(NOTE: This article is not intended to be an exhaustive comparison of ILPs and other investment-type insurance products. It is aimed at raising awareness of a few basic differences to aid readers in deciding which type is better for them).
When buying insurance, if protection is the only priority, then the most suitable products would be term policies, these being the cheapest because there’s no investment or savings element.
However, many people know that besides providing protection, insurance policies can also help to save and grow wealth. These policies will cost more because a portion of the premiums paid will go towards investing and saving.
The two most common insurance products in the market that combine both these goals are investment-linked policies (ILPs) and participating life policies. These products are typically used for investment and wealth accumulation.
At first glance they may look like they both serve the same purpose of helping you grow wealth. But what are their actual differences, and how should you choose between the two?
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How do ILPs work?
When you purchase an ILP, you are essentially buying units in a unit trust, typically called a “sub-fund”.
Some units are then sold to pay for the insurance component as well as other charges such as fund management fees and the rest remains invested in the unit trust.
ILPs have cash values which are dependent on how well your funds perform. For this reason, cash values are not guaranteed.
This is an important point to bear in mind because if the fund chosen does not perform, then it is up to the policyholder to switch out of it, possibly incurring switching fees. Here’s why this is important.
While you are paying the same monthly premium throughout the life of the policy, the cost of insurance typically increases year on year because as you get older the risk of death, disability and illness increases. This is even if you maintain the same coverage or sum assured.
This means that more units may have to be sold to pay for the insurance charges, leaving fewer units to accumulate cash value under your policy.
If you have a combination of high insurance coverage and a poorly performing sub-fund, the value of your units may not be enough to pay the insurance charges. You will have to top up your premium or reduce the coverage, otherwise the policy could lapse.
No guarantees, no blind trust
It is important to note that not only are cash values not guaranteed, so is investment performance.
Also, when it comes to investing in a unit trust, past performance should not be taken as a reliable indicator of how the fund might perform in the future.
In short, although ILPs offer the possibility of high returns provided the fund chosen does well, they come with a sizeable amount of investment risk because in the worst-case scenario, the policyholder can lose the entire value of the investment.
This means that investing in an ILP requires active monitoring on the part of the policyholder because all the investment risk is borne by the policyholder.
In other words, if your priority is protection and you are not familiar with how unit trusts work or if you are unsure as to how to select a suitable fund, then perhaps ILPs are not for you.
How do participating life insurance policies work?
When you buy a participating life insurance policy, the portion of the premium which you pay that goes towards investment or savings enters a fund known as the participating, or par, fund for short, and the responsibility for managing the fund rests with the insurance company.
A typical par fund would be invested in government and corporate bonds, equities, property and cash. The proportion invested in each asset class (often referred to as the investment mix) may change over time, as determined by the insurer.
Participating endowment or life policies share in the profits of the company’s participating fund. Your share of the profit is paid in the form of bonuses or dividends to your policy.
Returns for participating whole life and endowment policies tend to be modest compared to the potential returns that ILPs can generate.
However, as noted earlier, ILPs come with much greater investment risk and require active monitoring on the policyholder’s part.
When deciding on a policy that offers investment returns, it is therefore important to know exactly what you are buying.
If you are a risk-averse person looking mainly for protection, then perhaps ILPs are not for you.
Conversely, if you understand how unit trusts work, understand the risks and are happy with the potential benefits that ILPs can bring, then by all means go for this type of policy.
