Seth’s Blog on Finance

“Double Charges” in a Regular-Premium ILP

There are charges involved in both investing and getting insurance coverage. Purchasing stocks incurs a brokerage fee, and investing in unit trusts involves annual management fees and sales charges. Bulk of the first few years of premiums of an insurance policy goes to “distribution costs” (mainly commissions to the agent). Typically, distribution costs are highest in the first year and steps down over the next few years of a policy.

Regular-premium investment-linked policies (ILP) are touted by many agents to be for both insurance and investments, but do you know that many such policies charge the policyholder distribution costs (on top of investment charges) on his investments, and investment charges (on top of insurance charges) on his insurance?

The following diagram shows how various charges are imposed in the first year when a person buys a term policy for insurance, and then invests the remaining amount with a set budget:

Distribution cost is usually a large percentage of an insurance policy in the first year. (It can be 100% or even more than 100% of the premiums. This is the practice of an insurer spending more money in the first year trying to sell the policy so that it can recoup back the expense plus profits over the subsequent years. For the sake of simplicity, a distribution cost of 80% is used for the illustrations.) This distribution cost is imposed only on the term policy. The rest of the premiums are assurance charges, or the “true cost” needed for insurance. Actually, it does not matter how much distribution cost is incurred in a term policy as long as it is fairly priced (of course, a term policy with higher distribution costs tends to be more expensive) since none of the premiums are invested.

A sales charge is imposed when someone purchases a unit trust. Let’s take it to be 5%. Similarly, this 5% is only imposed on the amount of money invested and has nothing to do with the insurance component of the entire portfolio.

What about a front-loaded regular-premium ILP? The following shows the situation in the first year of an ILP:

When the budget is used to purchase an ILP, the distribution cost is imposed on the whole lot of money which is meant for both insurance and investment. This explains why the first year’s allocation rate (percentage of premium used to buy investment units) is very low, somewhere between 15- 25%. This leaves very little invested in the first year, which is the worst weakness of an ILP (amongst others) in my opinion as it causes significant opportunity costs to the policyholder due to the fact that a bulk of money which could have otherwise been used to accumulate and compound over the years are lost in the first year.

Further to that, there are still assurance charges to be paid. Instead of deducting the assurance charges from the remaining 20% first, the entire 20% is used to purchase units first, incurring a sales charge of 5%. This actually subjects the policyholder to investment charges for paying off the assurance charges necessary to be insured (ie, if the assurance is $200, it will be increased to $210 due to the sales charge). While not as significant as the previous point, it is insult to injury and represents another layer of unnecessary costs.

Actually, all of these costs are transparent and reflected in the Benefit Illustration of an ILP which can span 20 to even 30 over pages, but there is no point in such transparency because laypeople are not be able to understand such information easily. Many merely rely on whatever their agents say as these agents are in a position of trust. Heck, I doubt many agents really know what they are selling in the first place, but I don’t think they mind one bit. Where do you think these unnecessary charges end up?