Why "Return of Premium" Term Life Insurance Is No Free Lunch

Ever been offered a "Return of Premium" rider?

Since the 1990s, life insurance companies have been offering these special riders on top of term life insurance. Often called ROP (perhaps as opposed to RIP), the riders work in a seemingly straightforward way. If you die before the term of the policy (normally 20 to 30 years), you receive a death benefit (or at least your beneficiaries do). That part is traditional. But because of the rider, if you live past the term of the policy, instead of losing the premiums you've already paid the insurance company pays you back every penny you paid in.

There are a couple of gotchas. For starters, the premium is usually higher than that of the standard term life insurance, which means the rider isn't free. Now, you might not care about that since the idea is that you can recover everything at the end.

The problem is that you're not getting everything at the end—you're losing any interest you would have earned on the money had you invested it yourself. And that includes not only interest on the rider-related premiums, but also interest on the basic term policy—which without the attractive-sounding rider you might not have bought in the first place. The insurance company, meanwhile, holds on to the money you're putting in over the course of 20 to 30 years and pockets the investment gains, paying out a portion to those lucky customers who outlived their policies. This loss of interest is the hidden cost of such a rider.

Not only that, but if you do indeed die during the term of the policy, your net death benefit (that is, the insurance payout minus the premiums you've paid) would be smaller than under a traditional term life insurance policy.

If you run the numbers, you'll see that on average, you're better off investing the money yourself. This Investopedia article shows the math.

So why does the ROP rider seem appealing to insurance buyers? We can think of several reasons:

* The Appeal of the Free Lunch. The way the policies are marketed, they sound like free insurance because if you do die you get a payout and if you don't you get your money back. But as we've shown, if you look carefully at the numbers this "free lunch" will cost you. We suspect that because of limited time or the like, many insurance buyers won't bother to run the numbers.

* Risk Aversion. This, of course, is the same reason people buy insurance at all. And as we describe in our chapter on uncertainty, you can capitalize on people's aversion to risk in several ways, such as offering warranties or generous return policies. But for the person who's extremely risk averse, mere insurance is not enough, so with ROP riders, insurance companies go a step further: eliminating the downside risk of death—and of life. What's more, since any kind of investment carries some risk, insurance companies are betting that you are more willing to give up unknown future earnings (on money you could otherwise invest yourself) than to give up money already in your pocket.

* Loss aversion. People who look into term life insurance know that the odds of dying before the term of the policy are pretty low. Because only about 7 percent of policyholders die before the end of their policy's term, customers know there's a high chance that buying a term life insurance policy is just throwing money away. And people hate losing money: loss aversion (as opposed to simple risk aversion) means that although you might like to gain a dollar, you hate losing a dollar a lot more. Since the Return of Premium rider ensures against the loss of premiums, it can seem like an attractive option—even if it's really a poor deal.

Copyright Kay-Yut Chen and Marina Krakovsky, http://www.secretsofthemoneylab.com

Chen and Krakovsky are co-authors of Secrets of the Moneylab: How Behavioral Economics Can Improve Your Business (Portfolio/Penguin, 2010).