are not equal. In cases like these, side investment funds can be created with projected earnings at the same selected interest rate.
The interest-adjusted methods also have the same disadvantages as the traditional net method in the predictability of premiums, dividends, and cash values. Insurers know that certain intervals are routinely selected for comparison. Because of this, insurers may manipulate the cash values to make favorable costs at these selected terms.
Both methods can give conflicting results when comparing two or more policies. In addition, comparing different types of policy with these methods can be misleading and inappropriate.
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The IRR of Yield Method
Lastly, the internal rate of return method is used to determine the internal rate of return on the cash value of a permanent life policy that is held for a particular term. This method is useful because it evaluates the attractiveness of an investment based on the interest rate when the net present value of all cash flows equals zero.
Shop Around for the Best Price on Life Insurance
Picking the most cost-effective life insurance provider can be time-consuming, but it will be worth it in the long run. You’ll save money and get the best value for your investment over time. However, these calculations can be difficult to complete.
So, narrow down your options and ask for help from your financial planner. They will be able to tell you how the various life insurance options will affect your situation.