Return of Premium Life Insurance

Return of premium life insurance is level term life insurance carrying a provision that refunds the premiums paid if the insured is alive at the end of the term. It answers the objection people most often raise about term coverage, which is that surviving produces nothing, and it answers it by charging enough extra to fund the refund. The death benefit, the term and the level premium all work as they do on any other term policy; the survival benefit is the addition.

The phrase is used for two other things in life insurance, and the difference matters. On some small guaranteed-issue and final-expense policies, a graded death benefit returns premiums instead of paying the face amount to a beneficiary who claims during an initial waiting period, which is a limitation on a death claim rather than a benefit for surviving. And on an annuity, a return of premium describes the tax-free recovery of the owner's own basis. This page is about the term life design, in which the money comes back to the living policy owner because the term ran out.

Why the refund is not taxed, stated at source rather than asserted. Section 72(e) of the Internal Revenue Code governs amounts received under a life insurance contract that are not received as an annuity. Section 72(e)(5)(E)(i) applies that treatment to "any amount received, whether in a single sum or otherwise, under a contract in full discharge of the obligation under the contract which is in the nature of a refund of the consideration paid for the contract," which describes a return of premium settlement precisely. Section 72(e)(5)(A) then provides that such an amount is included in gross income "but only to the extent it exceeds the investment in the contract," and section 72(e)(6) defines the investment in the contract as the aggregate premiums paid, less any amounts already received tax-free. A refund equal to the premiums paid therefore equals the investment in the contract and leaves nothing to include. The point is worth stating carefully, because the reason the refund is untaxed is that it is the buyer's own money coming back, not that the tax code is doing the buyer a favor.

What the extra premium is buying, arithmetically. The refund is funded by the additional premium plus whatever the insurer earns on it, less the insurer's costs. So the buyer is making a long, illiquid, single-purpose savings commitment alongside the insurance, and the correct way to judge it is the implied rate of return: the annual return that would grow the extra premium into the refunded amount over the term. That number is usually low relative to what the same money could earn elsewhere, and it is not risk-free either, since it depends on the insured living, on the policy staying in force for the whole term, and on the insurer's continued ability to pay. Against that, the refund is contractually stated and, as above, generally arrives untaxed.

The conditions attached, which is where the design most often disappoints. The refund is contingent on completing the term. A policy surrendered early returns far less than the premiums paid, or nothing, and a policy that lapses for non-payment can return nothing at all, so the survival benefit is lost by exactly the households whose finances made the extra premium hardest to carry. Some contracts pay a partial refund on a stated schedule after a number of years, and that schedule is a contract term rather than a general feature. It is also worth being clear that the refund is not paid in addition to a death benefit: if the insured dies during the term, the beneficiary receives the death benefit and the premiums are not separately refunded, because the coverage did what it was bought to do.

What it is not. It is not cash value insurance. There is no account inside the contract that accumulates, can be borrowed against, or can be withdrawn from, and the surrender values that exist are a function of the refund schedule rather than of a policy account. That distinction matters because the two products are sold to the same objection and get compared to each other. The broader question of whether life insurance is a sensible place to put savings at all is a decision with its own page, and the answer there does not change because the wrapper is term rather than permanent.

The applicant is underwritten as for any term policy and chooses a face amount and a term. The premium is level and higher than a plain term premium for the same coverage. If the insured dies during the term, the beneficiary receives the death benefit and the policy ends. If the insured is alive at the end of the term and the policy has been kept in force throughout, the insurer pays back the premiums, as the contract defines them, and the coverage ends.

A hypothetical, to put a number on the trade. Suppose a 35-year-old is quoted $45 a month for $500,000 of 30-year level term, and $130 a month for the return of premium version of the same coverage. The plain policy costs $540 a year and $16,200 over the thirty years. The return of premium policy costs $1,560 a year and $46,800 over the thirty years, and $46,800 is what comes back at the end. The extra outlay is $85 a month, $1,020 a year, and $30,600 across the term. Setting aside $1,020 a year for thirty years and ending with $46,800 works out to an implied return of a little under 3 percent a year, and that is the figure to compare against what the same $1,020 would do elsewhere over the same period. The premiums are invented for the arithmetic; real quotes turn on age, health, insurer and term.

Two conditions attach to that 3 percent and both are worth stating with it. It is earned only by surviving the term with the policy in force, so a lapse in year twenty forfeits most of it. And it is untaxed, which raises the comparison against a taxable alternative by whatever the buyer's marginal rate would have taken. Whether the result still looks attractive is a judgment, but it should be a judgment made against a number rather than against the appeal of getting money back.

Pros

• The premiums come back if the insured survives the term, which removes the objection that most often stops people buying term coverage at all.
• The refund is generally received free of income tax, because it does not exceed the investment in the contract.
• The commitment is enforced. For a buyer who would not otherwise save the difference, the structure does the saving.
• The death benefit and term work exactly as on any level term policy, so the protection is not compromised by the feature.

Cons

• It costs several times a plain term premium for the same death benefit, and the extra money is locked into one purpose for decades.
• The implied return on that extra premium is usually low, and it is a return the buyer only receives by surviving and by keeping the policy in force for the whole term.
• Lapsing or surrendering early forfeits most or all of the survival benefit, and the households most likely to lapse are the ones the extra premium stretched.
• It is not cash value insurance: there is no account to borrow against or draw on if circumstances change.
• The refund returns nominal dollars, so thirty years of inflation falls entirely on the buyer.