Home' Trinidad and Tobago Guardian : January 24th 2015 Contents The case
ricilla, 38, owns and operates
a seven-seater taxicab and tour
service. The loan that she bor-
rowed to finance this vehicle
was repaid two months before
time. Last year, she inherited
a house from her grandmother but it is in dire
need of repairs and could cost up to $350,000.
Loans officer Billy, pleased with her track
record, is willing to provide mortgage financing
for a period of 25 years at a rate of six per cent
per annum. The only condition is that she
provides a term life insurance policy for at
least $200,000 to cover a part of the loan, in
the event of an untimely death.
Pricilla approached her cousin Betty who
works at an insurance brokerage firm. Betty
advised Pricilla that she could get a $200,000,
25-year term policy with a monthly premium
of $125. Betty reiterated that the only downside
with the plan was that when it matures, she
has nothing to get back. Pricilla was not
impressed with that feature and asked if there
was another policy that provided cash back
in the future.
Betty then took the opportunity to do an
illustration of a plan that would provide the
same level of coverage the bank required but
would also refund all of her premiums at matu-
rity as part of a guaranteed cash payout
$200,000 plus a bonus of $150,000. If she
dies anytime before the plan matures, the
company will pay $200,000 plus a refund of
the premiums paid as at that date.
If she becomes disabled for more than six
months, the company will keep the policy in
force until she recovers or until maturity;
whichever was sooner. If, for any reason, she
cancels the policy before the end date, a pro-
jected cash surrender value will be paid, less
any accumulated debt on the account.
Pricilla was excited that she really had noth-
ing to lose and shared the policy benefits with
Billy to see if he would accept the alternative
as collateral. Billy agreed but expressed his
concerns as to why the same coverage was
costing $689 more per month and wondered
if she could have found a better use for the
Pricilla knows the term is cheaper because
she has nothing to get back but she cannot
evaluate if the extra cost would provide value
for money down the road. She is now unde-
cided as to which policy to select and is seeking
The policy that Betty has put on the table
sounds very good especially the part about
getting back all of the premiums whilst still
enjoying the insurance coverage of $200,000
for the duration of the plan. In a way she is
actually getting free protection if she keeps
the plan in force for the contracted period.
Even if she cancels the plan, there is something
to get back. How much that would be is anoth-
The only thing that is a little difficult to
come to terms with is the monthly payment
of $814 ($689 + $125), which we will discuss
Purpose of insurance
In the world of personal finances, it is some-
times easy to deviate from the real purpose
of a particular financial instrument. Insurance s
primary function is to offer protection against
the financial loss that could occur if a certain
peril materialises. It is uncertain why the
banker requested only $200,000 coverage for
a $350,000 debt. Maybe the bank has its own
plan in place that covers part of the debt or
maybe Pricilla already has another policy for
Be that as it may, Pricilla s confusion really
started when Betty raised the point o.f "getting
nothing back." Pricilla s attention shifted com-
pletely from the primary objective to that of
saving and investment.
If her objective were savings and investment,
then the cash value policy would have to be
evaluated alongside other scenarios or instru-
ments that are comparable in order to make
an informed decision.
Savings and investment
This policy has a very tempting future value
of $200,000 plus a bonus of $150,000. Of
course, this is not free money because Pricilla
still has to pay for it and the total cost of doing
so is $244,200 ($814 x 12 months x 25 years).
She will earn a profit or gain of $105,800
($350,000 - $244,200). This amount would
be even more impressive if we removed the
monthly cost of a pure protection plan, that
is, the term life premium of $125.
Whilst from an actuarial standpoint this
may not exactly be the accurate approach, it
might still be helpful for the sake of a rough
Excluding the term premium component,
Pricilla would have invested $206,700 ($689
x 12 months x 25 years) to obtain the same
future value of $350,000, giving her a profit
or gain of $143,300 ($350,000 - $206,700).
Return on investment
Looking at this return through the lenses
of a financial practitioner, the first question
is: what was the return on this investment
over the period?
When we plug in the numbers using time
value of money calculations (monthly payments
of $689, period of 25 years and a future value
of $350,000) we find that the effective annual
interest rate was 3.92 per cent (only if she
stays for 25 years); not bad in a world where
rates on guaranteed investments is less than
half that figure.
The use of the words "guarantee" and
"investment" in the same sentence has the
power to allay many fears from an investor s
mind. However, guarantees can also be secure
in financial scenarios other than the usual
savings and investment instruments.
The real value of money
Looking back, it is not too far fetched to
imagine that the cost of living can double (100
per cent) every 10 years; the equivalent of a
rate of inflation of about seven per cent (6.95
per cent) per annum. This also means that
the value of money is moving in the opposite
direction of that rate.
A good example is the cost of a loaf of bread.
Ten years ago it was $6, today it is certainly
more than $12. This means that $6 today
would only be able to purchase half (50 per
cent) of a loaf of bread.
Applying this concept to the policy s guar-
anteed future value we would find that in 25
years, the buying power of $350,000 would
be just under $65,000 ($61,276) in today s
terms. What will Pricilla do with that money
in 25 years time?
The better use of money?
If Pricilla s world only consisted of a cash
value insurance policy that yielded 3.92 per
cent per annum, a piece of real estate that
could yield upwards of five per cent per annum;
a mortgage interest rate (hopefully fixed) of
six per cent per annum and an annual inflation
rate of 6.95 per cent, then we could decide
on a better use of the extra premium dollars
she has to pay.
Whilst it may be impossible to reduce infla-
tion and impractical to buy or improve real
estate in monthly installments; it would be
sagacious to accelerate the repayment of her
mortgage by the extra $689 per month and
hopefully without penalty. She could even
choose to rework the mortgage installment up
front to include the $689.
A 25-year mortgage of $350,000 at six per
cent would work out to $2,255 monthly. If she
decided to pay $2,944 ($2,255 + $689) the
term would be reduced to 181 months or 15
years. If she was prepared to live without this
installment for 25 years, then she should be
able to save it for the remaining 10 years of
her investing time horizon, which is a total of
$353,280 not including interest. If we applied
a conservative annual interest rate of 1.96 per
cent (3.92% / 2) she would see a future value
Additionally, because she would have paid
off her mortgage in only 15 years, the interest
saved would be $146,580 (see table above).
Also, the fact that she only needs the insurance
for 15 years, the term policy for $125 could be
discontinued after the debt is repaid saving a
further $15,000 ($125 x 12 months x 10 years).
D C F fi
C y y
F C C
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