Comparative Interest Rate Method

What is the Comparative Interest Rate Method, and how does it work?

The comparative interest rate approach is a method of determining the cost difference between two types of insurance plans. The comparative interest rate method is specifically intended to demonstrate the cost difference between a whole life policy and a decreasing term policy with a side fund.

The comparative interest rate method allows prospective policyholders and their agents to compare costs and benefits between the two different types of products. Because interest rates fluctuate, the value of the products, as well as an individual's demands, can change over time.

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TAKEAWAYS IMPORTAN

• THE COMPARISON INTEREST RATE METHOD is a method for comparing whole life and decreasing term life insurance plans.
• It involves comparing a whole life policy's yearly equity gain against the annual interest rate of a side fund associated with a decreasing term policy.
• If all else is equal, increasing interest rates on side funds will make them more appealing. Some customers, on the other hand, may value the peace of mind that whole life plans can provide.

How the Comparative Interest Rate Method Works

To understand how the comparative interest rate approach works, it's helpful to first review the structure of the two types of life insurance products that it's used to compare: whole life policies and decreasing term policies. In a whole life insurance policy, the policyholder pays monthly insurance premiums for the rest of their lives and is guaranteed coverage as long as they pay on time. Whole life premiums are sometimes set at a much higher level than what a young and healthy person may acquire through a decreasing term policy, with the benefit that the coverage will continue to be in effect if the policyholder is old and infirm.

A whole life policy's value grows over time, accumulating equity that the policyholder can borrow against, subject to the policy's terms and conditions. When a policyholder dies, their beneficiaries have the option of receiving the balance of the policy as a lump-sum death benefit or as dividends. Permanent or traditional life insurance policies are other names for these sorts of policies.

On the other hand, decreasing duration policies do not build equity over time. Instead, the policy is only active while payments are being made, and there is no residual value for the policyholder once the term has concluded. To solve this, some decreasing term policies include side funds, which are effectively investment funds that are offered in addition to the decreasing term policy. A portion of the policyholder's monthly premiums is directed to the side fund and invested on the policyholder's behalf in this scenario.

Comparing the attractiveness of these two types of programs is done using the comparative interest rate method. It involves comparing the predicted rate of return on the side fund with the rate at which equity grows in the whole life insurance.

Consider the following two hypothetical life insurance plans as a real-world example of the comparative interest rate method. 

The first is a whole life insurance policy with a $500 monthly insurance premium. The second option is a decreasing term policy with a 30-year term, a $100 yearly insurance payment, and a 2% annual estimated return on a side fund.

Assume you're a 30-year-old in great health while comparing these two policies. You reason that if you buy a decreasing term insurance and maintain healthy lifestyle choices, you will almost certainly pay less over the course of the 30-year term than if you get a full life policy. You are aware, however, that at the end of that period, you may be unable to obtain fresh life insurance at a reasonable price, especially if you have began to develop health concerns. As a result, it may be worthwhile for you to spend the extra $400 per month premium for the whole life policy in order to have peace of mind that you would be covered in the event of your death.

Another aspect to examine is the difference in interest rates between the two programs. The decreasing term insurance provides a side fund with an estimated annual return of 2%, whilst the whole life policy allows you to develop equity over time. If the side fund, for example, paid a ten percent interest rate, it would be much more appealing.