FAQ: True cost of life insurance

1. Does a life insurance policy provide good value for a person to plan for the future?

Insurance agents like to sell endowment and whole life policies, including variations of these policies, to consumers as a way to plan for their future. These policies offer poor value to the consumer.

The typical cost of an endowment or whole life policy is a reduction of 4% to 4.5% in the yield.

If the long term investment yield is 7%, a reduction of 4.5% gives you a net yield of 2.5%. This net yield is unsatisfactory, as it is not likely to cover the rate of inflation. You need to aim for a higher yield.

If you select a low cost insurance fund, the reduction in yield should be only 1%. This allows you to get a net yield of 6%.

If you are investing for 20 years, a difference of 3.5% in the yield (i.e. 2.5% from a life insurance policy compared to 6% from a low cost product) accumulates to 44% at the end of 20 years.

If you invest for 30 years, the difference is 80%,

For example, instead of getting cash value of $100,000 at the end of 20 years from a whole life policy, you could get $144,000 (i.e. 44% more) by buying Term insurance and investing the remaining savings in a low cost investment fund.

2. Why does the life insurance policy cost so much, i.e. a reduction of 4.5% in yield?

The reduction in yield comprise of:

a) Upfront marketing cost 1%
b) Expense ratio and mortality 1.5%
c) Guarantee penalty 2%
Total 4.5%

The upfront marketing cost is incurred in the advertising, marketing and commission to the agent. This could amount to 2 years of your savings. It is an upfront charge and is taken away from your savings during the initial few years.

The expense ratio is the charge for investing your savings and administering your account. The mortality charge is for providing the death, accident or critical illness cover.

The guarantee penalty is the cost to the consumer of getting the guarantee in the life insurance policy. The insurance company has to invest a large proportion (about 70%) of the investments in low yielding bonds to provide the guarantee. This has a significant impact on the yield (compared to the yield that can be earned from a diversified equity fund).

3. How can I get a higher return for my long term savings?

You can get a higher return as follows:

a) Buy a Decreasing Term to provide the insurance cover
b) Invest the remainder of your savings in a low cost investment fund
c) Invest in the fund directly, to avoid the upfront marketing expense

The reduction in yield to provide the insurance cover and expense ratio is likely to be about 1%.

If the investment fund can earn 7%, you can get a net yield is about 6%.

4. Is it risky to invest in an equity fund?

If you are investing in a diversified investment fund over the long term, say 10 years or longer, the risk will be reduced considerably.

By investing in a diversified fund comprising of 30 or more good quality investments (e.g. the largest companies in the stock market), you are diversifying your risk. A few investments may turn bad over the years, but they will be more than compensated by the good investments in the fund.

If you are investing over the long term, you will be able to get an average return from the good and bad years. In a good year, you may be able to earn more than 20%. In a bad year, you can suffer a loss. Over the long term, you will be able to get an average market rate of return.

The average return from the stock market over the past 30 years is more than 10%. For the future, the return is likely to be lower (due to global economic factors and other reasons), but the average is still likely to be quite attractive. Many experts predict an average return of 6% to 8%.

5. I have already invested most of my savings in a several high cost life insurance policies. Is it advisable for me to terminate the policies and invest in a low cost investment fund now?

First, you have to find an insurance company that is able to provide you with low cost Decreasing Term insurance and in a low cost investment fund with no upfront charge.

If you switch your investment now, you can benefit from the following:

a) Lower expense ratio
b) Higher return from the investment fund (i.e. no guarantee penalty)

The difference in yield could be 2.5%. Over the next 20 years, you could earn 27% more.

You have already suffered the upfront cost (which could amount to two years of your savings), but it is better to cut loss now and recover your loss from the higher return in the future.

The potential higher yield from the investment fund is not guaranteed and comes with a higher risk (i.e. avoid the guarantee penalty).

In my view, this risk is reduced considerably through diversification and a long term time horizon. But, you have to understand the risk clearly, before you switch your investment from the life insurance policy.

6. Can you recommend an insurance company that can provide low cost insurance cover and a low cost investment fund?

I am now working as a consultant to a relatively new life insurance company. I hope that this new company will be able to offer these good value products towards later in 2008.

Tan Kin Lian