In one of the earlier posts, we had discussed why you should not purchase traditional life insurance plan. Traditional insurance plans give you double whammy of inadequate life cover and poor returns.
After reading the post, you know you need to stay away from such financial products. But what should you do if you have already purchased such a plan? Should you continue paying premium or should you surrender such plans?
You realize by continuing to pay premium, you will keep earning low returns. Life cover was never really a forte of traditional plans. If you surrender, you face heavy surrender charges and will get back only a portion of total premium paid.
This is what makes surrendering the insurance plan so emotionally difficult. There is an additional option of making the policy paid up where you do not pay any further premium but the policy continues till maturity with reduced benefits.
So, what do you do? Continue, Surrender or make the policy paid up? In this post, we will help you understand how to approach this continue or surrender problem.
In this post, I have considered only traditional life insurance plans. There is no discussion on Unit Linked Insurance plans. Hence, any reference to a life insurance policy shall be read as a traditional life insurance policy unless stated otherwise.
There are following aspects to consider when you think about surrendering (or making it paid up) your traditional life insurance policy.
- Surrender charges/Paid up benefits
- Expected return on erstwhile and future investments
- Reversal of tax benefits: You get the tax deductions for premium paid under Section 80C. As per Section 80C the Income Tax Act, if you do not pay premium for two consecutive years, tax benefit availed through payment of first year premium shall be reversed. For example, if you pay the premium in the first year and discontinue after the first year, premium paid in the first year shall be added to current year’s income and taxed accordingly. There shall be no reversal of benefits if you surrender after paying premium for two years. If you want to know more about tax implications of life insurance, you can read my post published in Business Standard.
- Time to maturity of the policy
- Other actuarial inputs such as age of the policy holder etc
We will discuss these parameters in detail in this post.
When does my insurance plan acquire surrender value?
As per IRDA Non-Linked Insurance Products Regulations, 2013, if the premium payment term is 10 years or more, your life insurance policy acquires surrender value only after payment of full premium for three years. If the premium payment term is less than 10 years, the insurance plan acquires surrender value after payment of full premium for two years.
If you discontinue paying premium before the plan acquires surrender value (2 or 3 years as may be applicable), you won’t get anything back. If you discontinue after the insurance plan has acquired a surrender value, you need to communicate your decision to the insurance company. If you don’t tell them, your policy will continue as a paid up policy.
Book Suggestion: You can be Rich too: With Goal Based Investing (P.V.Subramanyam, M.Pattabiraman)
What will be surrender value for my policy?
As per IRDA Non-Linked Insurance Products Regulations, 2013, the surrender value for a regular premium and limited premium payment plans (and not single premium plans) shall be the sum of guaranteed surrender value and the surrender value of any bonus/additions already accrued to the policy. The guaranteed surrender value shall be atleast:
- 30% of the total premium paid less any survival benefits already paid if surrender between second and third years, both inclusive (after payment of 2nd premium till the end of 3rd year).
- 50% of the total premium paid less any survival benefits already paid if surrender between fourth and seventh years, both inclusive (after payment of 4th premium till the end of 7th year)
- If the term of the policy is less than 7 years, 90% of the total premium paid less any survival benefits already paid
- The value beyond the seventh year shall be filed by the insurer with IRDA and get clearance. The exact percentage will be mentioned in the policy document.
There is no surrender value for riders, if any, in the policy.
You can see that the surrender penalty is heavy in the initial years and goes down (as a percentage of total premium paid) as the time passes. This is to incentivize the policy holders to continue paying premium for their policies for longer periods. The high surrender penalty (or low surrender value) in the initial years acts as a big deterrent to customers in cancelling their traditional plans.
The actual surrender value will be higher of guaranteed surrender value or special surrender value. Special surrender value is calculated by adding paid up sum assured and accrued bonuses and the multiplying the sum with special surrender factor. Special surrender factor depends on multiple factors such as completed policy years, time to maturity, age at surrender etc. This factor may or may not be available in the policy brochure.
Finding out the surrender value of the policy is not much of a problem. You can call up customer care or visit the nearest branch of the insurer to find the exact value. You can also read the policy terms and conditions to get an idea of the surrender value.
What is a Paid up policy?
A paid policy is a policy that requires no further premium payments and continues to provide paid up (reduced) benefits till plan maturity. Please note you can make a policy paid up only after the policy has acquired a surrender value.
So, rather than surrendering your policy, you can also make the policy paid-up. As discussed, if you make the policy paid up, you do not need to pay any further premiums but your policy continues till its original maturity but with reduced benefits. Your paid up Sum Assured is in same ratio of the Original Sum Assured as total number of premium paid to total premium payments as per the original terms. For instance, if your policy and premium payment term was 20 years with a Sum Assured of Rs 10 lacs. If you make the policy paid up after paying premium for 5 years, your paid up Sum Assured will become 5/20 of the Original Sum Assured i.e. Rs 2.5 lacs.
The basic idea is that your death and survival benefits get reduced in the same proportion. In case you have a participating plan, you may or may not be party to future bonuses declared by the insurance company. You can read the policy terms and conditions for the exact treatment. A few policies do not share any future bonuses while the other plans share in proportion of reduced Sum Assured to Original Sum Assured. Typically, bonuses are declared per Rs 1000 of Sum Assured.
Hence, depending upon the policy terms, your maturity benefit will be:
Paid up Sum Assured + Bonuses accrued before making the policy paid up
Paid up Sum Assured + Bonuses accrued before making the policy paid up + Future bonuses declared (for paid up Sum Assured)
The treatment is similar in non-participating plans too.
Continue or Surrender or Paid-up
So, you have three options:
- Continue the policy: You continue paying premium. Surrender charges and reversal of tax benefits are not applicable. You continue to earn sub-optimal returns and have a low life cover.
- Surrender the policy: You face heavy surrender charges and potential reversal of tax benefits if surrender after the first year. No need to pay any further premiums. Life cover terminates
- Make the policy paid up: Surrender charges and reversal of tax benefits are not applicable. You life cover and maturity benefit gets reduced. No need to pay any further premiums. Continue with reduced life cover.
We pick up ICICI Pru Assured Savings Insurance Plan. It is a non-participating non-linked traditional insurance plan. To find out more about this plan, please read our post on traditional life insurance plans here. We have picked up a non-participating plan since this brings down the number of assumptions for comparison.
We pick up a plan with the premium payment term of 10 years and policy term of 12 years i.e. you pay the premium for 10 years while the life cover is for 12 years and you get maturity benefits after 12 years.
We pick up an annual premium of Rs 1 lac for a 30 year old non-smoker male. The Sum Assured is Rs 10 lacs. The maturity benefit will be Rs 13.86 lacs. This is equivalent to an IRR of 4.35% p.a.
As discussed earlier, once you have purchased the product, you have three options.
- You can continue to pay regular premium and continue policy till maturity
- You surrender the plan and invest the surrender value and the remaining premium installment into an investment product say PPF or mutual funds. You will have to purchase an additional term life cover so that you also have comparable life cover.
- You make the plan paid up. No further premium payments. Invest remaining premium installments in PPF or mutual funds. You will receive paid up maturity at the end of 12 years from the date of first premium and investment value from your PPF and MF investments.
Reading Suggestion: How to Retire Rich: Invest Rs 40 a day? (P V Subramanyam).
Approach for making a decision
You already know the maturity benefit under the insurance plan i.e. Rs 13.86 lacs.
You surrender the policy if the investment of surrender value along the remaining premium installments gives a value higher than Rs 13.86 lacs. However, you must also consider that the traditional plan provided you insurance benefits too. Hence, in addition, you must also purchase a term cover that provides the same sum assured (Rs 10 lacs) as the traditional insurance plan.
Similarly, you make the policy paid up if total of paid up maturity benefits and investment of remaining premium installments results in a value that is higher than Rs 13.86 lacs. Under a paid up policy, you are entitled to paid up death benefits. However, to simplify the problem, let’s take an additional term cover of Rs 10 lacs in this case too.
You can also compare the results for continuing the plan, surrender and making the policy paid up to make the decision.
The result will depend upon multiple factors such surrender value factors, no. of years policy has already been run, years to maturity of the policy, age of the policy holder, assumed return on investment.
For the plan under consideration, there was mention of Guaranteed Surrender Value Factors for premium and guaranteed additions and non-guaranteed surrender value factors for calculation of special surrender value. Though these values have been considered, the values have not been shown in the illustration to improve readability of the post.
All the premium installments already paid should be considered Sunk Costs i.e. the cost that has already been incurred and cannot be reversed. So, forget about the premium installments already paid. Keep your emotions out. Make the decision on the basis of numbers alone.
Though utmost care has been taken to calculate surrender and paid up benefits value as accurately as possible, there may still be a few errors. If you find yourself making such a decision, you can talk to your insurance company to get much accurate numbers.
At 8.7% p.a. return on investment in a PPF Account
ICICI Pru ICare II has been considered for term plan. The premium for Rs 10 lacs for 15 years for a 30 year old male is Rs 4,469 (inclusive of service tax). If you surrender the policy in the first year, tax benefits under Section 80C will be reversed. 30% tax slab has been assumed for the policy holder. This taxation aspect has been accounted for. Decision to make the policy paid up or surrender is assumed to be made at the end of the year. The comparable values have been highlighted in light blue.
Given the original maturity benefit of Rs 13.86 lacs, there is not much to gain (in fact you lose out) if you surrender the policy after year 2 (i.e. payment of second year premium). Even if you plan to make the policy paid up, there are minor benefits if you do that in the initial years.
You can see that IRR for the original maturity was a meager 4.35% p.a. The product design (and surrender penalties) is such that you will struggle to outperform that.
At 12% p.a. return on investment in mutual funds
You can see that there are benefits if you surrender or make the policy paid up in the initial years. If you are closer to maturity, you are better off continuing with the policy till maturity.
PPF or Mutual Funds
An additional point to consider is the assumed rate of return. What should you use? One can argue since these insurance plans are long term products; mutual funds will suit the best. On the other hand, traditional insurance products are more debt like products that provide low but almost guaranteed returns. There are associated tax benefits too and hence PPF will be an apt replacement.
Here is an excerpt from one of my earlier posts.
PPF provides guaranteed returns (although Government announces the return every year). Hence, there is little volatility from PPF investments. A combination of term plan and PPF will provide the same tax benefits as the non-participating plan. Insurance premium for non-participating plan qualifies for deduction under Section 80C. The maturity and death proceeds are exempt from income tax. Both term insurance premium and PPF investment can be claimed for deduction under Section 80C. Interest from PPF is not taxable and proceeds from PPF are tax-free. Hence, a non-participating plan and our combination of PPF and term provide exactly the same tax benefits.
Given the risk characteristics and tax treatment, I prefer PPF as a replacement for investment needs.
- The earlier you surrender or make the policy paid up, the better it is.
- As you move towards maturity, the surrender charges will nullify the impact of higher returns
- If you are closer to maturity, then you are better off continuing with the plan till its maturity.
- The results are for a specific product. The results can be entirely different in other plans. This plan had a maturity of 12 years. Plans with maturity of 20 or 25 years can throw up entirely different results. This is because you will earn high return on investment for a greater number of years. This is likely to counter surrender charges better.
- Products will vary based on surrender value factors and other actuarial inputs. This will impact your decision.
- Between surrendering the plan and making it paid up, the assumed rate of return on investment tilts the balance. A higher assumed rate of return will favour surrender of plan.
You can see there are benefits if you surrender or make the plan paid early in the policy term. As you move towards policy maturity, continuing with the plan may actually be a better alternative. For the surrender value and information about paid up benefits, you can contact the insurance company. Alternatively, you can seek professional help from fee based financial planner or a SEBI registered investment advisor.
This is also a commentary on product design. Though one can argue the product design acts as a deterrent to surrender plans midway and promotes long term investment. On the other hand, one can argue that the plans are so skewed in favor of insurance companies that you may have to continue with the plans despite potential of twice or even thrice as high returns (8.7% p.a. and 12% p.a. vs 4.35% p.a.)
Needless to say, it is better if you do not purchase such plans in the first place. As I have mentioned many times before, there is no need to mix insurance and investment. However, if you have purchased the plan, do a purely mathematical analysis and decide the future course of action. As we have seen, the smarter choice can even be continuing with the plan.
An additional point to note: in case you surrender your policy or make the policy paid up, you must compensate for the reduction in total life cover by purchasing an additional life cover. No matter what you do, you must have adequate life insurance at all times. My preferred mode of life insurance is term insurance.
Image Credit: Moolanomy, 2012. Original Image and information about usage rights can be downloaded from Flickr.com