Dubai: When we invest in anything, we most often do it eyeing a decent-sized profit at the end of the investment term. But when investing in traditional life insurance plans, this need goes unmet. So we buy costly ‘variable’ life insurance plans that in reality offer very little insurance and only modest returns.
With ‘variable’ life insurance policies, a portion of your premium goes toward the investment component called ‘cash value’, and you can also withdraw or borrow against the funds to pay for expenses. On the other hand, ‘term’ life insurance policies don't have cash value. This lasts for a set period and is cheaper.
“While term plans are pure life insurance products which are the cheapest and the best way to buy a large insurance cover, many now refuse to buy them because they don't get any money from the plans at the end of the term when the death benefit isn’t claimed,” said Pamela Barbaglia, an insurance analyst based in Dubai.
“Instead, they prefer insurance products with savings or an investment element such as a traditional money-back plan or more sophisticated stock market-linked products. These products pay back the premium with returns earned from investment at the end of the chosen term.” But are they worth it?
How insurers operate
The amount you pay to the insurer is not what is invested. The insurance premium comprises of fees that provide life cover to the policyholder, interest payment, and the expenses which cover operating costs of selling insurance, investing the premiums, and paying claims.
“With the investment component of an insurance premium, the amount permitted to be invested may be just around 8 to 10 per cent of the total investment. So you cannot really expect a great return from their insurance product,” added Barbaglia.
“Moreover, the money may sound good now, but will be worth far less when you finally get it. Let's say you are promised a lump-sum amount two decades down the road. When accounting for yearly inflation eroding the value of any currency, the amount would be worth around half as much in today's prices.”
Risk of being underinsured
The problem with money-back insurance policies is that while the premium is much higher, one may still end up underinsured.
Say, you are a 25-year-old male looking for a life cover of Dh10 million for 30 years. If you took a normal term insurance cover, the premium may be around Dh8,000 per year. But the premiums you pay for your death benefit remain with the company after your term life insurance expires, and not with you.
In not wanting to lose the premiums in such a situation, you opt for an insurance cover with an investment return. Now, the premium goes up to Dh42,600. If you cannot afford that, you might be tempted to go for a policy of Dh5 million that cost Dh21,300 a year, which underinsures you.
While term plans are pure life insurance products which are the cheapest and the best way to buy a large insurance cover, many now refuse to buy them
“It is a very costly way to invest. There's the cost of the insurance protection itself – which is usually more expensive than what you would pay for a regular term insurance policy. There are the marketing and sales commissions,” added Brody Dunn, an investment manager at a UAE-based asset advisory firm.
Each insurance product has its own commission specifications. But the trend is that in the first year, the agent's commission is the highest. It decreases for the next three years and after that, drops even more. In the very first year, your agent may get around 15 to 35 per cent of your premium as commission.
In the next three years, it will drop to between 5 and 15 per cent. After that, it will be between 2.5 and 7.5 per cent. The upfront commission (amount paid in the first year) is the highest, and then the rest of the commissions are much lower. So the higher the premium you pay, the more the agent benefits.
Overpriced with hidden charges
There's also the ‘surrender charge’ that may be levied if you decide to drop your policy within the first 10 years or so. The amount of a surrender charge varies by insurer and type of policy, but it is not uncommon for it to exceed the total amount of your first-year premium.
And, on top of all that, there are annual investment fees. Those are not broken out in all policies, so it's often hard to determine how much you're paying. In policies where they are disclosed, however, they can be substantial: 3 per cent or more, year in and year out. But what makes up that 3 per cent?
Most of the annual investment fee comprises of the investment management fee, which can run as high as 2 per cent a year. Added to that is the annual mortality charge and the additional expense factor, which together goes by the name of ‘M&E’.
The heavy fees involved with cash-value life insurance can really drag down your returns
Investment managed poorly
“’M&E’ charges are essentially thrown in to assure the insurance company a profit, even if all those other fees somehow don't. They also place your money into the equivalent of mutual funds managed by the insurance company, and not by specialised market-specific managers,” added Dunn.
“The heavy fees involved with cash-value life insurance can really drag down your returns. Especially when you consider the alternative that mutual funds often have annual costs under 0.5 per cent. That's a lot less than the 3 per cent or more you'll pay for the investment component on a cash-value policy.”
So in other words, depending on your coverage and investment needs, life insurance may not be the best way to build wealth as it may not be enough to support your retirement fully. Also, bear in mind that if you don't need the insurance component, there may be better investment options on the market.
While traditional insurance can be considered as an investment in the sense that you're putting away money to help you or your family when an unexpected incident could set you back financially – essentially an investment on your family's financial security, it won’t give you any returns or profits.
With ‘variable’ life insurance policies, life insurance can be a profitable investment vehicle. But it isn't the best choice for all. They may offer a variety of investment options for the cash value, but you cannot adjust your premiums. There are greater investment risks with these than with other types of coverage.
Some insurers even let you customise the speed at which the cash value grows, and you may be able to pay all of your premiums in a whole life policy over the first few years, or even all at once in a single premium, boosting the cash value, but your premiums will be higher if you don’t spread them out.
“My advice is if you need life insurance, get the traditional term life insurance, which is purely an insurance product. If you want to invest, invest in market-specific products, mainly because your money will be managed by experienced professionals,” added Dunn.