Insurance Policy 101: Guaranteed and Non-Guaranteed Values
I recently had a discussion with a client recently who was looking to purchase a savings plan. As I was going through with him the benefit illustration and product summary (a document that features the numbers, terminology, exclusions etc.), we came to the page which reflected the plan’s surrender value table. It featured 2 columns prominently: i) The guaranteed and ii) non-guaranteed values of the policy over the term of the policy.
Even though he knew about the two values, it still perplexed him as to why they had to co-exist. Why couldn’t the insurer just provide guaranteed values, given that he would be investing a significant sum? He wanted a safe instrument that could offer decent returns (higher than what bank savings deposits were offering). He felt uneasy with the non-guaranteed benefits as the guaranteed benefits alone did not make the policy enticing. As human beings, we are generally wired to prefer taking fewer risks. When presented with two types of benefits, you would naturally want something guaranteed as opposed to one that is not. I then asked him a question:
"What happens to the money that you put in your savings deposit in the bank?"
As a consumer, you are promised a certain level (VERY LITTLE!) of interest annually. In some cases, the banks offer you a higher rate if you can fulfil certain requirements such as minimum spending on your credit card or purchasing of certain financial instruments. The bank’s promise for this savings deposit is this – Whatever you place in the bank account is yours and the interest will be accrued annually and you are free to access this money anytime, no questions asked.
In return, the bank can utilize the money they receive in the savings accounts to loan out money. However, the interest paid out by the bank on the money they borrow (your savings deposit) is much less than the rate they charge on the money they lend. But did you know that only $75,000 per depositor per bank is protected under the deposit insurance scheme? Even with what seems like a safe instrument such as a bank deposit, there is also a risk involved.
Insurance companies offer participating policies, policies that offer both guaranteed and non-guaranteed benefits, such as Whole Life, Endowment or annuity plans. Policyholders who purchase participating policies (par plans) share in the profits of the participating fund (par fund) of the insurer. The par fund is one where the premiums of all participating policies are pooled together in this specially designated fund.
This fund invests in a range of assets to generate an investment return. These assets include equities, government and corporate bonds, property and cash. This mix of assets is determined by the insurer. How well the fund performs is determined by the investment return of the fund, the claims experience of the fund and the level of expenses incurred by it. For the policyholder, the fund pays out guaranteed and non-guaranteed benefits in the form of bonuses.
Every year, the non-guaranteed bonuses are determined and declared to the policyholder. These bonuses get added to the sum assured of the policy and once declared, they cannot be reduced or taken away by the insurer. Does this mean the returns to your policies are uncertain? Yes, however, the fact that these policies combine both guaranteed and non-guaranteed bonuses, gives the policyholder a sense of certainty as the insurer has the obligation to pay the guaranteed benefits even if the par funds were to perform badly.
A large proportion of the par fund is invested into bonds in order to maintain guaranteed benefits. However, with a low-interest rate environment, bonds typically offer lower yields. For par plans to provide stable medium to long term returns, the combination of guaranteed and non-guaranteed bonuses allows them to not be as conservative should only the guaranteed benefits be offered.
There are two types of non-guaranteed bonuses:
1. REVERSIONARY BONUS
These bonuses are typically added annually to the policy and once added, they form part of the guaranteed benefits of the policy. This also means that you do not receive cash for these bonuses annually. Instead, whatever reversionary bonus collected will be paid out in full when a claim is paid out from the policy or when the policy matures. Early termination of a policy affects the reversionary bonus as the policy was not held till maturity thus only the declared bonuses till termination will be paid out and not the future ones owed.
2. TERMINAL BONUS
These types of bonuses are paid when a claim is paid, a policy matures, or you surrender the policy. These are separate from any reversionary bonus.
While there are recent changes that were announced highlighting the revision of caps of illustrated investment returns on participating policies, these changes were created in the best interest of policyholders and potential purchasers to make better financial decisions. While there are many factors to consider before purchasing a policy, speaking to an agent (like me!) can clear any doubts you have and help ease your decision making. Do drop me a message below or email me at email@example.com and I will be happy to assist you.