Vanishing Premium What It Is How It Works Example

Vanishing Premium What It Is How It Works Example

Vanishing Premium: What It Is, How It Works, Example

Alexandra Twin has 15+ years of experience as an editor and writer, covering financial news for public and private companies.

What Is a Vanishing Premium?

A vanishing premium is a fee paid for an insurance policy that continues until the cash value of the policy covers 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 holders of permanent life insurance to use policy dividends to pay the premium.
  • Over time, the policy’s cash value grows until the dividend is equal to the premium owed.
  • Eventually, dividends are used to cover the premium cost, causing the premium to "vanish."
  • More often than not, dividends decrease the premium over time.

How a Vanishing Premium Works

A vanishing premium allows life insurance policyholders to pay premiums from the policy’s accrued cash rather than out of pocket. The premium only vanishes after a certain period of time.

Premiums are paid from the policy’s dividends, allowing policyholders to use their cash for other purposes. This also ensures that the insurance coverage remains active as premiums are automatically paid.

Consumers interested in policies with vanishing premiums should carefully consider the math used to determine when the premiums will vanish. Sufficient interest or dividend rates are necessary for premiums to be eliminated.

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Overly Optimistic Assumptions and Vanishing Premiums

Historically, vanishing premiums have been associated with insurance fraud schemes, where misleading sales illustrations deceive clients by promising premiums to vanish sooner than they actually do.

Unrealistic assumptions about interest rates and investment returns can affect the accumulation of enough principal to generate dividends at the specified threshold, which is the concept behind vanishing premiums.

Vanishing premiums have faced controversy in the past when insurance companies were overly optimistic about investment returns and premium disappearance timing.

Vanishing Premium Example

For example, consider a whole-life insurance policy with a $5,000 premium. To make the premium vanish, the policy’s accrued cash value must generate an annual dividend of $5,000. With an interest rate of 5 percent, the cash value needs to reach $100,000 to eliminate the premium.

Special Considerations

Whole-life policies typically provide a minimum annual growth rate alongside an expected growth rate based on the insurance company’s investment portfolio performance. Achieving the threshold needed for premiums to vanish may take more time if the interest rate is not sufficient to maintain the required amount of principal.

Savvy investors will calculate the total cost of a whole-life investment with vanishing premiums and compare it to cheaper options like term life insurance. They will also consider the potential benefits of investing the difference in premium prices into other investment vehicles.

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