Making a molehill out of a mountain

Many endowment policies are cashed in early, and often at a loss. John Andrew offers some options

Suppose you were in desperate need of some cash. The obvious solution is to borrow the money you need from a bank or other lender. However, suppose this is not possible. If you have an endowment policy, you may be tempted to cash it in with the life insurer that issued it. But before doing so, stop and consider some other options. For example, using it as security to borrow from the life company or selling it on the secondary market.

Historically only one third of all policies taken out actually reach maturity. An average of 30 per cent are cancelled within the first three years. Such early cancellation results in policyholders receiving only a small fraction of the premiums paid, if anything at all.

About 40 per cent are either surrendered or sold, while the remainder stay the course until maturity. The Association of British Insurers, the industry's trade body, estimates that policies worth pounds 5.5bn are surrendered each year.

The amount a policyholder gets back when surrendering varies from one life company to another. When making the calculation, some companies are more generous than others.

Their basic criteria for the assessment is:

the amount of premiums paid; the time that the policy has been running;

the commission paid to the person who sold the policy;

the company's administration charges;

the life cover from which the policyholder has already benefited and the performance of the underlying investments.

An alternative course is to borrow against the policy from the life company. Of course, it is possible to use the policy as security to borrow from a commercial lender. The advantage of a secured loan as opposed to a normal personal loan is that the interest rate will normally be lower. However, the disadvantage is that the capital will usually have to be repaid, which can make the monthly repayments high.

Borrowing from the life company against the policy is similar to an endowment mortgage. Only interest is paid - the loan will be repaid with the proceeds of the policy when it matures. As well as the premiums, interest will have to be paid to the life company each month.

An alternative option is to sell the policy on the Traded Endowment Policy (TEP) market. Although the second-hand market in traditional with-profits endowment policies is more than 150 years old, it has grown substantially in recent years.

From 1843 until the late 1980s, it was conducted by a sole auction house in London. By 1989, the entire market turnover was only pounds 5m. However, in that year market makers began to buy and sell the policies. Last year, the turnover was about pounds 200m.

The reason why the TEP market has grown substantially is that policyholders can generally obtain more for their policies by selling as opposed to surrendering them. This is because many life companies' surrender values do not reflect the full inherent worth of their policies as continuing contracts.

Also, early cancellation results in the policyholder being charged a penalty for breaking the contract. The fact that there is a difference between the surrender value and the real worth to an investor has resulted in the growth of the market.

Naturally what the market makers will buy is determined by demand from investors. Policies which may be sold on the TEP market are mainly traditional with-profits endowments. Flexible endowments and "industrial branch" policies (those sold door-to-door) are not suitable for trading.

Neither are unit-linked policies, as there is no scope to pay more for them and then on-sell them to investors. This is because the value of the units at any time, multiplied by the number of units held, is the policy's current value. Also, market makers will normally only purchase policies with a minimum surrender value of pounds 2,000, which have run for at least seven years.

If contemplating surrendering or selling an endowment, consideration must be given to any possible liability to tax. The basic rule is that for qualifying policies, those with a fixed premium due to run unaltered for at least 10 years to maturity, no tax is payable if they have been running for 10 years, or for 75 per cent of the term if this is less.

Consequently there is no tax liability if a policy with a 10-year term has run for at least 7.5 years. If the policy has run for less than the time permitted by the basic rules, there may be a liability to higher rate taxpayers. The charge will be levied at the difference between the basic and higher tax rates on the difference between the proceeds of the policy and the premiums paid to date. Your financial adviser or life company will be able to give specific guidance.

Surrendering or selling an endowment policy should only be taken as a last resort. This is particularly so for those who took their policy out before 14 March 1983, as the policyholder will be getting tax relief on the premiums. Above all, the policyholder will be losing out on a tax- free lump sum when the policy matures, which includes the attractive terminal bonus.

There is also the chance of missing out on a windfall if the life company is currently "mutual" but later decides to become a public companyn

Case study

Should Tim surrender?

Tim divorced three years ago and will be remarrying shortly. In the early 1980s he took out two endowment policies with UK Provident, now Friends Provident. The first, Policy 1, started in July 1980 when he was 29. The sum assured is pounds 8,559, the gross monthly premium pounds 30, but with tax relief he pays pounds 26.25. Policy 2 started in August 1983, the sum assured is pounds 4,279, the gross premium pounds 17.37 and the net pounds 15.20. Both policies mature in July 2005.

In the light of his forthcoming marriage, he has been looking at ways of improving his financial position. He therefore asked Friends Provident for surrender values and the amount of a loan which they would be prepared to advance against the policies. He also approached Beale Dobie, market makers in second-hand policies, for the figure which they would be prepared to pay. The results were:

Loan Surrender Sale price

Policy 1 pounds 10,905 pounds 11,218 pounds 13,300 Policy 2 pounds 3,890 pounds 4,322 pounds 5,300

The loan from the life company, which of course would be subject to its credit assessment, is at an interest rate of 1 per cent a month (APR 12.6 per cent), which compares reasonably well with larger unsecured loans available commercially.

While the outright sale to Beale Dobie is better than surrendering to the company, Tim should remember that if current bonus rates continue, Policy 1 could have a maturity value of pounds 40,844 and Policy 2 of pounds 17,051 - a

total of pounds 57,895. Although experts expect bonus rates will fall in the future, Tim is nevertheless likely to be giving up a sizeable sum if he cancels the policy.

Tim's main priority before his marriage is a home. Instead of borrowing against the policies from the life company, he could use them as security for an endowment mortgage. Although we automatically think of a mortgage as having a 25-year term, there is no reason why he cannot have an eight- year endowment mortgage. As the life cover of the combined policies is only pounds 12,836, they can only be used for an advance of this sum. At current rates, the interest payments will be about pounds 70 a month. In addition he will have to continue to pay the monthly policy premiums of pounds 41.45.

It is unlikely that the pounds 12,836 insurance value would make for an adequate mortgage. However, there is nothing stopping anyone having an eight- and a standard 25-year mortgage on the same property. Not all lenders will do this, so it will be necessary to shop around. Assuming he requires a pounds 40,000 mortgage, it will be best for him to take out a pounds 27,164 repayment mortgage for the shortfall, which will cost him about pounds 200 a month.

He must ensure that the lender either charges no penalty upon early repayment, or makes a modest charge. This is important, because in July 2005, unless the bonus rates fall substantially, Tim should have sufficient to repay his entire mortgage. He will therefore have a home free of mortgage in eight years' time - a real case of having his cake and eating itn

John Andrew

MARKET MAKERS FOR SECOND-HAND ENDOWMENT POLICIES

1st Policy Ltd: 0181-455 1111 A1 Policy Shop: 01582-881296 Absolute Assigned Policies: 0181-951 1996 Beale Dobie & Co Ltd London/South: 01621-851133 Midlands: 0121-709 2500 North: 0113-239 1941 Scotland: 0141-353 0311 Endowments Direct: 01843-427575 SEP Marketing Ltd: 0181-446 9700 Surrenda-Link Ltd: 01244-317 999

When selling a policy, try to obtain quotes from more than one market maker.