I really enjoyed the movie ‘We Need to Talk About Kevin’. It was about how a mother was going nuts trying to bond with her problem child who eventually went on to (SPOILER ALERT) massacre his schoolmates. It was a fictional depiction of the many mass shootings in US schools.
I’ve been speaking to some insurance insiders and insurance watchers over the past few days and it seems that investment-linked insurance policies (ILPs) are not unknown to have unleashed their fair share of horror on policyholders. It goes like this: person buys seemingly innocent ILP only to be told many years later that they have to raise their monthly premium payments substantially to make good on coverage.
This shortfall seems like a travesty to someone who had been made to believe that they only need to pay the same and fixed premium throughout the policy’s life. Is this direct selling artfulness or simply that we don’t understand ILPs enough? Are ILPs like a ‘Kevin’ that’s waiting to blow up?
So it’s not a bad idea to understand how ILPs (and other insurance policies) work. There’s a great article from Loanstreet on the core types of insurance policies but since I love summarising things, I would just say that all insurance policies are birthed from the very basic ‘term policy’. All other fancy sounding policies are effectively add-ons to the term.
Term policies are plain vanilla insurance coverage where you get money for misfortunes befalling you in a given time period. Insurance companies can promise you this because they make money from gathering a large number of similarly fearful premium-paying people who won’t all suffer misfortunes and not at the same time. It’s a nifty idea that reduces insurance costs to allow the best peace of mind money can buy.
However, somewhere along the way, this risk-transfer service morphed into products with a lot of bells and whistles, namely savings and investment. In fact, no payouts should be expected if you’re in one piece, like a motor policy: no accident, no payout. Avoiding misfortunes is supposed to be a good enough reward.
So it follows that at the very basic level, a policy taken out on a life should have no income, no returns, no payout. If you want your policies coughing out income and returns, you’d have to pay for it. In fact, if you’re willing to pay for it, you can tag income and returns to anything. Anything. For instance your fridge, your car, your mobile phone, your roti canai.
Imagine a scenario where your roti canai guy serves you the option of adding an investment payout with your lifetime roti canai consumption. It sounds ludicrous but it can be 100% technically done. You just have to pay for it and the roti canai man, after taking out his cut of selling commissions, channels the roti canai ‘premiums’ to an investment manager. How many roti canai men can give investment advice that is as good as insurance agents, you ask? That’s a good question that perhaps is subject for another post.
The same analogy can be applied to cars. What do you feel about getting investment and savings with your motor insurance that will produce a beautiful retirement nest egg some years later? You can begin to feel how this is so out of place not least because it will totally jack up car insurance costs. This being the case, why are ILPs so accepted and ubiquitous?
6 things you need to know about the ILP structure
1. You’re paying for two products
You’re really buying an insurance policy and an investment product that are bundled into one. This isn’t necessarily a bad idea but don’t commit the fallacy of thinking that ILPs are a good deal just because investment comes with your insurance. From a budgetary viewpoint, it can also puncture a big hole in your wallet. Ask your agent for a plain vanilla term policy (and watch them either seethe or go totally bewildered or both at your temerity) or go to U For Life for affordability comparisons.
2. Cost of insurance (COI) is deducted before investing
Ignoring other expenses for the moment, the first thing an insurance company does with your premiums is to deduct the COI. To you and me, this number is a mystery. But this is where the insurance company spits out an amount after crunching numbers of all their premium-paying customers and probabilities of untoward events of what it costs to promise you peace of mind. Only then will the remainder go to investments.
3. COI of rises as you age. By a lot.
The table above is an example of a term policy premium schedule which reflects rising COI. Premiums start to rise as aging takes place but really accelerate as you go beyond your 50s.
This is true of any policy that you buy. This latent costliness is due to inflation and age-related riskiness. The reason why fixed premiums are common in many policies is just down to overpayment in the earlier years to cover for higher COI in later years.
4. Investment returns can be used to pay COI
This is how I understand it but clarification about how it works is at best elliptical. Because of the fixed-premium feature in ILPs, insurance companies are given permission to dip into your ILP investments to fund inflating COI. COI sometimes rise faster than what your fixed premiums pay for.
5. Fixed premiums may not be enough to cover COI
This is happening: your premiums are fixed, insurance companies are deducting COI from your premiums and investing the rest as COIs accelerate. If premiums are not enough, insurance companies dip into your investments. But this could also be happening: volatile financial markets may not work to your advantage and your investments may not be sufficient to cover shortfalls. It’s at this point that you would have to top up premiums, failing which your policy is at a high risk of lapsing.
6. ILP commissions are expensive: 160% of first-year premiums paid over 6 years
Commissions are the first thing to be deducted even before COIs are engaged. ILP comms are slightly cheaper than the 171% paid on non-ILPs but still very expensive. I’ve compared some ILP proposals that I’ve looked at with a hypothetical DIY version (separately buying term and buying low-cost index funds) using the same assumptions and the ILPs results in a nest egg of about 25% less than the DIY version.
In addition to paying sales commissions, you’d also incur management fees for the funds the ILP buys into amounting to as high as 1.5-2% of your investments.