When you think about life insurance policies do you think about the peace of mind you get knowing that you’d be protected for life?
Or, do you recall that one time when a friend-turned-financial-advisor sold you an expensive plan called an investment-linked policy?
Investment linked policies (ILP) are one of the most complex forms of insurance. Let’s see if you should buy one.
What is an investment-linked policy?
Among the life insurance policies available for you to choose from, investment-linked insurance policies (ILPs) are among the most complex and riskiest that you can purchase.
That’s because ILPs serve a dual purpose when it comes to providing life insurance – protection and investment. And, it’s the investment component of ILPs that funds both the protection and wealth-building aspects of the policy.
There are two types of ILPs available:
- Single Premium ILPs: As the name suggests, with single premium ILPs you purchase units in the sub-fund of your choosing with a lump sum premium payment. Typically, single premium ILPs tend to offer less insurance protection than regular premium ILPs.
- Regular Premium ILPs: Unlike single premium ILPs, regular premium ILPs allow you to pay your premiums in regular instalments. Regular premium ILPs also give you the flexibility to adjust your insurance protection.
On the surface, ILPs might sound like whole life (par) policies, but they’re actually quite different. For one thing, whole life (par) policies don’t give you much flexibility when it comes to choosing which the participating sub-fund.
ILPs on the other hand give you freedom to choose from a variety of sub-funds that compliment your investment style.
Also, unlike whole life policies that have a guaranteed cash value, ILPs have no guaranteed cash value. That’s because the policy value built up depends primarily on the performance of the sub-fund(s) invested in.
So the success (or failure) of an ILP depends on the investing skill of the consumer — you.
You will be responsible for choosing a sub-fund in invest in and that means having to understand how funds like Equity Funds and Geographically Specialised Funds work. You will need to inform yourself and do the necessary comparison.
Are all these terms boggling your mind right now? If you haven’t understood the risks that you are getting into, it’s safer to choose a simpler life insurance product for coverage rather than an ILP.
How is your premium used to fund your life insurance policy?
When you pay your premiums towards a term life policy, it goes completely towards insurance coverage, which means there’s no cash value to collect after the policy expires.
When you pay your premiums towards a whole life (par) policy, part of your premium goes to maintaining your insurance coverage and part of it is invested in the insurer’s participating fund, which (hopefully) builds up the policy’s cash value.
ILPs are a completely different matter because they are investment-centric. Most, if not all of your premiums go towards purchasing units for the sub-fund(s) you want to invest in.
Of course, depending on how the units are purchased, your premiums will be used to pay insurer expenses, fees and administration costs either fully or partially for the first few years of the ILP through front-end or back-end loading.
Here’s an explanation of how your premiums are used for front-end and back-end loading:
Front-end loading involves using most of your premium payments to cover the insurer’s expenses such as distribution and administrative fees. You’ll still have some of your premium going towards the purchase of sub-fund units.
After a few years, all of your ILP premiums will go towards purchasing sub-fund units. Well, once the insurer has taken its cut.
Here’s a chart showing what an ILP front-end loading payment plan might look like:
|Policy Year||Percentage of Premium Used for Insurer Expenses||Percentage of Premium Used for Customer Sub-fund Purchase|
Here’s an example of how front-end loading might affect your ILP cash value initially:
Here are two terms you must understand before reading on:
- Offer Price: This is the price at which you purchase sub-fund units. If your premium is $5,000 and the offer price of a sub-fund unit is $5, you would be able to buy 1,000 units.
- Bid Price: This is the price at which you sell your sub-fund units to pay for your ILP charges (ex. your insurance coverage). If the bid price is $4.90, then your ILP cash value would be $4,900.
If you were paying a regular ILP premium of $2,000 a year, $1,700 (85%) of your premium would go towards insurer expenses and $300 (15%) would go towards the purchase of sub-fund units.
Let’s assume the unit offer price was $1. With the remainder of your premium you can purchase 300 units.
But you’ll also have to pay the “insurance charge” by using the units you purchased to cover the insurance aspect of your policy.
If the insurance charge is $100 and the bid price (price at which units are sold) of your units is only $.90, you would need to sell about 111 units to cover it – meaning the cash value of your policy at the end of the first year is only $170.10 (189 units at a sell price of $.90)
Back-end loading is similar to front-end loading in that the insurer uses your premiums to pay for fees and expenses.
However, the big difference here is that 100% of your premium is used to pay these expenses at the beginning of your policy! That means your ILP would have basically ZERO cash value for the first few years.
After the back-end loading period you would be able to use 100% of your premium to purchase the sub-units of your choice.
Is an investment-linked policy right for you?
That depends on what you want out of your life insurance policy. If you’re a savvy investor and want greater control over the insurance coverage and investment growth of your policy – ILPs are worth considering.
Just keep in mind that ILPs can be very risky, as the cash value of your policy can take a hit if your sub-fund(s) perform poorly.
Not to mention your insurance premiums for the investment linked policy will increase as you get older, meaning more of your premium will have to go towards maintaining your coverage – reducing the premium that goes towards purchasing sub-fund units.
If insurance protection is more important to you in an insurance policy than wealth accumulation (a good investment portfolio can perform the function of “growing” your wealth too), you’re probably better off sticking with a term or whole life policy.
If you are ever pressured to sign off on such a policy, just remember that the only reason why your agent is pushing ILPs is that they earn much higher commissions from them and not because they’re so passionate about growing your money.
Would you rely on an investment linked insurance policy to build and protect your wealth? Share your experience with us below.