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.