Understanding surrender value

Understanding your life insurance contract is as important as understanding the need to invest in it the (IBSL) said.

Among varied opinions on investing in a life insurance contract, and the experience that follow, a gray area of understanding seems to prevail when one decides to terminate the policy prematurely. This is evident from the recent correspondence in the press and the complaints received by the, (IBSL) Insurance Board of Sri Lanka,from time to time. The general expectation of a policyholder surrendering a policy before the end of its full term is that if he/she has not made a claim under the policy, a major part of the premiums (if not all) should be refunded.

This article is intended to educate the consumer to have a better understanding of the nature of a traditional life insurance contract and how the surrender values build up.

What is a surrender value? A surrender value is the cash value available to a policyholder who terminates the insurance contract prematurely prior to a death claim or end of the policy term.

The surrender values available in a contract depend on; a) the type of benefits offered under the contract; b) the age of the policyholder; 3) the term of the insurance contract, and 4) the time elapsed at the time of surrender.

The main purpose of insurance is financial protection against unforeseen contingencies such as premature death, major illness or disability. An insurance plan issued for a specific term which provides only protection benefits would not accumulate a cash surrender values as the premiums charged would consist of the cost of providing protection by the insurer each year plus a margin for expenses and profit.

On the other hand if the contract provides life time cover (known as Whole Life benefits), such contracts would accumulate a cash surrender value. This is due to pre-funding of the mortality charges. In such contracts the insurance company charges a level premium throughout the life time of the policy owner to cover risk that increases significantly at advanced ages. As such the premium charged in the early policy years (younger ages) have an allowance to fund the higher mortality charges that arise in the later years at advanced ages. Therefore, if the policy is surrendered before a claim, the policy holder is entitled to a refund of the pre-funded mortality charges in the early years subject to a penalty for early withdrawal. Such surrender value would depend on the attained age of the policyholder and the time elapsed at the date of surrender.

If an insurance contract has a savings feature, i.e a maturity value or periodic payments throughout the term of the contract, a part of the premiums paid on such contracts are accumulated over the policy term to pay off these periodic payments or the maturity value on the dates they fall due. Such contracts too would have a surrender value if the contract is terminated prematurely, based on the policy term, the attained age of the policyholder and the time elapsed at the date of surrender.

By nature of the business, life insurance companies incur heavy expenses in the initial years of a policy by way of agency commissions, medical screening and underwriting costs, servicing and administrative costs, reinsurance costs and charges for protection benefits. All these expenses and charges put together, it is not unusual for an insurance company to spend more than the first year’s premium to acquire and place the business in their books. However, the insurer charges a level premium throughout the term of the contract, which means that the high initial expenses are spread over the policy term and recovered in later years. All is well if the premiums continue to be pay up to maturity. However, if a policy were to voluntarily terminate prematurely, the insurer would recover the balance expenses by way of a surrender charge. Needless to say, the longer balance term to maturity from the date of surrender, the higher the surrender charge. In other words, an early surrender would be subject to a higher surrender charge resulting in low surrender values during the early policy years.

It is usual for insurance contracts to have no surrender values in the first three years of the policy. The surrender values start building up after completion of the third policy year (sometimes the second policy year if the term of the policy is less than 10 years). The surrender values gradually grow to the guaranteed maturity value at the end of the term. If the contract is entitled to bonuses, there is a good chance of the surrender value exceeding the guaranteed maturity value before the end of the policy term.

Further, a direct comparison of surrender value with the cumulative premium paid can be unrealistic if the contract has more protection benefits and a low maturity value (savings benefit). In such a contract a major portion of the premiums would be utilized to provide protection benefits. Most insurance companies now offer a range of optional additional benefits that can be added to the basic contract. These additional benefits are known as riders and provide a wide range of protection benefits such as critical illnesses, disability benefits, hospitalization and surgical benefits and additional cover for accidental death. The additional premium charged for such riders cover the risk premium and expenses on a yearly basis and do not contribute to enhance the surrender value of the basic benefit. Hence it can be misleading to compare the total premium paid on the policy with the surrender value if the policy premium consists of additional premiums for such rider benefits.

Considering the above factors, it is important for consumers to understand that the surrender value of a policy does not bear a direct relationship to the total premiums paid on the policy. Surrender values are determined by using actuarial methods using the principle that withdrawing policyholders should receive a surrender value that is nearly as possible equivalent to their contribution to the funds of the insurer, less - 1) the cost of protection provided, 2) any expenses incurred by the insurer in establishing and handling the policy, and 3) perhaps a contribution to the insurer’s surplus. The surrender value so determined should ensure that a withdrawing policyholder should neither benefit nor harm a continuing policyholder in any substantial way.