Has anyone wondered how is it that insurance company could pay more than 100% of its first year regular premium insurance in commission? I never figured it out until now.
When an insurance company pays commissions, it will book this payment an amount owed to the insurance company by the policyholder. Thus, the policyholder “borrows” this amount from the insurance company in order to pay commission to the distribution channel.
For illustration, let’s say a regular premium ILP / whole life/ endowment / whatever pays 100% of the first year premium in commission (example only – actual commission varies widely between different products). We assume a premium term of 25 years and that the discount rate is 5%.
N=25 * 12 = 300 months
I = 5% / 12
PV = $1000 * 12 = $12,000 (assuming annual premium of $12,000. Can be any figure actually)
FV = 0
The “PV” above is the debt which the policyholder incurs as a result of paying 100% of the first year premium in commission.
I key in the above into my financial calculator and assuming ending mode, PMT = $70.15. In other words, the policyholder need to “pay” $70.15 monthly “loan” installment over 25 years in order to repay this debt entirely for every $1000 monthly premium.
So in reality is this possible?
Yes, the $70.15 is an amount that can be deducted through policy fees, charges, management fees of the underlying funds and profit embedded in the mortality charges and sometime bid-offer spread. Do not forget that management fee in absolute dollar increases due to a higher accumulated AUM over the years.
If the insurance company cost of capital is less than 5%, they actually make a profit by paying such a commission and charging a higher discount rate to the policyholder!
What happens if the policyholder terminates the plan early? He will have to repay the amount owed through high surrender penalty. If the surrender penalty is insufficient, the commission will have to be clawed back from the adviser otherwise the insurance company will lose money.
If you think about it, the high commission paid to the adviser is possible because the policyholder sacrifices liquidity. By giving up liquidity, a high commission becomes possible. So is this fair? After working for few years, I come to a conclusion that everybody’s financial goals and circumstances change constantly. That’s why a regular financial review is required. If the bulk of the money is stuck in non-liquid assets like into an ILP or endowment, what is there to review if things cannot be change? Thus, I prefer my clients to put their bulk of the assets in more liquid asset classes such as cash, fixed deposits, CPF, ETFs and unit trusts. I don’t recommend putting too much money in non-liquid assets such as ILPs and properties.
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