Monday, May 9, 2011

Are You Getting “Roped” into an ROP Term Life Insurance Policy?

The traditional life insurance industry’s bread-and-butter product that they would just assume sell to everyone would be some form of cash value life insurance – that is any life insurance policy that has a savings account associated with it (i.e. Whole Life, Universal Life, Variable Universal Life, Flexible Premium Variable Universal, etc.). The traditional life insurance industry’s least favorite form of life insurance to sell is called term insurance – mainly because term is much cheaper than cash value, thus making the agent’s commission much lower.

So, as a compromise between the higher priced cash value life insurance and the lower priced term life insurance, the traditional life insurance industry has recently introduced a new type of term insurance called Return Of Premium (ROP) term life insurance. With ROP term life, at the end of the guaranteed term period, the carrier will refund or return all of the premiums that have been paid. This can be a very enticing benefit because, even though living through a policy should be considered a good thing, often people feel cheated that they paid into the policy for years, but they didn't profit financially from it. In essence, people hate losing money: loss aversion means that although you might like to gain a dollar, you hate losing a dollar a lot more. Fact is only about 7 percent of policyholders die before the end of their policy's term and customers know there's a high chance that buying a term life insurance policy is just throwing money away.

With this relatively new product, the traditional life insurance industry is really catering to the emotional side of the general public. But, before anyone gets too excited about this product I feel the need to remind you that with any important decision that deals with spending a lot of money, not only do you need to look at the emotional side, but you also need to look at the financial side. This way you can be sure that you are making the most informed decision and most importantly, so that you can sleep well at night.

You can see in previous articles where I have compared cash value life insurance with term life insurance – giving both the emotional and financial side of the decision making process:
Since ROP term life insurance is advertised as a better product than regular term insurance I’d like to give you a comparison of the two products using a story about two men named Jim and Bob. Both Jim and Bob are 35 years old, have the same financial resources as well as the same insurance rating of standard non-tobacco. Also, both men decide to get a 30 year level term with a face amount of $250,000. The only difference is that Jim decides to get an ROP term life policy and Bob decides to get a normal term life policy.

Let’s see how Jim does with his ROP term life policy. An average annual premium for an ROP term life with the above credentials would cost around $1000 a year or $83.33 per month. If Jim were to die during this 30 year term, his beneficiaries would get the $250,000 death benefit. However, if the Jim were to outlive the 30 year term, he would receive all of the premiums that he paid into the policy over the 30 years or $30,000. Not too bad!

Bob, on the other hand gets a regular term life policy. Typically ROP term life insurance policies cost on average twice as much as the regular term life insurance policies. So, Bob’s policy would cost around $500 a year or $41.67 per month. If Bob were to die during this 30 year term, his beneficiaries would get the $250,000 death benefit. However, in this case, if Bob were to outlive the 30 year term, he would receive nothing! He would have paid $15,000 over the course of 30 years and he wouldn’t have anything to show for it! This would be a total loss wouldn’t it be?

Well, we said we were going to compare apples to apples, so both men were able to afford the same amount of money. So, let’s just assume that Bob, with the regular term life insurance, spent the same $1000 per year as Jim did with the ROP term life insurance -- only he invested the difference.

Here are some of Bob’s possible results if he would have invested the difference ($500 a year for 30 years) himself:
  • Working at an average 6% rate of return he would have $41,900.84 or $11,90.84 more than with ROP
  • Working at an average 8% rate of return he would have $61,172.93 or $31,172.93 more than with ROP
  • Working at an average 10% rate of return he would have $90,471.71 or $60,471.71 more than with ROP
  • Working at an average 12% rate of return he would have $135,146.30 or $105,146.30 more than with ROP
On an emotional level, I can see how this ROP term life insurance is sold. I mean, with a normal 30 year level term life insurance, if you outlive the policy, you get nothing in return. It’s a sort of use-it-or-lose-it type deal. But with the ROP term, you get all of the premiums you paid into it back if you out live their policy. Also, because of limited time or the like, many insurance buyers won't even bother to run the numbers. However, that return of premiums is really just a 0% return on investment. In essence, the insurer keeps whatever interest or investment returns the money made over the 30 years that it was lent. So the insurer got a free loan.

And in case you didn’t notice, this ROP term is not for free. The policyholder, on average, will have to pay double the cost of a regular term policy. You really get hit twice on the cost -- not only are the premiums much higher, but the loss of any interest to the policy holder can be a tricky hidden cost as well. Also, you can see that, even if the invested difference was making only a conservative 6% return, Bob would have still beaten Jim. So, this shows that you don’t have to be a Warren Buffett to come out on top with the regular term policy. By investing the difference, you could end up having more money at the end of the term period than you would get as a refund from the ROP life insurance

Another thing that is pretty interesting with the ROP term policy -- if you cancel the policy you get next to nothing in return. On a 30-year policy typically, if you walk away from your return of premium policy after, say, 10 years, you only get back 9% of the cumulative premiums you paid in. After 20 years, you'll receive 35% and not until you hit 30 years will you get your full investment. If you get out early, you really lose!

Another nice-to-know is that with the ROP, you either get the premiums returned if you outlive the policy or your beneficiaries get the death benefit – not both! With the regular term, if you were investing the difference, they would be separate entities. If you outlive the policy, you get to keep your investment. If you are to die during the term, your beneficiaries get both the death benefit as well as the investment.

You can borrow against the “ROP” policy, because it builds up “Cash Value.” However, when you do that, two bad things happen:

1. You must pay interest on what you borrow.
2. Whatever you borrow gets subtracted from the original Death Benefit or Face Amount.

Furthermore, “ROP” does not qualify to be an IRA. When you invest the difference yourself, you can choose a portfolio of mutual funds and “tag” it an IRA. And, if it’s a Roth IRA, your investment will grow tax-free, and at age 59 ½, you can start withdrawing, tax-free.

The way the ROP policies are marketed, they sound like free insurance because if you do die you get a payout and if you don't you get your money back. But as I’ve shown above, if you look carefully at the numbers this "free lunch" will cost you. Buying Term and investing the difference is still and will probably always be the way to go. Do not fall prey to the Insurance Industry’s latest gimmicks. Remember, when things sound too good to be true, they usually are. Get into the habit of taking some time to weigh both the emotional side with the financial side when making important money decisions.

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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