Term insurance with return of premium

Ordinary term insurance pays nothing if the insured survives the term. Many buyers dislike that.

So insurers sell a variant. A term policy with return of premium gives back the premiums at the end of the term if the insured is still alive.

Nothing is free. The premium on this variant is much higher than on a regular term policy.

The insurance company invests the difference. That invested difference is what funds the money handed back at the end.

So the buyer is really doing two things at once. Buying life cover, and making an investment he cannot see the return on.

The workbook's answer is to work that hidden return out. Take the extra premium, treat the refund as the maturity value, and use the RATE function in Excel.

What the product is. Several variants of term policies are available in the market, and a term policy with return of premium is one of them. In this variant the premium is normally much higher than a regular term policy, and the difference is invested by the insurance company to provide for the return of premium at the end of the term.

How to price it, in four inputs. The inherent investment return on the policy can be calculated using the RATE formula in Excel:

What the answer means. The rate that comes out is the return the insured is getting on the extra premium paid to choose the return-of-premiums policy. It is not the return on the whole premium, and it is not a return on the sum assured.

How to read that rate. Compare it with what the same money would earn elsewhere over the same period, after tax. The workbook's point is that the return is knowable, so the choice does not have to be made on feel. It adds that this working can be done for any pair of a pure term plan and a term plan with return of premiums from the same company.

A related design choice in the same section. The payouts under term policies have many variants: a lump sum, a fixed regular monthly amount for a specified period such as 10 years, or both. Tenure has stretched too, with some companies providing coverage up to 85 or 100 years, and the workbook notes that the premium for such extended term policies is much higher than for term policies that cover only the earning years. So return of premium is one of several ways a term plan can be made to cost more, and each needs the same question asked of it.

Where this belongs in the advice. Chapter 2's criteria for evaluating a life product put protection first. An investment cum insurance element should be considered only once the protection need is covered, and then judged against comparable investments.

The workbook's own real-life comparison, of a pure term plan and a return-of-premium term plan from the same insurance company.

The RATE computation the workbook sets out:

So the insured is getting a return of 4.61% a year on the extra premium he pays to choose the return-of-premiums policy. That is the whole content of the decision.

Reading the result. Rs 8,057 a year for 30 years is Rs 2,41,710 of extra premium paid in, coming back as Rs 5,24,190. It roughly doubles, over three decades, which is what 4.61% compounding looks like. An adviser can now put that 4.61% next to a PPF rate, a tax-saving deposit rate or an equity fund's expected return over 30 years, and let the client decide.

One arithmetic slip in the workbook to be aware of. In setting out the RATE inputs it writes the PMT as 8057 and, in brackets, 17,743 less 9,416. The premium figure stated everywhere else in the example, and the one used for the Rs 5,24,190 refund, is Rs 17,473. Rs 17,473 less Rs 9,416 is Rs 8,057, which is the figure actually used, so the bracketed 17,743 is a transposition and the computation is unaffected.

Chapter 2 (Features of Life Insurance Products), section 2.3, on types of life insurance products, covers term insurance with return of premiums immediately after plain term insurance, and works the Rs 1 crore, 30-year, Rs 9,416 against Rs 17,473 example to a rate of 4.61% using the RATE formula. Expect a question asking which Excel function gives the inherent return on such a policy, or one handing over the two premiums and the refund and asking what the 4.61% represents - the return on the extra premium, not on the policy.

• The 4.61% is the return on the EXTRA premium, not on the total premium and not on the sum assured. This is the single most commonly misread number on the page.
• PMT is the difference between the two premiums, Rs 8,057 - not Rs 17,473. Put the full premium in and the answer is meaningless.
• The refund is 30 times the ANNUAL premium of the return-of-premium policy, Rs 5,24,190, not 30 times the difference.
• Payments are at the beginning of each period. Using the end-of-period default changes the rate.
• The comparison must be between two policies of the same insurer. The workbook says so, because the underlying mortality charge and expenses then match.
• Return of premium is not interest. The premiums come back without any addition; the 4.61% is what the arithmetic implies, not a declared rate.
• The death cover is the same in both policies. Rs 1 crore either way. The extra premium buys the refund, not more protection.
• Watch the workbook's own typo. The RATE working prints 17,743 in brackets where the example everywhere else uses Rs 17,473.