Tan Kin Lian's Blog: Effect of deduction

Wednesday, May 07, 2008

Effect of deduction

Dear Mr. Tan,
You have written about the "effect of deduction". I am still not clear about this concept. Where can I find this figure? What does it mean?

REPLY
When an insurance agent sell you a life insurance policy, the agent is required to give you a Benefit Illustration. It shows the projected cash value and protection value (i.e the amount payable on death) at various durations of the policy.

There is a column called the "effect of deduction". It shows the amount that is taken away from you at the various durations. This amount is used to pay the marketing expenses, management expenses and life insurance cover.

For example, if your total savings over a period of 30 years is $150,000 and your gain is $100,000 (say), you should get $250,000. If the "effect of deduction" is $60,000, you will only get $190,000. Int his case, the deduction takes away 60% of the gain.

If you invest through other products, the expenses and fees usually take away about 15% and leaves you with 85% of the actual gains. The deduction under a life insurance policy is much higher and usually leaves you with less than 50% of the actual gain.

If you are being sold a life insurance product, ask the agent to show you the "effect of deduction". If the deduction is less than 20%. the policy gives good value. If it is higher, you should look for other investments.

1 comment:

tatos@irc.rizon.net said...: Well in actual fact, as an 'independent financial planner/researcher' (at this moment in time, while avoiding promoting any kind of products, including whatsoever, investments, savings, insurances, I am so naive~), I sincerely hope everybody should know what is the difference between Insurance, Investments, and perhaps eventually, your own notion of 'Value' at the end of the day, before you even start thinking of retirement, hopefully.

While most people consider the 'Value' of Insurance, they often compare it using expected projected gains from investments, minus the Cash Value in the Policy, to see the difference in yield (which is often referred to opportunity costs), this is purely from an Investor's perspective. Which in my opinion, is totally different from what Insurance is all about.

From a strictly 'uninformed financial planner' perspective, Cash Value Life Insurance is one of the worst type of insurance money can buy, for you can get much better bargains (cost-wise) and 'same coverage' using by buying Term Insurance (a.k.a. those Insurance Policies without Cash Value).

Foremost, the reasoning is sound, only when you consider just the COST of getting the guaranteed Sum Assured (upon Death or Total and Permanent Disability or so whatever in your policy that has Sum Assured), and hence 'Instant and Cheap Estate' upon death or TPD. But statistics had shown that most people who bought Term Insurance at such 'cheap costs' (premium) at the time of interception of the policy to the expiry of the policy have really low chances of actually contracting Death or TPD. Most people buy Term Insurance at around age 16~30, while premiums are cheap, the odds of death and TPD are not in their favour (statistically again), while most death and TPD claims are obvious from 60+ ages onwards.

So whenever a 'Financial Consultant' says its more bang per buck than permanent insurance, it is less likely to be in force when you die (sadly speaking), unless the Term Insurance comes with Renewable and/or Convertible options, which could make it flexible, in terms of addressing your needs (if it changes at any point of time).

While Term Insurance with Renewable and/or Convertible options must have sound impressive in theory, one must consider the impact of renewing/converting your Term Insurance.

1) Renewing your term insurance DOES NOT guarantee that you pay the same amount premium for the same amount of Sum Assured, even though you might not have to go through underwriting.

- This first impacts people who are renewing their term policies, the amount of premiums paid have to be adjusted to their new age, according to the Sum Assured, there are little ways around this. And the most terrible case is when one renews his/her Term policy from age 60 onwards, where each renewal might see a jump of premium payable from a few hundred dollars per year, to a few thousand dollars per year. This is to account for the rapid increment of chances of Death and TPD happening to you. And the worst of it all - The insurance company would not be obliged to refund any sum of money, if any, back to you if you decide to cancel the policy, for there are NO CASH VALUE. You can't even use it for Collateral.

2) Renewing Term Insurance might be THE ONLY insurance you can afford or allowed to purchase at the point in time, like if you are already around 50+ years old and no insurer allows you to buy any other policies except Term Insurance, or you do not have the means to even plan out a longer term policy (due to poor retirement planning, perhaps).

- For Convertibility, its like Renewability except it is a one-way option. That is converting to a permanent plan (Life or Endowment). But that doesn't still mean you still pay the same premium for the same Sum Assured, your premium payable would still be required to be recalculated according to the age when you convert and (usually increased) for the same amount of Sum Assured. But the new permanent plan (if its permanent), would have a leveled premium system, unlike the renewability option - That is the new plan would settle on a new fixed premium payable (usually per annum or per month) for the same Sum Assured, and the new premium payable would not change, ever in your whole life, unless you do policy loans, lapse your policies etc. (depending on the Insurance contract).

Then again why would premiums cost much more in a permanent Life Insurance? This is because the premiums you (and everybody) pay regularly is pooled to become part of the cash reserves for the Insurance Company, this pool serve for a number of purposes:

Costs - papers, staffs, agent commissions, offices, managers, electric bills all costs money, this is often what they refer as 'Distribution Costs' or expenses and its most obvious during the first few years of your whole life policy, where you do not even see a single cent of Cash Value. This sounds expensive, but in today's world - There is nothing called FREE LUNCH. Even if you buy stocks with no middle man, you would have to hire a lawyer to negotiate a contract...

Costs of Policy Lapsing - Some people are tricked/lazy/financially unable or outright disgusted by premium payments might lapse or surrender their Policies at any point in time, those who do lapse even before the cash value builds up would cost the Insurance Company money, so that must be taken into account. Also this cost would deter some policyholders from surrendering their policies based on whims alone.

The rest of the reserve would be used by the Insurance Company for investment to drive the costs down while bulgeoning the same pot of money to maintain and pay for the 'Natural Premium'.

Simply speaking, Natural Premium is calculated mainly by Death Rates and Morbidity Rates (Morbidity Rates include chances of Total and Permanent Disability) of the certain age group, proportionate to Sum Assured. So basically, somebody at age 80 is much more likely to die compared to somebody at age 20, Natural Premium proportionally accounts for this and this Natural Premium for a person of age 80 can go as high as several times the total Premiums paid by the policyholder, provided he/she live this long. Insurers have to cover for this shortfall of Natural Premium, by replenishing from the surplus (of the reserve after investments).

The most debatable decreditment of Cash Policies is that why put Cash Value into a long term policy when the policy would ONLY PAY the Sum Assured upon death and TPD (and not including Cash Value). This again make people think of Insurance as a 'Leveraged' Saving Vehicle and perhaps 'Useless' Saving Vehicle, where beneficiaries cannot access Cash Value if the insured dies. This again depending on what your opinion of 'Value' is.

For me, the Cash Value is a collateral incase I need liquid cash (for partial withdrawal, loans), but its not the major feature I prioritise when I look in Insurance Policies.

What I look for 'Value' is whether the coverage is adequate for my needs, even to the end of my own retirement (Retirement planning should be on everybody's priority, start while you are young. Hell! I'm only 23!)

What most people are required to know when they buy insurance is to know whether their existing insurance contract already covered most and the major of their needs, or whether they need to review or (dust/springclean) their policies by sitting down with some 'Quality' insurance advisors and deal with their policies one by one. Then one can start thinking about investments.

But please do remember, its easily to be caught up by Financial 'Purists' saying Insurance should be strictly non-savings, or in the extreme sense, Insurance 'Advocators' saying Insurance is a kind of investment.

The moral of the story is not to blur or shake the credibility of the two but to find a 'Value' though yourself (perhaps with additional help from financial advisors, self-help sites, research and simple logical thinking). IF you are one of the 50% Singaporeans that are expected to need long-term healthcare in the future, you might not have to disinherit your children, or more importantly, your surviving spouse, by taking up a loan for being caught undercovered by Insurance.

- Gah. I sound like a Naive Brat.; May 14, 2008 10:11 AM