Mr. Tan Kin Lian started work in 1966 and qualified as a Fellow of the Institute of Actuaries in 1975.
He joined NTUC Income, Singapore in 1977 as the general manager/chief executive officer. During this stewardship, the assets of the cooperative increased from $28 million to $17 billion and became a leading life and general insurance co-operative.
Mr. Tan is now the President of the Financial Services Consumer Association (FISCA), a non-profit organization formed to educate the public on financial planning. He has published a few books on life insurance and financial planning. He also lectures as an adjunct professor in a university in Singapore.
Chapter 1 - Introduction
I have received many requests from consumers to give my views on the life insurance policies that they have bought previously or are being recommended to them now. They are mostly whole life or investment-linked policies that are intended to provide insurance protection and as a form of savings for the future.
I wish to present the results of my analysis in this book. They represent the policies that are now sold in the market in Singapore. I have removed the name of the consumer and the insurance agent from the benefit illustrations.
The focus on my analysis is on the amount of the accumulated premium that is taken away from the consumer. Most of these products offer a modest amount of insurance protection which, in my view, should take away 10% of the premium. The remainder is invested to earn an investment yield that should be returned to the consumer. The insurance company can take away another 10% for the investment service. It is fair for the insurance company to take away a total of 20% of the accumulated premium over a period of 25 years. This is my benchmark for a life insurance policy that is fairly priced to the consumer.
If the life policy does provide a large amount or wider scope of coverage, it may be justified for the deducted proportion to be higher than 20%. But this is likely to be not a commonly situation.
It is important for the consumer to pay a fair price for a life insurance policy. For most consumers, the life insurance policy represents the biggest financial commitment after the mortgage payment on your home. They should study the cost and benefit analysis carefully before making this commitment.
Chapter 2 - Structure of a life insurance policy
A life insurance policy performs two functions
Insurance protection for premature death, disability or medical expenses
Savings for the future
The consumer has to pay a premium that reflect the actual cost or value of the benefits provided by the policy and also a loading that is taken away by the insurance company to pay the commission to the agent, the expenses of running the operation and to give a profit to the shareholders.
Take the case of an insurance policy that provides protection only. If the average cost of the claim is $100 a year, it would be fair for the insurance company to charge $200 a year, as they need the loading to cover their expenses. In a competitive market, they may reduce the loading and charge only $150.
The loading for the investment portion should be lower and should be comparable to the fee that is levied by the manager of an investment fund or unit trust. The total fees should not exceed 10% of the invested sum.
As a larger proportion of the premium is intended for investment, a fair amount that is taken away should be 20% of the premiums that is paid. This is to cover the insurance protection and the investment service.This leaves 80% of the accumulated premium to be returned to the consumer.
If the actual cost of the benefit is $240 a month, you should pay a monthly premium of $300. If you are paying a monthly premium of $400 to $500, you are paying too much. The problem is - the consumer does not know the actual value of the benefit.
A good way for the consumer to know if the premium is fairly priced is to look at the amount that is deducted from the accumulated premium. This is shown as the "effect of deduction" in the benefit illustration that has to be provided with the life insurance policy. This amount has to be compared with the "value of the accumulated premium". If the deduction is more than 20% over 25 years, it is likely to be too expensive.
For example, if you pay $500 monthly over a period of 30 years and the investment yield is 5% per annum, the value of the accumulated premium is $418,000. If the cash value of policy is $250,000, the amount that is deducted is $168,000.This represents a deduction of 40%.
If you find a policy that deducts only 20%, you will be able to get a higher cash value of $334,000 at the end of 30 years. The difference is $84,000 over 25 years. It is a lot of money.
The amount that is deducted could even be higher. I have seen some benefit illustrations that show a deduction of 50% or more at the end of 25 years. This type of policy gives a very poor payout to the consumer.
The benchmark of 20% for 25 years applies to most typical policies. If a policy is specially designed to have a high proportion of the premium that goes to the insurance protection, it is justified to have a higher deduction. But most policies that are sold in the market are intended to provide a modest protection and to have a larger proportion of the premium that is intended for investment. For these policies, the benchmark of 20% is applicable.
Chapter 3 - Buy Term Insurance and Invest the Difference
The consumer has the option to buy a term insurance policy to provide the insurance protection and to invest the savings in a low cost investment fund. By adopting this approach, the consumer is likely to pay less than 20% of the value of accumulated premium.
The consumer is even likely to earn a higher yield on the amount that is invested, compared to the yield earned by the insurance company.
The consumer needs only to buy a term insurance for 20 or 25 years. For a young consumer, the cost of this coverage is extremely low. It is possible for a consumer to buy a term insurance of $300,000 and pay an annual premium of less than $300. This premium is fixed for the duration of the policy.
If the consumer wishes to be covered for an earlier payout on the occurrence of a critical illness, the premium will be slightly higher. It is important that the insurance be taken for a period not exceeding 25 years or for a shorter period, if the policy is taken at an age above 40 years.
The consumer can invest the savings in a low cost investment fund. An example of this type of fund is an investment fund that is invested to mirror a stock market index and is traded in the stock exchange. A few of such exchange traded funds are available at a management fee of 0.3% per annum. Over a period of 30 years, this is likely to take away only 6% of the accumulated amount.
Some consumers are worried about the risk of investing in the stock market. The risk is actually quite small, if they follow the following rules of diversification:
a) Invest in a large, professionally managed fund as it offers diversification. You will not be badly affected if some investments go bad, as the impact is small and is compensated by other good investments.
b) Choose a low cost fund, where the fund manager takes only a small fee. If you choose an indexed fund, you enjoy diversification and pay a fee of only 0.3% per annum.
c) Invest for the long term, i.e. 10 years or longer. The fund will do badly in some year but will do well in other year. Over the long term, you can get an average rate of return.
d) Invest 80% of your savings in a fund that is largely or fully in equity, as equity gives a higher return over the long term. You have already reduced your risk through diversification and averaging out the good and bad years.
e) You can keep 20% of your savings in a money market fund or in short term assets. The return may be lower, but you can withdraw the savings at any time to meet emergency needs, without having to pay a penalty or suffer a capital loss.
f) Avoid trading in the market. There is a high transaction cost involved in buying and selling your investments. Most investors are not able to read the market well to achieve a trading gain that can offset the cost. Their financial adviser is also unable to read the market well, in most cases.
Published by easicircle with permission from Mr. Tan Kin Lian.
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