Saturday, November 20, 2010

Garrett Goh: Strategy behind buying term insurance

Published in Straits Times Online Forum

I REFER to the ongoing discussion on insurance products (Madam Lim Pueh Joo, "Investment-linked policy works best for me"; yesterday), specifically to address the "advantages" of investment-linked policies (ILP).

Madam Lim is technically correct in that once the term insurance period ends, renewal premiums will be costly if a person develops a medical condition.

However, purchasers of term insurance are not looking to renew their policies at the end of their terms.

Buying term insurance is only half of the strategy. Advocates of term insurance will save and invest the difference between the premiums of a comparable ILP policy and term policy.

Consumers who buy term insurance and invest the difference will very likely be able to accumulate their own "cash value" by the time the term policy expires.

This self-accumulated "cash value" will be at least equivalent to, if not greater than, the insurance coverage purchased.

Having a personal "cash value" is also more advantageous,because one can claim one's own money without restrictions, such as adhering to the strict definitions of 30 critical illnesses.

It is well known that ILP policies introduce many additional fees that increase their effective expense ratio.

Low-cost investment products have an expense ratio of about 0.5 per cent,

which is much lower than the ILP expense ratio. The latter may be around 2 per cent or higher. ILPs appear to be a win-win situation only because consumers are not well educated about the cheaper alternatives out there.

Garrett Goh

http://www.straitstimes.com/STForum/OnlineStory/STIStory_605149.html

11 comments:

Vincent Sear said...

I feel it understandable for someone who's uncomfortable with the volatility of investments to accept the higher expense ratio and lower potential returns of a whole life or term endowment policy in exchange for the comfort and peace of mind. In these policies, policyholders aren't investing elsewhere with returns linked back but are participating in the insurance fund.

For people comfortable with investment volatility through the long term, there's no reason to spend so much on the distribution cost of a regular premium ILP. Distrubition cost is charged on both the insurance and investment portions of the policy when both could be and are distinctively separate. Whereas in case of a term policy, the policyholder pays a much lower distribution cost for the insurance only, saving more for investment returns.

However, buy term and invest the rest may mean lower distribution cost but not necessarily higher returns than a whole life or endowment policy. Term policy is total cost and total loss if there's no claim. Whatever is saved and invested may also return a loss, sometimes hefty loss that's irrecoverable for decades, e.g. in early 1990s Japan fund or in early 2000s technology fund.

Garrett said...

Vincent, you are assuming that an investor is going to put 100% of his money into a single country fund or single sector fund. That is not investing. That is speculation (aka gambling). With a diversified portfolio of low-cost funds and a time horizon of 40 years for a young person, it is virtually impossible to have a loss at by retirement.

zhummmeng said...

Agents' commission for 1st year is 50%,followed by 25%,25% and 5% for another few years.This is apart from other charges like mortality and morbidity, management fee, advisory fee and profit to the company...Estimated to break even at the 15th year and at the rate of return of 7%.
Wholelife breaks even at 20-25th year.
Regular ILP is LOW risk compared to wholelife..Wholelife is very risky because it NEVER can achieve your goals, whether it is protection or saving.WL fails in both. It is a MISCONCEPTION that WL is low risk.Consumers like to bullshit themselves that it is because they don't understand.Let's see if they should die soon and see how much their family can get. Let's see if they retire whether they have enough fund to retire. There is NO SAVING at all with WL. The real return is NEGATIVE.Wiht ILP , at least there is a chance to get a decent return of 4% but maybe after 25 years..WL is condemned!!!
Some foolish people think that with WL their mortality and morbidity cost is FREE. They are expense and after one year if there is no claim they become the income of the insurer.The company doesn't return the cost to the policyholder just like term which is also an expense.This shows how much smart aleks know about WL.Anyway, fools and suckers are plentifool and that is why insurers still can sell WL and regular ILPs.

zhummmeng said...

Don't waste time on him....it goes to show how 'savvy' he is. He doesn't know that he doesn't know.Let him labour under that illusion.

Vincent Sear said...

Garrett:

You're right, but with a time horizon of 40 years, even the worst WL would return remarkable profits with costs amortised into negligibility. Why? Let's say upfront costs are 100% of annual premiums. Over 40 years, that's just 2.5% per year. Of course, with costs paid upfront, future value compounded effect has to be taken into consideration, still should average around 3% per year.

Another thing many people missed about WL is the RB inflation-proofing if there's a claim many years down the road. If you buy $100k now, your claim if 10 or 20 years later won't be $100k. It'd be much more than that, typically about 300% of cash bonuses. This is an important protection feature that both term and ILP don't have.

Note that I'm not particularly advocating for traditional whole life. I'm just looking at it neutrally and objectively. The days of 8% to 10% bond interests are over, so the days of WL breaking even at 10 to 12 years are over too, regardless of which company and who's the CEO, actuary and investment officer. Is it still good for you, you decide.

Zhummmeng:

I don't understand why you're sounding so personal. There's no need to. I'm just addressing the issue. The issue in this case being cost savings between buy term and unit trusts separately or combine both in a regular premium ILP. The figures are there. You can prefer to pay more for convenience, service etc. It's alright with me. It's your money.

Garrett said...

Vincent, you are obviously ignorant of what is going on. If you think the only cost in WL is the upfront cost, then the effects of deduction should decrease proportionately as one ages to almost zero at the end. This is NOT reflected on the BI.

I would like to see some proof before you talk about 300% cash bonus as well. I am very skeptical.

And lastly you are also oblivious as to how WL policies invest the pool money. NTUC Vivolife to my knowledge is the only company that releases some details of its portfolio and it is invested conservatively like 60% bonds and 40% stocks. For a young investor, this allocation is totally in appropriate.

The fact that WL policies have a higher expense ratio and more conservative portfolio (with lower expected returns) can only lead to the only conclusion that young people to purchase into WL will be losing out on a lot of money in the long term. That's a mathematical fact, not an opinion.

Vincent Sear said...

Garrett:

RB is reversionary bonus, not cash bonus. It's typically worth 3 times cash bonus at claim, i.e. it's worth one-third at surrender. Check out any WL BI.

Traditional life fund is usually 70/30 bond/equity. It's regulatory requirement because of the insurance risk-adjusted reserves to meet claims. Yes, it's not optimal for a young investor with a healthy risk profile and horizon.

Note I've never claimed WL to be the best or to be all to everybody. It's true that in the long run, most buy term and invest the rest would outperform WL. It's a mathematical probability, not a mathematical certainty.

I'd only suggest WL for people who can't get over the psychological barrier of paying term premium and getting nothing back at the end if there's no claim. I wouldn't suggest WL for investment purposes. It's still an insurance policy for contingency protection.

If one goes for cheaper term willing to forsake the premium totally, to save more money to invest for returns, that's fine and well, in fact optimally so in view of returns potential. The returns would probably more than cover what's paid for the term.

Vincent Sear said...

Garrett:

Upfront distribution is cost, real money paid and cannot decrease to cost even if at advanced years, there's no cost. The effect of upfront deduction would still be there and reflected, decreasing as in amortisement but could never reach zero. For example, 100% premium cost is 100% in year 1 and becomes 5% in year 20. Even no more cost is incurred for that particular year, what's incurred earlier would be reflected.

It's the same for unit trusts. Whatever 2 to 5% you paid as sales charge would affect the performance as long as you hold it, even though it's just one-time upfront (no counting effect of annual management yet).

zhummmeng said...

WL products invest in a one size fits all portfolio. It disregards the needs of the policyholders. Everybody's money into one pot..low , medium and high risk policyholders, there is no distinction..this portfolio is supposed to be a low risk portfolio..In investment, it is very TRUE that low risk gives low return.
Net this return and the policyholders get very paltry return even after 30/40 years and which is NEGATIVE REAL RETURN.It means after 40 years you are no better off than you were, maybe worse.
As for the sum assured which is supposed to increase with bonus...look closely and you notice it is an illusion..Truth is the insurer cheats you on this.
First the increase is NOT inflation hedged..secondly if there is a claim the cash value is NOT PAID to you. Minus the cash value you might even notice that you have been conned and you have been paying same premium for LESS sum assured over time.
Get your facts right... remember my advice... wake up and know what you don't know and you will be wiser.

zhummmeng said...

Assuming you buy a 20 year limited payment WL try keeping your whole life till you are 100 years old and you will see the nominal return becoming negative because the bonus given by the insurer CANNOT outpace the compounding mortality charges. The high charges will begin at age 65 and it will double at age 70 and double at 75 and the band gets narrower until when you hit 100 maybe there is NO cash value left.
Those who surrender partially at 65 for cash for retirement it is even worse. Why?
the compounding interest charged by the insurer and the increasing mortality charges will hasten its demise, lapse.
All these, the insurer and the agents don't tell you.

Garrett said...

Vincent:

Please stop spreading your half-truths of this blog.

I have yet to see any WL illustration (and I do have a few) with a 300% bonus to sum assured, either RB or cash bonus. Can you provide a PDF to back up your claim? Also, what projections (in terms of annualized returns) were used to come up with this figure, and how realistic do you think it is with a conservative portfolio for the WL pool money?

You have said that WL pool money is required to maintain a conservative approach and agreed that is inappropriate for young investors. Case closed. No need to argue on mathematical probability vs mathematical certainty. A 99% probability is good enough to be a certainty, so you are just harping on the minor technicalities.

You suggest WL for people who cannot get pass their psychological barrier of getting back no money. I suggest educating these people on how to think properly when it come to finances. Financial illiteracy is the main reason why people get swindled and conned.

Finally, you are nitpicking on the technicalities of distribution cost. I said "almost zero" not zero, and if you extend to t=infinity, it will be zero. However, we do not see this decreasing trend of effect of deduction vs time. For mid-20s male, NTUC Vivolife at 10th year the effect of deduction is 30%, at the 40th year the effect of deduction is 40%. This proves there is more than just the first few years of commission eating WL returns and there are hidden costs that increases the overall expense ratio.

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