Saturday, November 24, 2007

Buy Term and Invest the Difference

Dear Mr. Tan,

Why does a life insurance policy give a poor return to the policyholder? Is it due to the cost of insurance protection?

REPLY

The return to the policyholder (i.e. the person who buys the insurance policy) will eventually work out to be:

a) The return earned by the insurance fund from investing the premiums, less
b) The deductions from these returns to cover the expenses, mortality and profit margin.

If the investment fund earns an average of 5% per annum, the return to the policyholder is likely to be reduced by the following:

a) Cost of selling insurance: 1.2%
b) Mortality (i.e. to provide the insurance protection): 0.3%
c) Profit margin to insurance company: 0.5%

The return to the policyholder will, in this case, work out to an average of 3%

If you "buy term and invest the difference", you are likely to get a return of about 4.7% (i.e. after deducting the cost of the life insurance protection).

If you save $300 a month, the difference in payout at the end of 20 years is:

Return of 4.7% p.a. $115,000
Return of 3% p.a. $ 97,000
Difference $ 18,000 or 18% more than $95,000

By separating insurance from investment, you will earn 18% more (in this case), over a period of 20 years.

The difference comes mainly from the selling cost and profit margin of the insurance company.

3 comments:

Anonymous said...

Thank you for educating us on insurance especially from an expert like you. All this while the insurance agents never told us. They have us believe that tradition wholelife and endowments with cash value are good for protection and saving. They never told us the setbacks of this type of plans. What the others say about insurance agents being unethical and unscrupulous is true after all.Eg.I found out from an NTUC insider agent that that the agents like to sell limited premium living plan and Revosave because they carry very high commission for agents to qualify for contest. They are expensive but they give low return and low insurance coverage.No value for money. Customers can be suffocated financially over time and worse they can only meet a bit of your needs. Why buy them ? I guess those who bought must have been unduly misled and seduced into it.

TMAN said...

Your rate of return on the permanent insurance is very conservative to say the least. Now, what about the expenses built in to the funds? What happens in 30 years? Life insurance is long term and there is a very high probability that the cash value in permananent life insurance can be accessed without creating a taxable situation. Also, cash values in permanent insurance are not subject to market risk. Yes, I am an insurance producer and I work for NMFN and am proud of it. Remember to diversify your portfolio.

Anonymous said...

Anonymous in AL:
TMAN is very fortunate that he produces for what is arguably best permanent insurance product line available bar none. Also most NML agents are far better trained and professional. I do not recall an incident where an NML agent has oversold a permanent policy at the risk of under insuring clients. It is unfortunate for TMAN/NML that other companies do not aspire to the level of NML and issue policies for the benefit of their policy holders. NML is the exception and not the rule, therefore buy term and invest the difference makes most sense for most consumers. Note:For most UL's or whole life policies insurance portfolio's I review (assuming the company supplies an in-force-ledger) we are looking at optimal times to bail out and are layering term insurance to fix the need analysis. As for NML, I do not recommend a replacement and incorporate the policy into the conservative bond portfolio mix. In my practice I promote buy term and invest the difference. The invested difference is key and usually takes the form of maximizing 401 k matching contributions,Roth IRA accounts or section 529 programs. So I agree with Mr. Tan.

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