ROP-portunity: The counterintuitive inner workings of return-of-premium term insurance

"Money-back guarantee!" How many times have we seen this ubiquitous tagline flash across the television screen?

This same sales approach is becoming more common in the life insurance industry as popularity of return-of-premium (ROP) term has increased in the past few years. This concept has been around for a long time and was used in the past to sell disability income insurance. However, that was a niche product. ROP term, on the other hand, is a mainstream product that has now hit the broad insurance market.

Since the early years of ROP term, the money-back guarantee on an insurance product has always made for a great sales pitch, giving rise to such slogans as "No-cost (ROP) term," "Coverage when you need it, money back when you don't," and (our favorite) "Win-win-win." The last quotation refers to ROP term’s multifaceted benefit structure that promises to deliver one of the following: 1) a benefit at death, 2) an option for permanent insurance in case of impaired health (called a conversion provision), or, preferably, 3) a return of your premium at the end of the level-term period. Healthy, unhealthy, or deceased, you can derive some benefit from the policy.

These sales pitches certainly hit home at the kitchen table. No one wants to have to pay for an event that is not expected to happen. And while the return-of-premium benefit does come at a higher price for the insured, the agent is motivated by the potential of higher commissions to convince potential buyers of the product’s value.

Comparison to regular term 

The ROP-term premium is more than four times as high as a regular 15-year level-term product at typical ages for insurance buyers. The ROP-term premium on a 20-year plan is more than twice as high as on regular term, while the 30-year plan is about 50% to 60% higher. This is why the 30-year plan is the most popular plan for the ROP-term product. Return of premium on a 10-year plan generally is not offered, because the ROP-term premium is higher on a 10-year plan than on a 15-year plan.

While the premium is certainly higher for the ROP-term products, the guaranteed return on investment to the policy owner is generally at least 4% if the policy owner holds onto the policy until the end of the level-premium period. A few years ago, it was not uncommon to see after-tax policy owner returns of more than 10%, but the pricing assumptions have changed over the past few years, so the guaranteed returns have come down. 

The policy owner return on investment is calculated by subtracting the base-term rates from the total premium and receiving the entire premium paid at the end of the level-premium period as the return on investment. This did allow some companies to advertise higher base-term rates with competitive ROP-term premiums and therefore allowed them to advertise higher policy owner return on investments.

Pricing concerns

As mentioned above, the pricing assumptions for the ROP term product have changed over the past few years. The most important pricing assumption for these plans is the lapse assumption. When these products first became popular, a few companies assumed the same lapse rate on the ROP-term product that they assumed on the base-term product. The ultimate lapse rate may have been around 5%. Now most companies are grading their 3% ultimate lapse rate down to 1% in the last few durations before the 100% return-of-premium payment. This assumption change profoundly affects profitability; several companies have had to increase their ROP-term premiums as they have decreased their ultimate lapse assumption. graph 1

Generally, from a profitability standpoint, term products are not affected by the net investment-earned rate assumption because the reserves are relatively low due to large amounts of reinsurance. The ROP-term product has much higher reserves directly related to the return-of-premium feature, which is often not reinsured, and therefore the net investment-earned rate has a material effect on the profitability of the company. Companies should create sensitivity tests on the net investment earned rate during the pricing process to understand the implications of the ultimate earned rate.

The reserve methodology has also varied by company over the past few years. A few companies have held reserves at the cash-value level (percentage of return of premium), while other companies have reserves assuming a death benefit during the level-premium period followed by an endowment benefit equal to the return of premium at the end of the level-premium period. Some of the companies holding the cash values have moved toward life insurance with endowment benefit method, which has caused them to increase their reserves.

Regulatory and tax concerns

Many state regulators have concentrated on the cash values of these policies. Companies offering ROP-term policies must offer upon surrender a slowly increasing percentage of the premium throughout the level-premium period in order to meet both minimum nonforfeiture and the "smoothness test." These provisions do not seem like complex requirements, but the methodology involved is very time consuming when one considers all underwriting classes and all level-term periods. Several states require that insurers certify that all issue ages meet this requirement.

A new proposed regulation—Actuarial Guideline CCC (AG CCC)—will likely change the provisions of this methodology. Typically, the premiums following the level-term period have been used to reduce cash values during the level-premium period. AG CCC prevents this from happening by essentially basing the minimum interim cash values on the pure endowment in the form of the ROP amount at the end of the level-term period. This regulation could mean higher minimum ROP benefits during the level-premium period. Smoothness would still need to be proven along with this new minimum benefit pattern.

The ROP-term product also has tax implications. Of particular interest is compliance with the definition of life insurance (Section 7702). If a company returns all paid premiums and the policy has several riders, the premiums may exceed the guideline premiums and therefore be out of compliance with Section 7702. Thus it is common for ROP-term products to follow the cash-value accumulation test, which possibly forces the death benefit higher but keeps the policy in compliance.

Not your father's ROP

Just as the understanding of pricing assumptions, reserves, and regulatory and tax issues has evolved over the years, so, too, have product designs. Initially, the products paid a percentage of the cumulative premium to 100% of the premium at the end of the level premium when the policy owner surrendered the policy. The percentages were generally zero in the first five years and thereafter were just high enough to comply with the Standard Nonforfeiture Law.

More recent designs have allowed for a higher percentage of premiums returned by offering enhanced cash-value riders. These riders are more expensive but offer the benefit of higher cash values. Policy owners also no longer need to surrender their policies at the end of the level-premium period. They automatically receive the benefit at the end of the level-premium period. The policy will continue as long as they continue to pay premiums, similar to traditional non-ROP-term policies. A few policies allow the return of premium at the end of the term period to accumulate at a specified interest rate.

While there are several complications and unanswered questions for the ROP-term product, it remains popular in the market­place. You can be sure that the lure of the money-back guarantee is here to stay.

Keith Dall is a principal and consulting actuary with the Indianapolis office of Milliman. He has designed and priced many term life, universal life, whole life, and annuity products, which included secondary guarantees, return of premium riders, and long-term care riders. Keith has worked with life insurance and annuity products in the high-net-worth marketplace, and has been actively involved in principles-based reserves.

Donna Megregian is a consultant in the Indianapolis office of Milliman. Donna consults on life insurance products and has been involved with term, group term, return-of-premium products, universal life, and whole life. She has experience with minimum premium and shadow account secondary guarantee universal life and asset-liability management. She is currently involved in the life illustration practice notes and the nonforfeiture workgroup.