In my many posts on traditional life insurance plans, I have tried to make simple excel models to demonstrate that the traditional life insurance plans make for poor insurance and investment products and that such plans should be strictly avoided.
In this post, I will demonstrate why endowment insurance plans are bad without using any excel model.
In this post, when I use the term endowment plans, I am referring to the traditional endowment life insurance plans. It includes both participating and non-participating traditional plans.
In addition, I do not intend to discredit any profession. There are good people and bad people in every profession.
1. You may remain underinsured with endowment plans
This is a problem with all insurance plans that provide investment benefits too. This applies to both traditional life insurance plans and Unit Linked Insurance plans (ULIPs).
Your premium payment ability may determine your life coverage. For instance, the annual premium for New Jeevan Anand for a life cover of Rs 50 lacs (Male, 30 years, and 30-year tenor) is Rs 1.77 lacs while premium for Rs 10 lacs cover is Rs. 35,591. Assume you need a life cover of Rs 50 lacs.
It is quite possible that you may not be able to shell out Rs 1.77 lacs as annual premium for Rs 50 lacs cover.
What would you do?
Would you settle for a life cover of Rs 10 lacs? If you would, then we have a problem.
Purchasing life insurance is not shopping for grocery or shopping for clothes. If you think a variety of apple at Rs 200 per kg is too expensive, you may purchase an apple variant which cost say Rs 140 per kg. It won’t impact you much in terms of nutrition and health. Or you would purchase only 700gms of the expensive apple. That’s ok too.
However, life insurance is different. Just because you cannot afford a life cover of Rs 50 lacs, it does not mean your life insurance requirement is any lower.
You can purchase a life cover of Rs 10 lacs when the requirement was for Rs 50 lacs cover. Nobody will stop you. But have you ever thought how your family will manage financially if something were to happen to you? Perhaps not. High time you start thinking in that direction.
Moreover, it is not that you can’t purchase life cover of Rs 50 lacs for less than Rs 1.77 lacs. If such was the case, there is not much you can do. However, you have an option in term insurance, where the cost will be much cheaper. Therefore, it would be unwise to remain under-insured despite paying such high premium.
Build a good insurance portfolio is as important as building an investment portfolio. Perhaps, even more important.
If you fall short of the desired investment corpus, you may still figure out a way to manage since you are still around. However, in your absence, will your family be able to figure out the way? Not just that, the shortfall may be quite high.
2. Focus on the timing of bonus too
Let’s consider the example of LIC New Jeevan Anand.
Under the participating traditional plans, bonuses are announced every year.
These annual bonuses make for an excellent sales pitch. The sales pitch goes like this.
You have to pay annual premium of Rs 35,593. In return, you will get annual bonus of Rs 40,000 (Rs 40 per thousand of Sum Assured) every year. Hence, effectively you are not paying any premium (or a low net premium). In addition, you are getting a life cover of Rs 10 lacs and a very significant amount at maturity.
Who can say No to such a brilliant plan?
However, during the sales pitch, the timing of the bonus is conveniently ignored.
Even though a bonus of Rs 40,000 was announced for your policy, you will not get this amount right away. You will get this only at the time of maturity of the policy.
It is not difficult to see Rs 40,000 today is not the same as Rs 40,000 20 years later. Inflation will reduce the purchasing power of Rs 40,000 over 20 years. At inflation of 8% p.a., Rs 8,581 today will have the same purchasing power as Rs 40,000 20 years later.
For policy term of 25 years, the bonus announced after the first year is given to you only 24 years later. Bonus announced after 10th year is given to you 15 years later.
In contrast, the annual premium has to be paid every year (and not at maturity). Hence, the adjustment of annual premium with the announced bonus is not the correct approach.
Moreover, the bonus of Rs 40,000 does not earn any return until maturity.
3. Endowment plans provide poor returns
You get returns in the range of 4-6% p.a. In a way, you get guaranteed poor returns with endowment plans. Your age will affect your returns.
You will be much better off purchasing a term plan and investing in PPF or mutual funds.
Must Read: Say No to Traditional Plans
4. Endowment plans have high exit cost
There might be unforeseen scenarios where you might have to exit your investment to fund an emergency. Alternatively, you might realize later that you made a wrong decision by investing in an endowment plan.
However, the exit penalty in endowment plans is very high.
In the first few years, you get hardly anything back.
Even after that, if you exit, you will get only a small portion of the premiums paid till the date of exit (surrender).
Hence, forget about earning good returns, you end up losing a part of premiums paid too.
The exit cost is so high that despite the poor returns that endowment plans offer, it may make sense to continue the plan (rather than surrender) if you have paid premium for a few years.
Must Read: Continue, Surrender or Paid-up
You can argue that the high exit costs ensure that policyholders stay in the policy and do not exit at the slightest temptation. I do not buy this argument.
ULIPs are insurance products too. ULIPs don’t have heavy surrender costs (as in traditional endowment plans). Please note I am not arguing that you must invest in ULIPs.
If you want investors to continue in your product, structure a good product. Do not create unreasonable exit barriers.
5. High commissions result in low returns
Even though the commissions are built into the price, IRDA and the insurance companies have shown no intent to rationalize the cost structure.
As much as 35-40% of the first year premium can go to the intermediaries as commission.
This also explains the heavy surrender (exit) penalty.
Since the commissions for the initial years are quite high, the insurance company gets to keep a limited portion of your annual premium. If you surrender the plan, you can’t expect an insurance company to pay from its pockets because they have already paid the commission which can’t be clawed back.
They follow the easiest escape route. Penalize you.
When the commissions are very high, there is an incentive to mis-sell. The agents may be inclined to sell you plans that fetch them the best commissions (and not necessarily the plans that are the best for you).
Moreover, since the first year commissions are quite high, there is huge incentive for the intermediaries to switch you to other plans or somehow convince you to reinvest maturity proceeds in a new plan. (Remember, not everyone does that).
Though I do not have any evidence, I have read at a few places that the intermediaries create a wrong impression that you will not get maturity proceeds unless you purchase another endowment plan from them.
So, the agents play on your fear and make money out of it.
6. Endowment plans are opaque
It is like a black-box. I don’t know what mechanism the insurance company uses to arrive at the annual bonus amount. You pay a premium. A number pops out at the end of the year.
Endowment plans are so opaque that even Government is not sure how to tax the premium amount. You pay 18% GST on the premium of term insurance plans. In the case of endowment plans, everything is quite jumbled up. Traditional plans have both insurance and investment components. Hence, Government charges 1/4th the service tax rate (4.5%) in the first year and 2.25% in the subsequent years.
Who is at fault? IRDA, Insurance Companies or the Insurance Agents?
I would blame IRDA and the insurance companies more. Insurance agents can only sell the products that are structured by the insurance companies. Of course, there are crooks everywhere.
If IRDA can rationalize the cost structure of ULIPs, it can do the same with traditional plans. For the reasons known only to IRDA, they have chosen not to do this.
This has been done under the garb that insurance remains a push product and the distribution needs to be incentivized.
Well, ULIP is an insurance product too but the intermediary commissions are not so high. Why different rules for the two types of insurance plans? ULIPs are far superior products to traditional plans.
Perhaps, IRDA does not want to take LIC head-on.
By the way, LIC is not the only insurance company selling endowment plans or traditional life insurance plans. All private life insurers such as ICICI Prudential and HDFC Life sell such plans and those plans are equally bad. But yes, LIC is a behemoth.
LIC remains a cash cow for the Government and a source of easy money for meeting their divestment targets etc. The Government may not want to change the equation. Hence, many forces are at play that keep traditional plans safe from regulatory ire.
What should you do?
Simple. Do not purchase any endowment insurance plans.
Separate your insurance and investment needs.
Stick to term insurance plan to meet your life insurance requirement. Choose investment products such as PPF and mutual funds for your investment needs.
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