Understand the risk-reward trade-off when getting a universal life plan
A friend recently asked me what I thought of a universal life plan that an insurance adviser had presented to her.
That piqued my interest as I have been hearing a great deal about universal insurance and its rising popularity among Singaporeans.
For an initial investment of US$250,000 (S$360,000), according to the illustration she sent by WhatsApp, the policy has a projected surrender value of about US$460,000 in 20 years and US$650,000 at the end of 30 years.
As a sweetener, the product guarantees an interest of 4.2 per cent in the first three years to speed up the break-even point. In short, the policyholder may surrender the policy with no loss of capital by the end of the fourth year.
Like most universal life plans, this comes with a contractual minimum guaranteed return rate of 2 per cent per annum.
What makes this particular plan attractive is the high leverage it affords the policyholder.
Although it stipulates a minimum single premium of US$250,000, the plan requires my friend to put up only about US$50,000 in cash, with the remainder to be financed with a bank loan. The cost of this loan was pitched at 1.31 per cent per annum, based on a floating rate equivalent to the lending bank's cost of fund plus one percentage point. This leverage of five times (US$250,000/US$50,000) works out to a surrender value of 13 times (US$650,000/US$50,000) the initial capital after 30 years.
These days, I can't think of any investment that has this sort of leverage without a high degree of mark-to-market risk, which reflects its current market value rather than its book value.
According to an insurance adviser, premium financing on universal life plans is a useful tool for estate planning as it allows for a larger payout, without the corresponding high capital outlay.
That is borne out by my friend's benefit illustration, which showed a death benefit coverage of US$1.1 million on a cash outlay of US$50,000. On the other hand, the death benefit may be less relevant to her as she is single and her parents do not count on her for financial support.
To get more bang for the buck, instead of taking a straight bank loan to finance the premium, the insurance adviser suggested assigning the policy to the bank as collateral and taking the cash from the loan to buy investment-grade corporate bonds. The returns from the bond investment should more than cover the interest expense of the bank loan. Sounds like the makings of an excellent plan, but I advised my friend to bear in mind the following risk factors.
Firstly, she should not let the short break-even period lull her into thinking that she can change her mind and surrender the policy at little financial cost. Distribution cost, which is paid by the policyholder, amounts to a hefty US$18,000. This sum will be deducted upfront from the premium paid at the outset of the policy. Breaking even at the end of the fourth year merely means that her money is tied up for four years to pay the insurer.
That's provided she didn't take on any financing. At 1.31 per cent, the interest she will pay a year works out to about US$2,600.
Hence, the effective break-even point can be 10 years or more.
It will cost her dearly even if she gets back her entire initial investment by surrendering the policy at its break-even point.
This cost is known as an opportunity cost, which is the benefit she would have forgone from not investing her capital in an alternative product during the period. For example, if she puts $50,000 in the upcoming tranche of the Singapore Savings Bond, the total interest earned over 10 years is $12,800. Moreover, this investment is totally risk free.
Opting for premium financing may also reduce her eligible loan quantum under the Total Debt Servicing Ratio framework if she subsequently takes up a loan to buy a property.
INTEREST RATE AND FOREIGN EXCHANGE RISK
I am not sure if the 1.31 per cent loan interest will remain on the table after the United States Federal Reserve hiked interest rates by 0.25 percentage point last month.
The three-month, US-dollar Libor - which is the average interest rate at which some banks in London are prepared to lend to one another - trended up to 0.62 per cent last week.
Add one percentage point spread to that and the borrowing cost is now 1.62 per cent. Rates are likely to continue to rise, which means higher borrowing costs going forward.
The loan may also need refinancing since most premium financing contracts have terms that are shorter than the life of the policy.
As this product is priced in US dollars, my friend will also be exposed to foreign exchange risk.
MARGIN CALL RISK
Events in the past 12 months - threats of a Greek exit from the euro zone, scrapping of the Swiss franc peg against the euro, a commodities rout, the economic slowdown in China and the mauling of its stock markets - have underscored a more hostile investment climate today than in the past.
A projected return of 4.2 per cent over 20 to 30 years may seem undemanding, but current market volatility can lead to poorer returns in the short term. Coupled with rising interest rates, it is possible that the bank may ask her to top up the loan on her premium, failing which the policy may have to be surrendered at a loss.
Industry sources say the risk of a loan recall for universal plans is low but not inconceivable. The risk is real as the fine print in the illustration sheet stipulates that her loan is recallable on demand.
If my friend decides to invest in the plan, it is important to keep all the paperwork, including illustration sheets and the policy statement.
Read them carefully to make sure the key selling points highlighted in the sales pitch are in the legal document.
There have been cases of overselling by enthusiastic advisers, resulting in policy benefits that did not match customers' expectations.
I can attest to this. In 2003, when my second daughter was barely two months old, I went to a bank to open a joint savings account in her name. A relationship manager pitched to me an education-related insurance plan.
Flushed by a renewed sense of responsibility, I was easily persuaded into signing up for two plans, one for each daughter.
I was drawn by the projected returns, with a base case scenario of 6 per cent. Alas, it was too good to be true. I have since received regular updates that gave a number that was lower and lower as the years went by.
I can understand this as global interest rates fell and stayed at rock-bottom levels over a prolonged period. But what makes me sore is the misinformation during the sales pitch. I was told that the payment of monthly premiums would stop once my daughters reached the age of 11. They will get a lump sum payment at 19.
I realised too late that this was not written into the contract when I made my inquiries, as premiums continued to be deducted after my older daughter turned 11 three years ago.
The only useful information I got out of the bank was it had sold its life insurance business to British insurer Prudential and that I might find my answers there.
It was a chastening experience.
I have learnt to be sceptical during investment presentations and am more prepared to clarify doubts, make a note of key policy features and verify that these are indeed written into the contract. I am also mindful about the possible downside of the investment and getting the adviser to walk through a worst-case scenario with me.
When possible, I seek the opinion of a friend or colleague for a different perspective.
Which was what my friend did.
My verdict on her universal plan?
Given that her main concern is not to bequeath her wealth but to build up a retirement nest egg, I will say it is fair but not compelling.
A version of this article appeared in the print edition of The Sunday Times on January 17, 2016, with the headline 'Know your insurance plan before signing on the dotted line'. Print Edition | Subscribe
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