With-Profits Life Insurance

Published Sep 8, 2024

Definition of With-Profits Life Insurance

With-profits life insurance is a type of life insurance policy where the policyholder is entitled to a portion of the profits generated by the insurance company’s investments. Unlike a standard life insurance policy, which pays out a fixed sum, a with-profits policy provides a share of the insurance company’s profits in addition to the guaranteed sum assured. These profits are usually distributed to policyholders in the form of bonuses, which are added to the policy’s value and paid out either on maturity or upon the death of the insured.

Example

To understand with-profits life insurance better, imagine Sarah purchases a with-profits life insurance policy with a guaranteed sum assured of $100,000. The insurance company invests the premiums paid by Sarah and other policyholders in various assets such as stocks, bonds, and property. Suppose that over the course of Sarah’s policy term, the insurance company’s investments perform well and generate substantial profits.

Each year, the insurance company evaluates its profits and decides to distribute some of them to the policyholders. This distribution is made in the form of bonuses. For instance, after the first year, Sarah’s policy might earn a reversionary bonus of $2,000, which is added to her guaranteed sum assured. If the company continues to perform well, Sarah may receive additional bonuses in subsequent years, further increasing the policy’s total value. By the time the policy matures or Sarah passes away, the final payout will be the sum assured plus all the accumulated bonuses, potentially exceeding the initial $100,000.

Why With-Profits Life Insurance Matters

With-profits life insurance plays an important role in financial planning by offering both life coverage and investment growth. For policyholders, this type of insurance can provide a more substantial financial benefit compared to traditional life insurance, given the potential for bonuses. Additionally, it helps policyholders participate in the financial success of the insurance company, offering a potentially higher return on their premiums.

From an investment perspective, with-profits policies offer a conservative and disciplined approach. Insurers typically adopt a balanced investment strategy, including a mix of high-risk and low-risk assets, ensuring a stable return over time. This is especially beneficial for individuals who are risk-averse but still seek to grow their investments.

Furthermore, with-profits policies usually include features like smoothing, which protect policyholders from the volatility of the market by spreading out gains and losses over several years. This reduces the immediate impact of market downturns on the value of the policy, providing a more consistent growth trajectory.

Frequently Asked Questions (FAQ)

How are bonuses in with-profits life insurance policies calculated?

Bonuses in with-profits life insurance policies are typically calculated based on the profits made by the insurance company from its investments. These bonuses can be of two types: reversionary bonuses and terminal bonuses. Reversionary bonuses are declared annually and added to the policy’s guaranteed sum assured. Terminal bonuses, on the other hand, are awarded at the end of the policy term or upon the death of the insured. The calculation takes into account factors like investment performance, market conditions, and the company’s overall financial health. The exact method of bonus calculation can vary by insurer, but the goal is to distribute a fair share of profits to policyholders.

What is the smoothing process in with-profits life insurance?

The smoothing process in with-profits life insurance is a mechanism used by insurers to reduce the impact of short-term fluctuations in investment returns on the bonuses awarded to policyholders. Instead of directly passing on all investment profits or losses in a given year, the insurer aims to smooth out these gains and losses over time. This means that during good investment years, not all profits are distributed as bonuses; some are held back to boost bonuses in less favorable years. The smoothing process helps provide more predictable and stable bonuses, ensuring that policyholders are not overly affected by market volatility.

Are there any risks or downsides to with-profits life insurance?

While with-profits life insurance offers potential benefits, there are also risks and downsides to consider. One major risk is the reliance on the insurance company’s investment performance; poor investment returns can result in lower bonuses or even reductions in the policy’s value. Additionally, the costs associated with managing and administering the investments can be high, which might reduce the overall return for policyholders. The smoothing process, while beneficial in volatile markets, may also lead to lower immediate bonuses compared to the direct performance of investments. Lastly, with-profits policies can be complex, and understanding the detailed terms and conditions requires careful attention, which could be a challenge for some policyholders.