Explain how an ILP uses your premiums to buy units and how charges are taken out of those units.
Find the product summary for an ILP you hold or have been shown, and look for the line that says what the policy pays on death. It names one of a few designs. That design decides how much you pay for the cover each year and how those charges grow as you get older.
Jun Hao ran into this when he hesitated over a whole life plan. Ryan, who was selling it, offered him an ILP instead, with the same S$200,000 of cover for the same S$4,000 a year (example figures). Ryan said it had "more upside" because the money would go into funds Jun Hao could choose. Jun Hao noticed that the ILP illustration looked better than the whole life one at the higher illustrated rate and worse at the lower rate. He asked why the two rates told such different stories, and whether the cover itself was safe. The answer depends on how an ILP is built. The basics are in lessons 5.1, "An ILP is insurance and funds in one policy", and 5.2, "The charges that set ILPs apart from unit trusts", in Unit trusts, robo-advisors and managed money compared.
An ILP turns each premium into units in one or more sub-funds. The share of each premium that buys units is the premium allocation rate. In some policies the full premium buys units from the start. In others the allocation rate is low in the early years and rises later, and the part of the premium that doesn't buy units pays for distribution costs. Read the allocation table for the first ten years to see which kind you have.
The units make up the account value, which is sometimes called the policy value. The insurer takes its charges by cancelling units, usually every month. Typical charges are a policy or administration fee, an insurance charge for the cover, sometimes a charge on the account value, and charges for any riders. The sub-funds' own management fees are taken differently: they come out of the unit price, so no units are cancelled for them. If you leave in the early years, a surrender charge may also be taken off what you get back. Because of all these charges, the account value grows more slowly than the sub-funds do.
ILPs pay out on death in different ways, and the design changes what the cover costs. The product summary states which design a policy has.
On the "higher of" design, the policy pays whichever is higher: the sum assured or the account value. As the account value grows, more of the payout comes from your own account, so the insurer has less of its own money at risk. On the "plus" design, the policy pays the sum assured plus the account value, so the insurer's risk stays at the full sum assured whatever the account does. Some investment-focused ILPs pay little more than the account value on death. These give you very little cover.
The sum at risk is the amount the insurer would pay on death on top of your own account value. On the "higher of" design, it is the sum assured minus the account value. On the "plus" design, it is the full sum assured.
The insurance charge is usually based on the sum at risk. To work it out, take the sum at risk in thousands and multiply it by the rate for your age. That rate goes up every year, slowly at first and then steeply. Lesson 1.2, "Why premiums rise with age, and how level premiums hide it", explains why.
Take S$200,000 of cover on the "higher of" design, with yearly rates that are not any insurer's: S$1.00 per S$1,000 of sum at risk at age 35, S$3.50 at age 50 and S$12.00 at age 65.
At 35, the account holds S$5,000, so the sum at risk is S$195,000 and the charge is 195 x S$1.00 = S$195 for the year. At 50, the account holds S$30,000, the sum at risk is S$170,000 and the charge is S$595. At 65, the account holds S$40,000, the sum at risk is S$160,000 and the charge is S$1,920.
On the "plus" design the sum at risk stays at S$200,000, so the same rates give S$200, S$700 and S$2,400. On either design, the charge at 65 is roughly ten to twelve times the charge at 35, and it keeps rising after that. An ILP is effectively stepped cover inside a level premium.
Put together, an ILP is a level premium paying for charges that rise with age, and those charges come out of an account whose value moves with the markets. In good years the account grows faster than the charges reduce it. In poor years the account falls and the charges are still taken. If the account value falls far enough, there aren't enough units left to pay the charges, and the policy lapses unless you pay in more. Lapse tends to happen late, when charges are highest and cover may be hardest to replace.
This is the main reason an ILP illustration can look so different at its two illustrated rates, and it answers Jun Hao's question. At the lower rate, the rising charges use up the account in the later decades. At the higher rate, growth stays ahead of the charges.
An ILP illustration is laid out much like the whole life illustration in lesson 3.2. It shows premiums paid, account value and death benefit, each at the two illustrated rates for ILPs. These rates are different from the par fund rates. The ILP illustration also shows charges, and some show the effect of deductions and the total distribution cost, as par illustrations do.
Read the illustration all the way to the end, well past year 20. For every year shown, find the account value and the death benefit at each illustrated rate. Some illustrations show the year the account would run out at the lower rate, or note that top-ups would be needed. Then ask what you would need to pay, and from what age, to keep the cover in force to the age you want.
Jun Hao went through the ILP product summary and listed each charge in three columns: what it is, how it is taken, and how it changes over time. He ended up with five lines:
The allocation rate rose over the first years. The policy fee was a fixed monthly amount. The insurance charge rose with age and depended on the sum at risk. The sub-fund fees came out of the unit prices. The surrender charge fell to nothing after a set number of years.
Of his five lines, only the insurance charge grew every year for as long as he held the policy. Use a list like this together with the three-number method for estimating total charges, which is in lesson 5.4 of Unit trusts, robo-advisors and managed money compared, "Separate the insurance and the investment in an illustration".
Now make the same list for an ILP you hold or have been shown. Take the most care over the column on how each charge changes.
Use an ILP illustration or product summary. List every charge, how it is taken, and how it changes with age or over time.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).