The equal outlay method is one of several methods used to compare the cost of life insurance policies. While it may be used to compare both similar and dissimilar policies, it is often used to compare policies that have flexible premiums.
Using the Equal Outlay Method
The equal outlay method assumes that the policyholder pays (outlays) the same premiums for each policy and purchases equivalent death benefits every year. The goal is to find the policy with the highest death benefit and cash values. The method may differ depending on what types of policies are being compared. For instance, when comparing flexible premium policies, the death benefits and premiums can be made equal. Then the projected cash values can easily be compared. However, when comparing a term policy with a whole life policy or two policies where the premiums are fixed, a side fund must be created to account for the difference in premiums between the two policies. The side fund is then added to the face value of the policy with the lower premium so that the death benefits can be compared. In the case of a term policy versus a whole life policy, the amount in the side fund established for the term policy can also be compared with the cash surrender value of the whole life policy.
Example: Barry was comparing a term policy (Policy 1) with a whole life policy (Policy 2). The annual premium for Policy 1 was $300 per year, and the annual premium for Policy 2 was $1,200 per year. The difference between the two premiums ($900) was put in a side fund and accumulated interest at a hypothetical rate of 6 percent. In Year 1 of the comparison, the side fund of Policy 1 equaled $848. This figure was compared to the cash surrender value of Policy 2 that was $0. The term policy face value plus the side fund equaled $100,848, while the face value of the whole life policy (dividends were used to purchase paid-up additions) was $100,020. After using the equal outlay method to calculate the cost of insurance for 20 years, Barry compared the two policies. He found out that up until Year 9, Policy 1 was the best value. However, at Year 10, the cash surrender value of Policy 2 began to exceed the side fund of Policy 2, and at Year 12, the death benefit of Policy 2 began to exceed the death benefit of Policy 1.
The equal outlay method is similar to the cash accumulation method in that when comparing a term policy with a whole life policy, the difference in premium between the two policies is accumulated in a side fund at an assumed interest rate (6 percent is often used). However, it differs from the cash accumulation method in that the face value of the policy is not changed so that the sum of the side fund and the face amount of the policy with the lower premium equals the face amount of the policy with the higher premium in order to keep the death benefits the same.
Note, though, that if you buy term insurance and invest the difference between the premium cost of the term policy and the whole life policy, you must also consider the tax consequences. The interest on the investment may be taxable income, but inside an insurance contract, it is tax sheltered.
Consider also that some term insurance premiums rise every year.
Strengths
Can be Used to Compare Both Similar and Dissimilar Policies
Unlike some other methods, the equal outlay method can be used to compare both similar and dissimilar policies, such as a term policy to a term policy, a flexible premium policy to a flexible premium policy, or a term policy to a whole life policy.
Tradeoffs
Results May be Inaccurate Unless Data are Carefully Chosen
Like other methods, the equal outlay method relies upon some arbitrary data to complete the calculation. One of the assumptions that may make the calculation inaccurate is the assumed interest rate used for the side fund (the higher the interest rate, the more attractive the policy with the lower premium/side fund). Another is the term used to compare policies (the longer the term, the more likely it is that a whole life policy will outperform a term policy). The results will be more accurate if a realistic interest rate is used and if the comparison is done over a long term rather than a short term.
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