Sunday, October 25, 2009

Effect of Deduction

The benefit illustration for a life insurance policy (i.e. whole life, endowment, critical illness) shows the projected surrender values based on an interest rate of 3.75% and 5.25%. The average of 4.5% represents, in my view, a fairly realistic projection of the future yield on the investment of a well diversified life insurance fund based on current economic conditions.

If you are getting this type of yield, it is important that the amount taken away from your savings should be modest, and not excessive. In my view, a reduction in yield (to cover the mortality and expenses) of 1.5% is acceptable, giving you a net yield of 3%. If you buy riders to cover other risks, the premiums are charged separately and do not affect the calculation for the basic policy.
I find that most benefit illustrations show a higher reduction in yield, due to high commission and high profit margin for the insurance company. The product is bad for consumers and should be avoided.
The reduction in yield is not shown in the benefit illustration. However, you can compute it by looking at two figures that are shown, namely the "effect of deduction" and the "value of accumulated premiums".
Based on the benchmark of 1.5% reduction in yield, the "effect of deduction" should not exceed the following percentage of the "value of accumulated premiums".

Premium
payable for

Maximum
deduction

10 years

8%

15 years

11.8%

20 years

15.6%

25 years

19.4%

For example, if you pay $X a year in premium and the value of premium after 20 years is $100,000, the "effect of deduction" should not exceed 15.6%,or $15.600. I have seen many examples where the effect of deduction could be twice of the fair amount, giving a poor yield to the policyholder.
Tip: If the "effect of deduction" is less than the above benchmark, the policy gives you a good value. If it exceeds the above benchmark by a small amount (say 5%), it is still acceptable. But do not accept any product where the "effect of deduction" is more higher. If you are earning so little (due to the low interest environment), do not allow the insurance company or the agent to take so much away from you.


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4 comments:

  1. Lin DaoyiOctober 25, 2009 5:33 PM

    Hi Mr Tan,

    When you say that the effect of ddeduction is higher than the benchmark amount by 5%, do you mean X% plus 5%, or X%*1.05?

    I ask because for the 10 year period mentioned in the table, the benchmark effect of deduction is 8%. If it is 8+5%, then it becomes 13%, which is on the high side.

    Kindly clarify.

    Thanks,
    Daoyi

    ReplyDelete
  2. Tan Kin LianOctober 25, 2009 7:29 PM

    It is X% plus 5%. You can use your judgement, really.

    ReplyDelete
  3. UnknownOctober 26, 2009 5:10 PM

    Dear Mr Tan

    Is there another way of looking at it; ie 'break-even' year when total surrender value is the same as total premium paid. Using my own life policy, the break-even year is approx 21 - 22 year. Is it reasonable?

    I recently requested a post sales benefit illustration. The info contained is lacking in details compared to LIA's guideline; e.g projected rates of return, effect of deduction etc were not shown.

    cheers.

    ReplyDelete
  4. Roti KopiOctober 31, 2009 3:58 PM

    Hi,

    I am reviewing my whole life policy which i found it to be very expensive. I signed this policy in 2002.

    I look at the schedule and it states that, at end of policy year 25, the Guaranteed Surrender Value is 66,305 and the non-guaranteed SV is 74,202. Total SV is 140,507. annual premium paid would have been $126,900.

    Total Effect of Deduction is 109,163. I take effect of deduction divide by total SV and it's 77%! I think i better cut loss now and take a term life policy instead.

    Many thanks to your enlightening posts!

    Regards,
    Harry

    ReplyDelete