Every premium pays for risk, costs and sometimes savings

You will be able to explain the three parts of a premium and why the same sum assured can cost very different amounts.

Two friends, both 30, ask an adviser for S$500,000 of life cover. One leaves with a term policy costing a few hundred dollars a year. The other leaves with a whole life plan costing several thousand. Both were told they had the same cover. They didn't buy the same thing, and the reason sits inside the premium.

Every premium you pay is split three ways. The first part pays for the risk itself: the chance that the insurer has to pay a claim this year. Insurers price this from large pools of people, so the healthy majority's premiums pay for the claims of the few. At 30, the chance of dying in any one year is small, so this part of the premium is small too. It rises every year you get older.

The second part pays the insurer's costs. That includes running the company, checking claims, and paying the adviser who sold you the policy. The cost of selling a policy is called the distribution cost, and on long-term policies much of it is paid in the first few years.

The third part exists only in some policies. It is savings. A whole life plan or an endowment charges far more than the risk alone costs, and the extra is invested for you. That is where the cash value comes from, and it is why such a plan costs several thousand dollars a year rather than a few hundred.

Term insurance is almost entirely the first two parts. You pay for cover for a set number of years, and if nothing happens you get nothing back. That sounds like a waste until you see the price. Because there is no savings part, the same S$500,000 of cover costs a fraction of what a whole life plan charges.

Whole life does something different with the timing. Its premium is level, meaning it stays the same for the life of the policy, even though the cost of the risk rises with age. In the early years you pay more than your risk costs, and the surplus builds a reserve that carries the policy when you're older and the risk is high. Add the savings part, and you get a policy that builds a cash value over time.

That cash value comes in two pieces, which every benefit illustration shows separately. The guaranteed value is written into the contract. As long as the insurer stays solvent, that is what you get. The non-guaranteed value is a projection. It depends on how the insurer's participating fund performs and on the bonuses it decides to declare. The illustration shows it at two assumed rates of return set by industry rules, and those rates are reviewed from time to time, so read them off your own document rather than remembering a figure.

Now the early years make sense. Your premium has paid for risk, paid the costs that were loaded at the front, and only then started saving. That is why a whole life plan surrendered in year three or five returns far less than you put in. Nothing has gone wrong. The money went where the pricing said it would.

None of this makes one product good and the other bad. A policy that builds savings suits some people. Cheap cover with separate investing suits others. Module 3 compares them on the same money. What this lesson gives you is the question to ask about any premium: how much of it pays for risk, how much for costs, and how much is saved for me, and on what terms.

Take one policy you hold, or one you've been shown. Find the annual premium and the sum assured, and check whether the illustration shows a cash value. If it does, the premium includes savings. If it doesn't, you are paying for cover and costs alone.

Take one policy you hold or have been shown, note the premium and sum assured, and check whether the illustration shows a cash value.

Course

• Insurance Decoded