As per the vanishing premium definition, it enables the policyholder of a permanent Life Insurance policy to utilize the dividends earned on that particular policy for making the required premium payments.
As observed in the past few years, the cash value of the policy has been proven to grow to the point in which the dividend one earns becomes equal to the premium the holder owes. In this situation, one can use the dividend payments to cover the premium payments. Hence, the premium of such a policy is termed as "vanished".
However, vanishing premiums have been a controversial subject earlier at a time when insurance providers have been excessively optimistic about:
a) the timing when the premiums will vanish, and
b) the potential future investment returns.
Premiums, however, don't vanish so much as they are known to decrease, while the dividends are used to cover a significant portion of the premium over a given timeframe. Vanishing premiums are mostly used in life insurance.
A vanishing premium offers a life insurance policyholder an option to make premium payments from the cash collected within the policy itself through dividends. It is opposed to the policy in which the insured has to pay for his/her premium amount each month.
Therefore, the entire process is quite cost-effective since the policyholder no longer needs to make premium payments by taking out money from his/her pocket after a predetermined time period. The system also enables the policyholder to put aside cash they would have spent on premiums for some other crucial use.
If you wish to eliminate premiums, you must maintain the dividend or interest rates in your policy sufficient enough to make the payments.
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Suppose a whole-life insurance policy has a premium of
INR 5,000. To let the premium vanish, the collected cash value of the policy must throw off a specific annual dividend; in this case, INR 5,000. Hence, at a 5% rate of interest, the policy's cash value should reach INR 100,000 to make the premium disappear.
Historically speaking, vanishing premiums is often associated with fraud schemes found in the insurance Industry. In this regard, insurers were considered to be using misleading sales copies and advertisements to fool customers. These Insurance companies made their potential clients believe that their premiums would really vanish sooner.
However, in reality, these premiums hardly vanished at the expected time, leaving the customer to pay his/her premiums from his/her pocket!
Moreover, making unrealistic assumptions about investment returns and interest rates can have a great impact at the time when the investor tries to accrue the required principal for throwing off the dividends at a predefined threshold. This describes how a vanishing premium case looks like!