What Are Vanishing Premiums in Life Insurance?
A vanishing premium is a periodic fee paid for an insurance policy that continues until the cash value of the policy grows enough to cover the fee. At that point, the premium “vanishes” as payments are no longer necessary but are instead covered by the policy’s internal value and dividend stream.
Key Takeaways
- A vanishing premium allows a holder of permanent life insurance to use the dividends earned on the policy to pay the required premium.
- Over a number of years, the cash value of the policy grows to the point where the dividend earned is equal to the premium that is owed.
- Eventually, the dividend payments cover the cost of the premium, and as a result, the premium is said to have “vanished.”
- Often, premiums don’t completely vanish; they decrease with dividends covering a more substantial portion of the premium over time.
How Do Vanishing Premiums Work?
A vanishing premium provides a life insurance policyholder with the option to pay premiums from the accrued cash in the policy rather than out-of-pocket payments by the insured. The premium only “vanishes” in the sense that the policyholder no longer has to pay it personally after a period.
The funds for the premiums essentially come from the dividends generated by the investment’s accrued cash. This allows the policyholder to allocate cash that would have been used for premiums to other, potentially more lucrative endeavors. It also ensures that the insurance coverage does not lapse, as premiums get paid automatically.
Consumers exploring policies with vanishing premiums should closely scrutinize the calculations justifying when the premiums will vanish. To eliminate premiums, the underlying investments must maintain sufficient interest or dividend rates for making payments.
The Risk of Overly Optimistic Assumptions with Vanishing Premiums
Historically, vanishing premiums have been implicated in insurance fraud schemes where insurers used misleading illustrations to make potential clients think their premiums would vanish much sooner than realistic. Unrealistic assumptions about interest rates and investment returns can significantly impact accruing enough principal to generate dividends at a necessary threshold for a vanishing premium.
Vanishing premiums have been controversial when insurance companies project overly optimistic future investment returns and unrealistic timings for when premiums will vanish.
Illustrative Example
Imagine a whole-life insurance policy with a $5,000 annual premium. For the premium to vanish, the policy’s cash value must generate an annual dividend of $5,000. At a 5% interest rate, the policy’s cash value would need to reach $100,000 to eliminate the premium.
Special Considerations
Whole-life policies generally offer a minimum annual growth rate and an expected growth number contingent on the insurance company’s investment portfolio’s performance. The minimum growth rate may require significantly more time to reach the necessary threshold for making premiums vanish, depending on whether the interest rate remains high enough to sustain the required principal amount.
Given that premiums often decrease rather than vanish, savvy investors must calculate the overall cost of a whole-life policy with vanishing premiums and compare it to cheaper options such as term life insurance. They should also consider potential gains from investing the difference between those two premium amounts into other investment vehicles.
Related Terms: life insurance, premiums, dividends, whole-life policy, interest rates.
