Return of Premium Term Life

Overview

A common complaint charged against standard term life insurance is that it only "works" if the policyholder dies, and because most policyholders outlive the term of their contracts, their premiums are going to waste. Although this is the nature of all insurance — paying a premium to cover against an unlikely but potentially disastrous scenario — the life insurance industry has addressed the core complaint against term life with return of premium life.

Return of premium insurance works just like ordinary term life, except it pays back all premiums if the term expires and the policyholder is still alive. This feature comes at the cost of higher premiums overall, up to 60% higher. The insurance company uses the padded premiums as investment capital throughout the length of the policy term to earn enough interest to cover mortality charges and earn profit. After the term ends, the all premiums can be returns because they've served their purpose and generated profit for the insurance company.

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Comparing Examples

Standard Term Life Example

Tom purchases a level term life policy for 20 years with $500,000 worth of coverage. The insurance company calculates a premium of $1,000 per year. This amount covers his mortality charges plus overhead and profit of the insurer. Over the course of 20 years, Tom would pay a total of $20,000 in premiums. If Tom dies within 20 years, the policy pays out $500,000 to his beneficiaries. But the far more likely scenario is that Tom outlives the policy and gets nothing in return. The policy expires and all payments go to the insurance company.

Return of Premium Example

Ann purchases a return of premium life policy for 20 years with $500,000 worth of coverage. The insurance company determines a premium of $1,500 per year (50% more than Tom's level term life). Ann pays this amount for 20 years for a total of $30,000 worth of investment ($10,000 more than Tom makes through the same span of time). If Ann dies while her policy is in effect, her loved ones receive a lump-sum of $500,000. But, in the more likely case, Ann doesn't die. Because she purchased ROP instead of level term life, Ann gets a check for $30,000. While Tom was paying the bare minimum to keep him family insured, Ann paid extra to maintain capital in her policy.

Which is Best, Term or ROP Term Life?

Choosing being standard term life and ROP is boils down to your investment horizon. Would you rather have low monthly payments now for the same amount of coverage or would you rather pay extra to make use of the premiums at retirement? If you are strictly concerned with pure coverage and you don't have enough cash to cover the higher premiums of ROP insurance, term is right way to go. If you want to treat your life insurance as an investment, if you have enough income to cover the higher premiums, and you're bothered by the prospect of not getting anything in return, ROP is the best choice.

In the long-run, return of premium insurance is more economical than standard term, because only 1-2% of term policies ever pay out. ROP lets you hedge your bets: it protects against the unlikely scenario that you die prematurely and provides a nice payout in case you don't. Interestingly enough, in the case that you don't die and ROP refunds your full premium, you got life insurance for free.

An Alternative to Return of Premium Life

A common alternative to paying the higher premiums of ROP is buying term life and investing the difference. This strategy applies to all "feature-rich" life insurance products, advocating that policyholders buy the cheapest, most bare-bones policy available (non-guaranteed term) and invest the extra charges and rates that would have been charged by the insurance company in a separate savings portfolio. In the case of ROP, you can buy standard term and invest 50% of your annual payment into a CD, bond, or mutual fund. Arguably this will yield an even better return outside the constrictive hands of the life insurance companies.

The "investing the difference" approach is sounds given several assumptions: 1) that policyholders take the effort to invest the additional 50% on their own, 2) that policyholders take the time to manage their own investment portfolio, 3) that the right investment is made — one guaranteeing fixed income, and 4) that market conditions and interest rates perform reasonably well. Not following through on these steps could result in no savings at all or even loss of capital due to poor performance. ROP insurance offers guaranteed capital without the hassle.

An Example of Investing the Difference

Let's assume ROP has 50% markup over term life. If a 20-year term policy with $500,000 worth of coverage costs $1,000 per year, ROP would cost $1,500. Over the full 20 years premiums on both policies would total $20,000 and $30,000 respectively. Even if we assume that the difference ($10,000) were invested in a long-term CD or bond from year one, a 6% average yield over 20 years would be necessary to accumulate the $30,000 worth of capital that would be paid out by the ROP policy. Take into account taxation on earnings, brokerage house charges, and the fact that the $10,000 dollar difference wouldn't all be invested at year one, and ROP comes out on top. Granted, the difference could be invested in mutual funds or the stock market, but then we're comparing apples to oranges because equities have higher risk and could in fact end up losing you money.

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