A Sense for Money
In addition to providing you with valuable life and health insurance coverage, life policies can be an important cornerstone of your investment portfolio. By selecting appropriate policy types you can strengthen your investment portfolio with a useful array of characteristics such as smoothed investment returns, guarantees, professional fund management and access to overseas markets.
There are three main types of policy available and this week’s post describes their key attributes in order to help you understand how they work.
Non Profit Life Policies
With such policies, the premiums and benefits are fixed at outset and fully guaranteed throughout the term. For example, you pay a fixed $1,000 in premium each year, and the policy pays out a fixed sum insured of $30,000 in 25 years time (or on earlier death). When calculating the premiums and benefits, the insurer needs to make an assumption about what rate of return it will be able to get on the premiums you pay over the next 25 years. Now the insurer really has no idea what rate of return they will be able to get on premiums you pay in 20 or 25 years time, so they will err on the side of caution and use a low rate in their calculations. If interest rates are currently 10 percent, the insurer may use 6 percent in its calculations to allow for the fact that interest rates may decline. The problem from the consumer’s perspective is that this can look like a raw deal. You know that interest rates are currently 10 percent, so why would you want to lock into 6 percent for 25 years? Only if you think interest rates are going to fall dramatically is the answer. But things are not always rosy for the insurer either – they may think 6 percent is cautious but if rates tumble to 2 percent (as has happened in some markets) the insurer has a real problem – they are guaranteeing you a return of 6 percent but can only invest your premiums at 2 percent.
With Profit Life Insurance
With profit policies take a different approach in that the insurer will give you a lower initial guarantee but will increase your sum insured each year by sharing some of its profits. For example, your $1,000 premium might give you a guaranteed sum insured of only $15,000 (compared with the $30,000 available from a non profit policy). But each year the insurer will add bonuses to your sum assured, depending on the profits it makes. In most scenarios, you would expect your eventual return after 25 years to be higher than the return from the nonprofit policy.
Unit Linked Life Insurance
With unit-linked policies the insurer takes the premium, deducts amounts for expenses and the cost of life insurance, and invests the balance in an investment fund of your choice. For example, if you pay a $1,000 premium, the insurer may deduct $100 for expenses and the cost of providing you with life insurance coverage of $900 is used to purchase units in an investment fund of your choice and these units will be credited to your personal investment account within your policy. The benefit you get at maturity in 25 years is the value of your investment account – so if your investment fund has done well, you will get a good return whilst if it has flopped, you will not even get back the money invested. One key feature of these products is that the insurer will often let you choose from a wide selection of funds, from secure funds with guaranteed returns to high risk/reward funds such as commodities and overseas equities. They will even allow you to switch from one fund to another as your views and risk appetite changes.
The following illustrates the proceeds that you might expect to get from the various types of policy, both on death within the term and on maturity after 25 years. (All numbers illustrative only):
Year Non Profit With Profit Unit Linked Unit Linked
(Good performance) (Poor performance)
1 30,000 15,000 30,000 30,000
5 30,000 17,000 30,000 30,000
10 30,000 21,000 30,000 30,000
15 30,000 25,000 30,000 30,000
20 30,000 32,000 38,000 30,000
25 30,000 40,000 50,000 18,000
Which one is for you? Some general guidelines are:
• Those who like stability and guarantees, or think interest rates will decline substantially may go for the non-profit option
• Those who are willing to take a lower guarantee in exchange for the upside of sharing in the insurer’s profits may like the idea of a with profit policy
• Those who like a flutter on the stock market or have a view on particular market sectors may prefer the unit linked route
Of course you could also get more than one policy for increased diversification. At the very least you should get some personalized quotations and review the various choices open to you before you make a decision.
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