Life Insurance: Actuarially speaking, they got it wrong

As problems emerge with low-cost endowment policies, we show how to make informed choices and avoid the trials of life

MOST of us buy life insurance when we obtain a mortgage. It's usually a condition of taking out a home loan. Many of us who took mortgages in the 1980s were sold low-cost with-profits life insurance that mixed life cover and investment, and were designed to pay off the capital.

Now there is concern that these policies may not yield enough to cover the mortgage. After the bonanza of the 1980s, when bonus rates kept rising, the pay-outs have been falling.

The Faculty and Institute of Actuaries has forecast that bonuses on with-profits policies could fall by 5 per cent a year, meaning that the pay-out on a 25-year endowment could halve in 15 years. Investment yields and growth are expected to be low now that inflation is lower.

With-profits life insurance is a long-term commitment. Investments will fall and rise during the 10, 20, or 25 years, so the profits are given out as bonuses which smooth ups and downs. These annual amounts, called reversionary bonuses, are based on the guaranteed sum assured. They reflect how the fund has done and how the company's actuary - the person who designs the life expectancy tables and sets bonus rates - expects it to perform in future.

The terminal bonus is paid on maturity. It is meant to reflect the real growth in the fund and is not guaranteed. If you keep your policy to the end, it can account for between 25 and 70 per cent of your cheque.

Low-cost endowments were created because most of us could not afford the premiums on a minimum sum assured equal to the loan. A 30-year-old man taking out a 25-year with- profits endow-ment with Equitable Life would pay a monthly premium of nearly pounds 162 for a pounds 50,000 sum assured. The firm's low-cost plan would cost pounds 66 a month. How is this done? The company assumes 80 per cent of current annual bonus rates will be maintained. It works out a basic minimum sum assured that will grow so that eventually there is enough to pay the mortgage and leave a lump sum.

So, instead of pounds 50,000 at the start, the life office assumes a lower figure and growth of 7 per cent which should ensure that, at 80 per cent of current bonus rate at least, there would be enough to pay pounds 50,000 at maturity. Life offices believe the extra terminal bonus would mean that policyholders would get a substantially higher pay-out. The companies all promise that in the event of early death, the low-cost plan will pay out a guaranteed pounds 50,000.

The problem is that when low-cost endowments were in their 1980s heyday, most life offices assumed future growth of 10 per cent or more for funds. "Insurers thought the bonus rates would go on forever. This led to unreasonable expectations," says John Hay, head of product marketing at Scottish Provident. "Now inflation is lower, assumed growth rates have come down."

Like many insurers, Scottish Provident will be writing to its low-cost endowment holders to tell them if their policies are still on target. "To put matters into perspective, the proceeds with a Scottish Provident policy have never failed to pay off a mortgage yet," says Mr Hay.

"If an insurer writes to its endowment customers, it's not saying that the maturity proceeds won't be enough to pay off the loan," agrees Graham Newitt, life marketing manager of Commercial Union. "It may be worth increasing premiums to be on the safe side. Over the last decade the average mortgage has fallen by pounds 200 a month as interest rates have fallen. Asking for another pounds 10 a month in premiums is only eating a bit into that saving."

The proceeds of maturing with-profits policies have not been bad. Tables produced by Money Management magazine show that the average return from 10-year endowment policies is 9.9 per cent a year. For 25-year policies it is 13.4 per cent.

But the average saver would have been better off with an equity-linked policy. An investor paying pounds 50 a month into a 10-year endowment policy with Scottish Mutual would have received pounds 8,021 this year. The same company's unit-linked growth fund would have paid pounds 8,730.

If you have a low-cost endowment mortgage, ask your insurer if it is still expected to pay out at least enough to repay your loan. If not, you may have to increase the premiums.

Off balance: falling bonuses on low-cost endowments mean some home owners are not sitting comfortably PHOTOGRAPH: AP

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