What Is Return Of Premium Life Insurance?
Return of premium (ROP) life insurance is a type of term life insurance that returns to the policyholder all of the premiums they paid during the policy term if they outlive the policy. This was an option developed in the 1990s as an alternative to the “live-and-lose” dilemma of traditional term policies.
Those who outlive the policy get to enjoy the peace of mind of having a life insurance policy while having paid a net $0 for it.
If that sounds too good to be true, it’s because it just might be. This article covers the basics of ROP life insurance and weighs its pros and cons so that you know exactly what to expect from it and can decide whether it’s right for you.
What Does Return Of Premium Mean?
Return of premium is a type of insurance policy where all or a portion of the premiums paid during the policy period are refunded to the policyholder if no claims are filed or if the claims filed are less than the premiums paid. This type of policy is most commonly used in life insurance.
Return of premium policies are not applicable to whole life or permanent life insurance, as these policies provide coverage until death, ensuring a death benefit will eventually be paid. However, in the case of term life insurance, individuals may hold coverage for 10, 20, or even 30 years without ever filing a claim.
To address this, many life insurers offer return of premium policies, allowing policyholders to receive a refund of all or part of the premiums they paid if no claims are made.
ROP Insurance vs. Regular Life Insurance
Regular term life insurance policies often leave policyholders at a loss after the term of coverage expires. The policy therefore offers temporary financial protection to the policyholder’s survivors. ROP life insurance prevents this loss.
Some policies even have an addendum that provide for a marginal amount of interest in addition to the return of premium. This allows the policyholder to retrieve the amount spent as a non-taxable lump sum amount.
Overall Factors to Consider
The primary distinction between regular term life insurance and ones with return of premium riders is that the latter costs more. Still, a full refund upon outliving the policy is an attractive feature so it’s worth considering.
It is also important to consider that money locked into an insurance policy cannot grow as it would in an investment instrument. Therefore, you should take into account the time value of money. For instance, you could invest the additional cost of the rider and earn a bigger return on investment than a refund of the premiums paid. This, however, depends on your risk tolerance, since investments do not guarantee a return either.
Finally, take into account your health and risk factors to asses how likely you are to outlive the policy.
Cost of ROP Riders
As mentioned above, ROP insurance costs more than regular life insurance policies. Regular life insurance policies cost approximately $15,000 for 20 years’ worth of coverage, while ROP Insurance costs as much as $25,000 (on average, ROP insurance policies are 30% more expensive).
This means that instead of merely paying $15,000 for protection, you are locking in an additional $10,000 of your money for the duration of the policy at marginal or zero interest.
Why Buy ROP Insurance?
Many life insurance policyholders are uncomfortable with the idea of taking a loss should they outlive the term of their insurance policy. So, the idea of being able to retrieve the amount they paid in premiums and essentially having free protection for the duration of the stipulated period is appealing.
Individuals who are risk averse would prefer policies that stipulate a return of premium. The market for ROP insurance usually comprises individuals in their 30s or 40s in the low- to middle-class economic bracket. This social class is not in a position to lose any money paid in insurance premiums. At the same time, they are likely to live out the term of their life insurance policy and so probably won’t claim the death benefit.
Older individuals in their early 50s with a considerable number of minor dependents would also be inclined to take on a ROP policy. The benefit of being protected by a life insurance policy throughout an extended stay in the workforce is essential for older people who are still breadwinners for their families. At the same time, they would prefer to receive a full return for their use, should they outlive their policy.
Another reason individuals might prefer ROP insurance is that it forces them to save. ROP insurance, like regular life insurance, demands constant payment of premiums; otherwise, the policy would lapse and the amount would be forfeited. ROP insurance, then, is an appealing instrument for any individual struggling to set aside a fixed amount on a regular basis.
Cons of ROP Insurance
ROP insurance has some clear benefits but it also has its share of drawbacks. First, the scheduled premium payments cost significantly more than that of regular life insurance, making it more difficult to maintain consistent premium payments for ROP insurance, especially for those in the middle to lower income brackets. There is, then, a possibility of the policy lapsing altogether, if the policyholder faces financial struggles.
Moreover, to compensate for the high premiums, new policyholders tend to downgrade the coverage. Instead of purchasing the coverage they need, policyholders may cut corners to be able to afford the return of premium rider. This compromises the main purpose of an insurance policy: protecting the individual against financially burdening their survivors.
In addition, the cost of ROP insurance increases over a prolonged period when you take into account the time value of money. Financially savvy individuals who are adept at investing in the stock market or buying mutual funds lose the opportunity to grow their money faster. The interest rates in ROP insurance policies are usually marginal at best.
With the average mutual fund or unit investment trust fund growing at 18% per year, it is easy for an investor to outpace the growth of the money placed into an ROP insurance policy. Investors with a higher risk appetite can even place the money that would be spent on the cost of a return of premium rider into an equity fund composed primarily of blue chip equities to earn as much as 40% per annum. This is not possible with ROP insurance policies.
Is Return of Premium an Attractive Option?
Because ROP riders return the premiums to the policyholder if they outlive the policy, it looks, at least on the surface, like a better option in comparison to a standard term life insurance policy. With the latter, if you outlive the policy, you lose out on all the premiums you invested in providing you and your family financial security. However, with ROP insurance, you also lose out on the money for the period it’s tied to the policy.
This money, if it were invested elsewhere, could grow much more in value. In fact, the marginal interest insurers provide is usually below the rate of inflation. It would be better to maximize the time value of money by placing it in investment instruments tailored to fit specific financial objectives.
Who Benefits from ROP Policies?
Despite the lack of growth of any money invested in an ROP policy, this form of life insurance may still benefit certain types of individuals in some ways. If you fall within one or more of the following three categories, you may want to consider purchasing this rider if you plan to invest in term life insurance.
1. Those Who Have Limited Resources to Continually Fund Life Insurance Policies
Perhaps one of the most immediate benefits of adding an ROP rider to life insurance policies is that it prepares policyholders for subsequent renewal of their policy. Because insurance premiums become more expensive as you age, it will cost more to maintain security on your life as time goes by.
ROP life insurance policies prepare you for the transition from a policy with low to moderate premium payments to ones with higher premium payments by refunding you with startup money for the first few years of coverage of a policy purchased at a later age. This seamless transition from one policy to the next provides an incentive for purchasing an ROP rider.
More specifically, individuals in low- to middle-income brackets who have multiple beneficiaries can appreciate this benefit of ROP insurance. In sum, it allows people with limited income to maintain financial security on their life for their beneficiaries without completely sacrificing their money.
2. Those in High-risk Occupations Who Want to Avoid Income Tax
Another incentive for purchasing ROP riders for life insurance policies is that the lump sum paid to you as the policyholder will not appear on your 1040 (Income Tax Return) as a form of income. Under the Internal Revenue Code, returns of principal may not be classified as income.
This is almost universal throughout the world. Governments who recognize the lump sum payout after the expiration of the ROP insurance policy as a form of income only tax the interest.
This affords individuals who work jobs that require their lives to be insured a chance to maximize their income. Aircraft pilots, seamen, and other individuals who work risky jobs can request their employers to instead purchase ROP insurance on their behalf by using a portion of their salary to pay off the premiums. This provides them financial security while allowing them to maximize their income over their career.
3. Divorced Spouses Who Must Name Their Ex-spouse and Dependents as Beneficiaries
Countries that have legalized divorce often require the erring spouse to secure a life insurance policy naming the plaintiff spouse and any children they may have had as beneficiaries. This is to secure the support that the erring spouse ought to have provided to the plaintiff spouse and their children.
In the event of the demise of the erring spouse, the plaintiff spouse and children can still receive support through the death benefit from the insurance company (find out How to Collect a Life Insurance Payout).
The period required for the erring spouse to support the plaintiff spouse and their dependents varies from country to country. The erring spouse will therefore incur twice the amount of expenses if obliged to provide support while paying premiums for the insurance policy. As such, it would be practical in this scenario for the erring spouse to purchase a return of premium rider for the insurance policy to later recuperate their money, should they outlive the policy.
Know What You Intend to Buy
The key to choosing between ROP and regular life insurance is knowing what you want to purchase, which requires a working knowledge of the difference between insurance and investment. In buying an insurance policy, you are purchasing security for your loved ones after your passing.
Moreover, life insurance policies offer a lump sum payout that is much larger than the total amount of premiums paid in the event of the insured’s death. Conversely, the lump sum payout at the end of the ROP insurance policy, should the policyholder outlive the set term, is unlikely to match the time value of the money.
Purchasing an investment instrument or shares in an investment trust fund is buying the chance to grow your money. These instruments offer you the chance to grow your money at a rate commensurate to your risk appetite for a set period. Even the most conservative of investment instruments still stand to outpace the growth rate of money locked into ROP insurance policies.
Diversifying your financial portfolio entails a balance in the amount of insurance and investment instruments you choose to purchase. Choosing to purchase an ROP insurance policy is the safest option for you if you do not want to lose any money at face value.
