Cash Value Policies – Why are There Losses on Early Termination?

Have you ever wondered one incurs capital losses on early termination of policies with cash values? Ask any insurance agent and the likely answer would be, “oh, these plans are for the long term and hence there are losses incurred when the plan is surrendered prematurely.”

Most people accept this answer readily, if they even ask at all. It seems like a fact of life few people bother to question.

For most policies of such nature, one makes a loss on early termination mainly due to the upfront distribution costs. Let’s take a look at some numbers from an actual savings policy. The annual premium is $1,275.

Looking at the first few years of the policy, you will find that the surrender value is almost exactly the result of subtracting the distribution cost from the premiums paid.

Year 1:
Total Premiums Paid To Date – Total Distribution Cost To Date
= $1,275 – $1,230
= $45
Actual Surrender Value: $0

Year 2:
Total Premiums Paid To Date – Total Distribution Cost To Date
= $2,551 – $1,778
= $773
Actual Surrender Value: $750

Early termination results in loss of capital simply because of the amount of money that goes to distribution costs. For the uninitiated, the distribution cost is mainly made up of commissions paid to the agent (and his manager). That is to say, upon early termination of the plan, you only get back what has not been paid out to remunerate the sales channel for selling you the policy.

Does this mean that there is no loss if one holds the policy till maturity? While it is true there is no capital loss as the maturity amount is greater than the total premiums put in, the loss has already been incurred in form of the distribution costs each time the premium is paid in the early years. One gets back more money when the policy matures because the amount of savings left (after the deduction of distribution costs) has grown and compounded over the years (assuming it performs according to projections) to cover up the distribution costs and insurer’s earnings, and make a profit for the policyholder. This is why while the projection is at 5.25% p.a., the effective yield of the policy is only about 2.59% p.a. The losses arising from distribution costs, insurer’s profits and opportunity costs are represented by the “effects of deductions”.

In this case, if one can find an investment of similar risk to an endowment policy (which underlying investments usually a mix of 30% equities, 50% bonds and 20% cash and other assets) that delivers 5.25% p.a., and has an expense ratio of less than 2.66% (which is very high) to give a greater than 2.59% p.a. return, he would be better off with this hypothetical investment than this policy. Even if the yield was similar at 2.59% p.a., he can still avoid the weaknesses of an endowment policy (low liquidity, no say in investment direction, policy terminates if he cannot pay the premiums etc).

To further illustrate, we can take a look at a person who has paid premiums for three years. Assuming he can find a investment that delivers 5.25% p.a. for the next 22 years with an expense ratio of 1.75%, this is what happens:

Number of Years: 22
Investment Return: 5.25% – 1.75% = 3.5% p.a.
Starting Amount: $1,764 (surrender value at end of Year 3)
Yearly Addition: $1,275

Amount received at the end of 22 years: $46,422

In this scenario, he stands to get a better return than if he held the endowment policy to the end of the tenure. Of course, it would be much better if the person did not take up the endowment policy in the first place. One should question whether or not giving almost two entire years of savings away as commissions is a good way to accumulate one’s wealth. One should also decide whether or not the endowment is too conservative (and with high costs) for an timeline of over twenty years.

This being said, it is generally not a good idea to prematurely terminate any insurance policy one has taken up. The usual disclaimers apply – do consult a qualified financial adviser with your interests at heart to analyse your specific situation and portfolio.

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