Michael on October 17th, 2008
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It’s Friday, so it’s time for this week’s reader-submitted Q & A. If you’d like to submit a question, click here for more information or simply email a question.

Thank you for writing this book. In one place, I have found a way to understand my financial future!

I have on question, though: My wife and I just bought a home, so it’s time to get some life insurance. I have gotten quotes for my term insurance but my father mentioned Term Return of Premium Life Insurance. I’ve looked into it and it seems like a good deal (I think?) but as this was not touched on in the book. I was wondering what your opinion of it is. (Maybe this could be a blog topic???)

Jeffrey R., Philadelphia, PA

A while ago, I blog extensively about life insurance, especially in the very popular post The Four Questions of Life Insurance.  You are correct, however, in that I have not previously written about the specific product you mention above, “Return of Premium” term life insurance.

Congratulations on your recent home purchase.  For the purpose of this post, I’ll assume that life insurance is appropriate for you and your wife (as you have concluded), but depending on your personal facts and preferences, it’s possible the act of simply purchasing a home wouldn’t cause you to automatically need substantial life insurance.  Again, read The Four Questions of Life Insurance for a discussion of when you truly need life insurance.

What is Return of Premium Term Life Insurance?

This is one of these things that sounds like what it is. Specifically, you acquire a term life insurance policy with a feature that provides, if you are alive at the end of the policy term, for the total return of what you paid in life insurance premiums.  In addition, this return of premiums comes to you tax-free.

You: So it does sound like a good deal.

But you know there’s always a catch.  Logically, you already knew that there was a reason why the insurance company is being more generous with a Return of Premium policy compared to an ordinary term policy. In this case, the “generosity” comes to you in the form of a significantly higher policy cost.

You: What?

In other words, the premium you are charged each year is far higher for the same coverage (say $500,000) where the policy provides for the return of premiums than if it does not.  It is these additional amounts that you pay every year that are effectively invested by the insurance company and then returned to you (albeit at a guaranteed tax-free rate) at the end of the term.  You’re paying more money then the cost of the insurance and the insurance company, by investing the extra amount, can easily afford give you all your money back at the end of the term.

Why People Buy Return of Premium Policies

Psychologically, people have a hard time buying things they expect to have no value.

You: That’s not true. I play the lottery.

Point taken.  Maybe for small dollar purchases, they mind less.  But when it comes to something more than a dollar or two, it’s harder for people to accept.  That, combined with the fear of confronting one’s own mortality, makes a purchase of a term life insurance policy more difficult to complete. So, when an agent can explain that you’d be guaranteed a payback (either in the form of returned premiums or the true jackpot (a life insurance claim from your early demise), it’s a more attractive sale.

Gary:  A more attractive product.

But it shoudn’t be.

You: Why?

You can create the same concept on your own, and likely do much better.

You: How?

Simply be purchasing a traditional low-cost term life insurance policy. Then, with the savings you’d obtain compared to the cost of a Return of Premium policy, invest the money on your own.  Depending on your investment performance and the cost difference between the policies, it’s possible that you could have even more money this way.  Plus, you’d be under control of your funds the entire time, not just at the end of the term of the policy.  With the Return of Premium policy, you lose all flexibility with this extra money.  Should you wish to switch to a cheaper policy or cancel it because it is no longer needed, you’ll forfeit a good amount of the potential returned premium, as you are considered to earn most of it back in the final years.

Verdict

Unchanged. If you need life insurance, get what you need at the lowest possible (read: plain vanilla term) cost.  Use the amount you’d save (compared to any alternative policy) for your many other financial goals, some of which, in all likelihood, you’re not able to currently obtain.

It’s quite all right for you to never see any financial value from your term life insurance because you outlived your policy. In fact, that’s exactly what I hope happens from mine.

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4 Comments to “Return of premium term life insurance overview”

  1. BK says:

    I have a couple of observations about this. True, a person could take the savings from purchasing a simple term life insurance and invest it themself. The problem is that about 90% of people will not do that. Second, a lot of investments that have the potential to do much better, have greater tax implications. And those that don’t, like a Roth IRA, have pretty strict rules when it comes to getting your money out before 59 1/2 (I think that’s right).

    So, for arguments sake, lets say a person is a lazy, undisciplined financial slob – or the average American. Wouldn’t this be a way for them to have piece of mind as well as some sort of a nestegg? It may not be ideal, but it may be a good savings option for a lot of people.

    I am certainly not pro return of premium life insurance, but I can also see the value of it for quite a few people. I do invest in mutual funds and have a Roth and a 401k – what are some other options as far as low tax / high yield investments? I think this is especially critical considering some of the talk surrounding the tax implications for investors with the change in leadership in White House.

    Regards

  2. BK says:

    By the way, I just put “Beyond Paycheck to Paycheck” on my Amazon wishlist – Christmas is coming.

  3. Michael says:

    @BK – thanks for your comments. While your thoughts are completely reasonable, I personally don’t see it that way. If one is willing to be disciplined enough to come up with all the extra money for a more expensive return of premium insurance policy, I believe that same person can be just as disciplined to put the same money in a Roth IRA (which has far less onerous restrictions than the typical ROP insurance policy).

    To your point, far better to save something the wrong way than to not save at all. But the best answer is to save and to save intelligently.

    Look forward to hearing from you again.

  4. ken says:

    The, really “THE”, best way to figure out if Return of Premium Life is best for you is to speak to an expert.

    The only other item I would mention is to be sure the “expert” candidates have achieved the CLU designation. (Chartered Life Underwriter) This is equivalent to a “Ph.D” in life insurance!

    Then you can be well, “almost” sure they really do know what they are talking about.

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