Investment-linked policies (ILP) combine insurance and investment into one nifty package. Ticking two checkboxes off your financial planner at a go sounds great yet, ILPs suffer a terrible reputation even amongst insurance products. Here's why.
The problem doesn’t lie with the product but the sheer amount of misleading opinions online. Google ILPs and I guarantee you’ll find a slew of ‘Why ILP suck’ articles.
This is one of the main reasons I set up Money Maverick. Financial bloggers sometimes lack a sufficient understanding of insurance products, not because they didn't study but because they aren't as incentivised as I am to study the A-Zs of the product. As a result, the content is either:
(i) out-of-date,
(ii) out of context, or even worse,
(iii) completely inaccurate.
In this article, I’ll be addressing a product highly misrepresented online - the ILP and the feared ILP time bomb.
The Time-Bomb
The simple truth is that there are over 13 types of ILPs and only 3 of them are time-bombs. Here are what time-bomb ILPs look like:
Front-end loaded ILPs with no net sum at risk (NAAR)
Back-end loaded ILP with no net sum at risk (NAAR)
ILPs which give both the sum assured + account value
Read: What do the terms front-end loaded and back-end loaded mean?
The Type 3 is one of main culprits as to why ILPs have such a terrible rep today. People were offered both the sum assured (S.A.) and the account value (A.V.) of their investments. Say your S.A. was $100,000 and you had accumulated $10,000 in your A.V., your death payout would be $110,000.
Needless to say, this sounded fantastic. Both the insurance companies and consumers thought this was a really smart plan but reality is never that kind. Here’s why.
These ILPs had a perpetual premium payment system, which meant buyers had to pay premiums till they were dead. Now, it’s no secret that premiums increase with age. The longer you held the plan, the higher your premium cost, and these skyrocket once you hit a certain age bracket.
If buyers were tired of paying, their investment returns (A.V.) would be drained to cover premiums. If their investments did not grow fast enough to cover the premiums, eventually their A.V. would hit zero. And if they still refused to pay premiums separately, the ILP would be terminated.
Moral of the story:
People wanted high insurance, high investment benefits but they failed because the older plans were crap. It’s as easy as that.
Time-bomb ILPs are still sold today but you should not go for them. They suck, big-time. There is only one scenario where you'd be a winner - if you passed early when premium costs were still low. Though you’d be dead, so there's not much winning there.
Not every ILP is a time-bomb
The reason why I still stand firmly by ILPs is because of the net amount at risk (NAAR) concept. The NAAR is “the monetary difference between the death benefit paid by a permanent life insurance policy and the accrued cash value”. It is the risk the insurance company takes on during the premium payment period.
NAAR in action:
If I need to pay $3,000 annually for 15 years for a $45k S.A. but pass away after the 5th year, the insurance needs to cover the remaining $30,000 [$3k x 10y] to give my family the full S.A. i.e. their NAAR = $30,000.
All ILPs with NAAR have limited payment periods i.e. you do not have to pay till you're dead.
Before the implementation of NAAR in the late 2000s, all ILPs were time bombs.
Here’s how the NAAR works. Let’s call this ILP a Type 4, where the company pays you either the sum assured or the account value, whichever is higher, in the event of death.
Say I (female, age 33, non-smoker) have bought a back-end loaded ILP with a sum assured of $30k. The annual premium is $6k and the payment period is 10 years.
Tip: You can check the NAAR at the back of your ILP report.
Y1 [Age 33]: I pay $6k and my insurance fees are updated for the NAAR of [$30,000 - $6000 = $24,000]. The cost of insuring my life is now $12 [24 x $0.50].
Y2 [Age 34]: I pay another $6k and my insurance fees are updated for the NAAR of [$30,000 - $12,000 = $18,000]. The cost of insuring my life is now $9 [18 x $0.50]. Notice how it decreases in cost each year.
...
Y5 [Age 37]: I've now paid a total of $30k and my insurance fees are updated for the NAAR of [$30,000 - $30,000 = $0]. The cost of insuring my life is now zero [0 x $0.513].
Since my payment period is 10 years, I have to continue paying $6k a year for 5 more years but that $30k goes directly into my investments (0 insurance fees). I now get to enjoy my investments net of external fees (after fees), with the option to continue paying premiums to grow my investments. There are no trailer fees (fees tagged to investing through a fund house or bank).
Moral of the story:
From Y1 to Y5, the NAAR protects me from losing my insurance as the company still has to pay out my $30,000 S.A. if I pass early. From Y6 to Y10, the NAAR rewards me by ending all insurance charges.
In summary, the NAAR safeguards your ILP during the payment period and eliminates insurance fees later on.
Did you know?
Some ILPs have a bonus feature called the Total and Permanent Disability [TPD] waiver or a Critical Illness [CI] Waiver where a tiny part of the premiums is directed towards them. These waivers are safety nets that come into play if you sustain a TPD/CI during the payment period. The company will pay your premiums for you until (i) the end of the payment period, or (ii) you recover (the chances of which are very low) Essentially, you will not need to worry about paying premiums along with your medical expenses.
One Bad Egg
It is absolutely essential that people understand the NAAR. The reason why it sounds foreign is because it is often overlooked or avoided. To make matters worse, many agents avoid ILPs because of the potential backlash so the chances of you hearing of it are even lower.
It’s all about the math.
Opinions are subjective but numbers aren't. If the calculations prove that a plan works for you, why let your financial future be affected by the media?
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Money Maverick