The Value of Return of Premium

A premium is the monthly payment required to pay for your policy. Let’s use Critical Illness insurance as an example. When purchasing an insurance product with a term – say ten, twenty, or thirty years – you usually have an option to select what’s called a “Return of Premium” rider.

A rider, simply put, is small add-on, or provision, that can be added to your policy to provide a variety of different benefits and options for an additional charge. Return of Premium (ROP) is an example of a rider.

Alternatively, a “Return of Premium” policy is another way that an insurance provider can offer this option. Regardless, both options accomplish the same task: to return the sum of your premiums back to you at the end of the term should the policy end with no illness.

Sounds like a no brainer…

Well, that truly depends on a few factors. At the surface, it’s easy to justify the additional cost when there is little risk to health or death since you would receive all of the premiums back, essentially providing you with free coverage with no tax liability right? Well, not exactly… There are a few things to consider when deciding to opt in or out of the rider.

Consider a scenario where you wanted to cancel your coverage, or convert it to a permanent life insurance plan: your insurance providers are not obliged return the premium depending on how the policy is terminated, modified or structured, thus leading you to incurring additional losses.

Another key component to consider is the opportunity cost of adding this rider to your policy. The additional principal that is put towards the ROP rider goes directly to the insurance company and gains zero interest. If you’re someone who is less tolerant of risk from a financial standpoint, the rider might be a viable option for you since an ROP guarantees a payout if the policy’s benefits aren’t claimed. Opportunity costs also raises the question of discipline. Instead of purchasing the ROP rider, you might think you can invest the equivalent amount…but the question stands: will that extra amount actually end up in an investment? It’s easy to speculate that every month the difference in savings will go to an investment, yet this is rarely the case in reality, especially over a long term. Having an ROP almost doubles as a forced savings mechanism. 

Now, if you’re someone who is more tolerant in terms of risk, you might want to invest that rider difference over the term of your policy into a low risk investment, such as a bond to help keep up with inflation. It’s important to note that the return of premium is guaranteed, so it isn’t really feasible to compare ROP to a higher risk investment that provides higher potential returns due to potential losses (among other factors), however this is dependent on your risk tolerance.

What about taxes?

As mentioned earlier, should you decide to invest this difference, there is a chance of having a larger tax liability when you’re ready to pull out your gains. Over a longer term, say twenty or thirty years, this might end up costing you more than just opting for the ROP which has no tax liability, since it’s considered a return of your principal.

Can I have an example?

Absolutely!

Let’s take a 30-year-old single male, non-smoker who is looking for Critical Illness coverage until they are the age of 75 for $100,000 of coverage. Let’s also assume that he can afford both options, one with ROP and one without.

His monthly premium would be $73.17 without opting for the ROP rider. We’ll call this Scenario A

With the ROP rider the monthly premium is $97.65. No other differences. This will be Scenario B

The difference between the two scenarios is $24.48 which is about a 25% difference

In Scenario A, the client would pay ~$39,500 over the next 45 years. Assuming that he lives to the end of the term with no illness, he receives no money back from the insurance company. 

However, there is that extra $293.76 ($24.48 x 12 months) that hasn’t been committed to the ROP. 

What if that was invested into a low risk bond yielding 2% a year for 45 years? The total value of the investment would be ~$21,500 at the end of the term! The advantage of having an investment like this is that your investment is liquid, you can pull a portion of this out at almost any time. 

Depending on the tax bracket and what type of investment the funds are in, the total realized gains could vary from 0% to 50% or more! 

In Scenario B, the client would pay ~$52,700 amount over 45 years. Once again, assuming that he lives to the end of the term with no illness, he’d receive a lump sum back from the insurer. Note that this amount returns to the client tax free. In this scenario, the only way to receive the funds back is to either terminate the policy, therefore having an adjusted lump sum returned. 

So, is it worth it?

There is inherent value in opting for an ROP depending on the length of time, your investment risk and your individual tax situation. Scenario A becomes much more favourable if you have a higher risk tolerance. The objective is to analyze each metric prior to making a decision. Speak with your advisor to ensure that you are selecting the most appropriate riders for your individual situation! 

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