Fixed insurance premiums have some advantages.

In an industry first, the insurer MLC has announced the default setting for the life insurance products it sells through advisers will from now on be “level” premiums, rather than the more common “stepped” premiums that increase with age.

The difference between level and stepped premiums is a bit like the difference between fixed and variable home loans. A level premium is largely fixed at the time you take out the policy, whereas a stepped premium can – and will – increase markedly.

Level premiums are calculated according to your age when you take out the cover. The annual premium essentially stays the same for the life of the policy, after adjustments for inflation and fee increases.

Stepped premiums, however, increase each year in line with your age, inflation and fees. They start off much cheaper than level premiums but cost more over time as you age and the likelihood of a claim increases.

The move to encourage policyholders to switch to level premiums could be seen as a way for an insurer to pocket more premium earlier but MLC's head of insurance product, Sean McCormack, says it's about sustainability.

While the front-end cost of a level premium may be off-putting for some people, MLC's experience is that the ever-rising cost of a stepped premium means many people eventually drop their cover “just when they need it most”, McCormack says.

“You need to choose an insurance option that's affordable for the long-term,” he says.

MLC gives the example of a 38-year-old man who takes out $1 million in life insurance, plus $500,000 to cover total and permanent disability and $500,000 cover for critical illness.

If he chooses stepped premiums, he'll pay a total of $374,918 over the 27 years until he turns 65. However, if he chooses level premiums, he'll pay just $118,430 in today's dollars.

So why would anyone choose stepped? McCormack says stepped premiums still account for two out of three life policy applications MLC receives, even after a big jump in level-premium policies in the past year or so. He suspects a lot of it has to do with the front-end affordability, while financial adviser Mark Staggs, principal of Godfrey Pembroke in Melbourne, adds that in the past, many people just wouldn't have been aware the level option was available.

In MLC's example, the 38-year-old would pay just $1752 for a stepped premium in the first year of the policy, compared with a vastly higher level premium of $4386.

However, MLC points out that by age 65, the annual premium under the stepped option would be a massive $48,754, while the level premium would have moved only in line with inflation and fee increases – “nothing like the rises you'll see from age-related increases”, McCormack says.

In fact, the annual cost of the level premium would have fallen below the annual cost of the stepped premium just nine years into the life policy, when the policyholder was 47.

Because level premiums are based on your age at the outset, the younger you lock in, the greater the potential savings, McCormack says.

His rule of thumb is that if you plan to hold life cover for at least seven years, you're better off choosing a level premium. The flip side of that is it doesn't pay to choose a level premium later in life. MLC doesn't offer this option after age 59.

Risk specialist Staggs agrees the “crossover” point for stepped and level premiums – the year the level premium becomes lower than the stepped premium – would be about year seven.

However, the absolute break-even point – the point at which you'll have recovered the extra you paid for level premiums in the earlier years – would be about 11 or 12 years, he says.

Staggs says people essentially take out life insurance for two reasons: to generate a lump sum for dependants upon death, or to cover a shorter-term liability such as a debt. So he starts by asking clients how long they see their working life extending. “If that's 15 to 20 years, say, it says to me that level is a far more economical way to go.” If the answer is 10 years, stepped may be the logical option.

When it comes to covering a debt, he asks how long the policy will need to be in force. If the debt will be paid off in the short to medium term, stepped is likely to be best; if it's a large sum that will take longer to repay, level is likely to suit.

Often, both circumstances need to be covered and he'll construct a “split” insurance policy that combines both stepped and level.

The client might need $1 million in life cover, for example, and he'll divide this into $500,000 on stepped, with a view to this being dropped in eight years' time when the mortgage is cleared, while $500,000 will be maintained long-term under a level premium.

This sort of split cover is also an option when affordability is an issue. “There's no point having insurance that becomes so high in cost that you're uncomfortable,” he says.

If premiums are too onerous, insurance is the first thing someone thinks of dropping when things get tight.

Instead, people should consider whether the insurance can be modified and the premium lowered.

Key points

Insurer MLC has changed the “default” setting for life insurance to level premiums.

Annual premiums are more expensive at the outset under the level option but are cheaper in the long-term. That's because stepped premiums increase as your age increases, while level premiums stay the same.

The break-even point is about 11 or 12 years — policies put in place for longer than this will be cheaper under a level-premium structure.

It's possible to devise a “split” policy, combining both stepped and level premiums, to help affordability or when part of the insurance need is short term.

LIFE INSURANCE - STEPPED OR LEVEL?
Annual premium payments over 20 years
STEPPED PREMIUM RATES 
                35 years old    55 years old
CommInsure      $503.82                 $2819.75
MLC Life Cover Plus $601.02             $3521.02
ING             $573.22                 $2829.85
AXA             $500.84                 $2825.16
Asteron                 $506.54                 $2986.94
Average of Top 5        $537.09                 $2996.54
Market Average  $558.06                 $3019.40
LEVEL PREMIUM RATES
                35 years old    55 years old*
CommInsure      $1002.18        $1002.18
MLC Life Cover Plus $1220.22            $1220.22
ING             $826.30                 $826.30
AXA             $810.36                 $810.36
Asteron                 $802.94                 $802.94
Average of Top 5        $932.40                 $932.40
Market Average  $936.10                 $936.10
Man non-smoker - Sum insured: $800,000
* Plus CPI and fee increases 
SOURCE: DEXX&R