These days, a lot of insurance agents are called financial advisors. You will note that “financial advisor” sounds nothing like “salesman”, despite that being what they actually are. When the very name of someone’s profession is an exercise in obscurity, it should set off alarm bells. However, ignorance shouldn’t be an excuse to keep letting yourself get ripped off, so arm yourself with the knowledge of the potential dangers. Here’s the ones to watch for when buying insurance:
Is Insurance Always a Rip-Off?
In a word, no. Certified insurers are not running a Ponzi scheme, nor are most insurance agents actively lying to you (their deception is usually in what they don’t say, not what they do).
You should also understand that, just because insurers are above-board and regulated, that doesn’t mean you can’t get ripped off. Put it this way: store X can sell you orange juice at $5.95, even though store Y next door is selling it at $4.95. That’s not illegal, even if it is a rip-off.
Same goes for insurance policies. All of them are regulated, but it doesn’t mean their pricing will be fair. In order to make sure you stop shortchanging yourself when buying insurance, watch out for the following:
- Actual Returns are Not as Good as They Seem
- Clauses on Settlement Options
- Premiums Disproportionate to Potential Loss
- High Effect of Deduction
1. Actual Returns are Not as Good as They Seem
Endowment insurance policies will project returns of between 3.75% to 5.25%. Investment-Linked Policies (ILPs) will project even higher returns. Now on paper this all looks pretty amazing.
By comparison, our CPF returns are only 2.5% (Ordinary Account) and 4% (Special Account). Bank deposits hover around 1%. So obviously there’s a catch…or two.
The first catch is that those numbers are just projected returns. Some buyers are misled by the benefits illustration; a piece of paper that seems to give exact dollar amounts on the policy. But don’t mistake specificity for authenticity. No fund manager, not even top performing hedge funds, can give you a 100% guarantee on returns.
The second catch is that there are cheaper ways to earn those same returns. Check out the column called “effect of deduction”, on the far right of the benefits illustration.
“Effect of deduction” is an elaborate way of saying “cost”. This is the insurer’s charge for covering you, and for attempting to get you the projected returns. It isn’t cheap.
Investing in blue chip stocks or index funds can deliver comparable returns, but at a much lower cost. The Straits Times Index Fund has generated annualised returns of 9%, and has no “effect of deduction”. So before being wowed by big returns, consider if those returns can be obtained for less.
2. Clauses on Settlement Options
Some insurance polices have settlement options. At designated intervals, you get a list of different options to choose from: re-invest pay outs, cash out the money, etc.
Most buyers assume that the settlement options are guaranteed. Because bloody hell, something has got to be guaranteed besides the agent’s commission. But you’d be wrong, as this case in 2012 demonstrates. The insurer’s response was that:
“Due to the current sustained low interest rate environment and uncertainties in market conditions, AIA Singapore will not be able to accept elections for settlement options.”
Simple lesson: ask about the clauses for everything. Especially if you can’t read the legalese.
3. Premiums Disproportionate to Potential Loss
When it comes to general insurance – e.g. insuring your office equipment, piano, apartment, and so on, pay attention to the total premiums paid versus the potential loss.
As a lot of buyers don’t think about this, some insurers gouge them with wildly disproportionate premiums. For example:
I have two computers in the office, and their combined value is $3,000. There’s minimal chance that they’ll be stolen, since they both run Windows Vista. But let’s say I buy insurance anyway, and fork out about $100 a month. I do this despite knowing that, in three years, I will be replacing both of them.
At $100 a month, my total premiums paid will be $3,600 across three years. The worth of the computers is $3,000. Between the two, it would be cheaper to (1) leave the computers uninsured, or (2) consult different insurers until I find one where the premiums do not exceed the value of the insured items.
(P.S. As a rule of thumb, do not pay premiums to cover losses you can pay out of pocket)
4. High Effect of Deduction
Let’s go back to the effect of deduction. This is critical, since it’s where a large chunk of your money goes. A good insurance policy shouldn’t take more than 20% to 25% of the money put into it.
So add the cash value of your policy (the final pay out, often at 30 years) to the effect of deduction. This grand total is how much money you’d get, if the insurer wasn’t taking their cut. Now, determine what percentage of the total is taken up by the effect of deduction. For example:
Accumulated Premiums (cash value + effect of deduction) = $350,000
Effect of deduction = $105,000
$105,000 / $350,000 = 30%, which is too high
Many insurance agents will tell you to look at distribution cost as the fee you’re being charged. This is true, since the distribution cost pays for things like the agent’s commission. But the effect of deduction is the real total that you’re paying, and includes costs such as back-end administration and even marketing.
Again, let me stress that all of this is above-board. There’s nothing illegal going on. But a lot of policies are rip-offs via omission; you’re paying more because of what’s not said, and what you don’t know. And unlike the price of orange juice in convenience stores, it’s not easy to compare insurance premiums.