How Do Life Insurance Cost Indexes Work?
Life insurance policies allow policy owners to make periodic payments over time in exchange for the guarantee that the insurance company will pay someone if the policy owner dies during the covered period. Some policies even offer living benefits such as dividends and cash value, which the policy owner has access to while she's alive. Because you pay premiums over time and receive benefits at some point in the future, determining which policy offers the best value requires complicated calculations. Fortunately, many companies provide life insurance cost indexes that allow you to compare policies on a common measure.
Types of Cost Indexes
Life insurance companies offer several different types of policies, each structured to provide specific benefits and address certain needs. Some policies, such as term, only offer protection and have no lasting value after they expire. Other policies, such as cash value life, can be surrendered or borrowed against for cash in addition to protecting against the financial loss of an unanticipated death. Different cost indexes account for the various uses of life insurance, helping shoppers compare the features they find important.
The basic calculation for a life insurance cost index starts by finding the net premiums. By subtracting dividends and cash value at the end of the period from premiums paid, you find the amount paid for actual insurance coverage. Net premium is then divided by a factor that takes into account the number of years and the amount of coverage. The result is the cost per year per $1,000 of insurance you take. For example, say you pay $300 a year for an insurance policy that pays $20 in dividends, increases $10 in cash value and provides $15,000 of death benefit for 10 years. Your net premium is $270. Divided that by 10 years times 15 $1,000 units of death benefit to reach a cost index of 1.8.
Time Value of Money
The basic calculation fails to account for the time value of money. Premiums are paid regularly and typically stay the same dollar amount over the life of the policy. Because of the time value of money, the last premium you pay is worth less than the first premium you pay. Interest-adjusted indexes use a discount factor to adjust for the impact of inflation.
Equivalent Level Annual Dividend
Because the net cost index subtracts out dividends, and dividends aren’t guaranteed, companies also present the equivalent level annual dividend to help buyers gauge the impact that dividends have on net cost. For example, if you were comparing a policy that pays dividends against a policy that doesn't pay dividends, you could add the equivalent level annual dividend to the net cost index to see which policy is the better deal in a year when dividends aren't declared.
Surrender Cost Index
A surrender cost index measures cost in terms of the cash value a policy owner could receive if he surrendered the policy. It helps buyers compare policies to determine which provides the best surrender value when the buyer is more interested in cash value than death benefit.
How to Use
The variety of underwriting factors allows every insurance company to offer leading rates in some category. Cost indexes allow buyers to compare the cost of insurance for different policies, based on whether they’re interested in the death benefit or surrender value, using a common measure. The lower the cost index for your age and gender, the less that insurance will cost you for the same terms. Cost isn’t the only consideration with life insurance, and you may want to consider factors such as credit rating and customer service reviews before choosing an insurer.
Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.