You have been looking to buy an insurance plan. You don’t want to purchase a pure vanilla term insurance plan since you do not get anything back. You have read about so many bad things about Unit linked insurance plans (ULIPs). So, you don’t want to purchase those either. You meet an insurance company representative/agent who talks about traditional insurance plans (kind of plans LIC sold to your parents or even some of us) which offer steady and almost guaranteed returns. Some people refer to these traditional insurance plans as endowment plans. You get excited. This is what you were looking for. Steady returns and life insurance cover. You go ahead and purchase the plan.
Well, you have committed a big financial mistake. By purchasing a traditional insurance plan, you guarantee yourself steadily poor returns and grossly inadequate life insurance cover. If that was your goal, then you have done just that. Congrats!!!
Where did you go wrong? You fell for this trap of steady and guaranteed returns. Traditional insurance plans are opaque, have hidden cost structures and have historically provided poor returns. Additionally, life cover is too low. A pure term plan or even a ULIP would have been a far better choice.
Traditional life insurance plans come in two broad variants. Participating and non-participating life insurance plans. Both the types are BAD and you should never invest in any of these plans. In this post, we will show you why. We will also demonstrate how a simple combination of a pure term and public provident fund (PPF) is far better than these traditional life insurance plans.
Before we move on to different types of traditional insurance plans, let’s first discuss a few common life insurance terms.
Common Life Insurance Terms
Maturity benefit is the amount that the insurance company pays you if you survive the policy term. Death benefit is paid to the nominee if the policy holder dies during the policy term. Sum Assured is the minimum death benefit.
Policy payment term is the number of years you pay the premium. Policy term is the number of years you are covered under the insurance plan. You get the maturity benefits after expiry of policy term. Policy term and premium payment term can be different.
Non-participating Insurance plans
Under such plans, you are aware of the death and maturity benefits upfront i.e. maturity amount is guaranteed upfront. So, you know upfront how much you are going to pay (in premium) and what you are going to get at maturity/death.
We have picked up a non-participating insurance plan ICICI Pru Assured Savings Insurance Plan to explain you the product features.
Maturity benefit = Accrued Guaranteed Additions (GA) + Guarantee Maturity Benefit (GMB).
Death benefit = Highest of (Sum Assured + GA, GMB+GA, 105% of sum of premium paid till date)
Sum Assured = 10 times the annual premium
Accrued Guaranteed Addition (GA): It is 9% for 10 year policy term and 10% for 12 year policy term. GAs will be added to the policy at the end of every year. Annual Guaranteed addition = GA rate* sum of all premiums paid till date.
Guaranteed Maturity benefit (GMB) is set at policy inception and depends on policy term, premium payment term, premium, age and gender. GMB will be known to you upfront. The details about GMB calculation are provided in the policy brochure.
Let’s consider the following example. A 30 year old male chooses a premium of Rs 50,000 per annum for a policy payment term of 10 years and policy term of 12 years. This means the policy holder will pay Rs 50,000 per annum for 10 years and will get the coverage for 12 years. Sum assured will be Rs 5 lacs. GMB will be Rs 3.18 lacs.
If the policy holder survives the policy term, he/she will get the maturity benefits. The maturity benefit will be Rs 693,269. This is composed of GA (Rs 375,000) and GMB (Rs 318,269). The net return is 4.35% p.a.
If the policy holder dies after 5 years, his/her nominee will get Rs 5.75 lacs.
You can clearly see that the returns are poor. In an insurance product, we can live with poor returns. Term plans provide zero returns. The bigger problem is the amount of life cover. For someone who can spare Rs 50,000 per year towards life insurance premium, he/she would want a better life style for his/her family than Rs 5.75 lacs can buy. So, with such products, you get guaranteed poor returns and low life cover.
Comparison with PPF and Term plan
Let’s try to build a product that provides similar risk and tax benefits as a non-participating plan does. Non-participating plans provide both insurance and investment benefits. We will pick up a pure insurance product and a pure investment product.
A term plan provides a pure life cover. There is no element of investment in a term plan. If the policy holder survives the policy term, nothing is paid to the policy holder. If the policy holder dies during the policy term, the nominee of the policy holder gets Sum Assured. We pick up a term insurance plan from ICICI Prudential (ICICI Pru iProtect Term Insurance Plan).
To take care of the investment part, we pick Public Provident Fund (PPF). 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.
We could have picked up mutual funds (instead of PPF) as mutual funds are better suited for long term investments. However, the risk characteristics of mutual funds and a non-participating plan would have been different. MFs carry far greater risk.
For the same 30 year old male, we take a life cover of Rs 50 lacs (greater than Rs 5 lacs in the non-participating plan). The premium for a term of 15 years will cost Rs 5,985 (inclusive of service tax). We invest the remaining amount in PPF (Rs 44,015) every year. Let’s compare the returns.
You can see simple combination of term plan and PPF beats the non-participating plan in each and every scenario. You would have got better returns if you had purchased a term insurance and invested the remaining amount in PPF (Public Provident Fund) account. Not only that, your life cover is much higher under a term plan.
We have always recommended keeping your investment and insurance needs separate. This above table just shows why. With the non-participating plans, you guarantee yourself poor returns and a low life cover. Why would you want to purchase such a product?
Participating Life Insurance Plans
Under participating insurance plan, only a minimum amount is guaranteed (upfront) at maturity and the rest depends on the quantum of bonuses announced over the policy term by the insurance company. The level of bonus depends on the performance of the participating/life fund.
What is a Participating/Life fund?
Let’s see how it works. Premium amount from the participating plans is pooled into a fund (participating fund). Every year, based on the investment performance of the fund, insurance company generates surplus returns. The surplus, if any, also depends on insurance claims of the participating plans, existing contractual obligations, future bonuses and actuarial assessment of the surplus. IRDA has mandated a minimum 90% of the surplus to be distributed among the policy holders as bonuses. Since the assessment of surplus is so subjective, performance of a participating plan is difficult to predict.
To confuse you further, there are many kinds of bonuses. There is simple reversionary bonus, compounded reversionary bonus, special reversionary, terminal bonus, interim bonus, loyalty addition and a few more. Enough to keep you confused and unduly excited.
Once declared, these bonuses are guaranteed and paid to the policy holder/nominee at maturity/death. These bonuses are not really hefty. You will get 2.5% to 3.5% of the Sum Assured per year. An insurance company may or may not declare bonus every year. Hence, there is no guarantee of bonus every year.
Problems with Participating plans
Hidden cost structure
There is no mention about the cost structure in policy brochures of traditional participating plans. There is no mentioned about agent commissions, fund management fees, policy administration charges etc. In absence of such information, it is difficult to do return analysis, even if you make assumptions about the performance of the participating fund.
Lack of transparency
It is not exactly clear how the performance of a participating fund translates to bonuses for the policyholders. For customers, a participating plan is as good as a black box. Every year, a bonus amount would pop up. You wouldn’t be able to figure out how. At least, I couldn’t. Where there is lack of transparency, you can be rest assured that customer will make the least amount of money in the entire value chain (agents, insurance company and the customers).
You can look at historical bonuses for a particular plan to get an idea of returns. Such plans typically provide 3-6% p.a. compounded returns, which is quite low over the long term.
Comparison with PPF and Term plan
We pick LIC New Endowment Plan and we will compare its performance with a combination of term plan and PPF.
Under LIC New Endowment Plan,
Death/Maturity Benefit= Sum Assured + Vested Simple Reversionary Bonus + Final Additional Bonus, if any
Simple reversionary bonus (declared annually) and Final Additional Bonus (one-time) are not guaranteed.
For the last two years, LIC has paid simple reversionary bonus of Rs 38/per Rs thousand of Sum Assured. At this rate, on a sum assured of Rs 10 lacs, you would Rs 38,000 as bonus every year. Please note that this will be paid to you only at maturity. And there is no element of compounding. So, at this rate, your total bonus at maturity will be Rs 5.7 lacs (Rs 38,000 X 15 years). This bonus can be greater or lesser than Rs 38 (per Rs 1000 of sum assured) and may even vary across years.
Final Additional Bonus (FAB), if any, is a one-time bonus and is paid in the year of claim or at maturity. This bonus is not guaranteed and you may or may not get this bonus. The FAB is paid at maturity only when the policy is in force for at least 15 years. We have considered the information about bonuses available on LIC website and a few other online resources available. For a policy term of 15 years and Sum Assured of Rs 10 lacs, the FAB mentioned was Rs 20 per Rs thousand of Sum Assured. It may be greater or less.
With this information in hand, let’s see how the plan performs as insurance and investment product. For a 30 year old male and Sum Assured of Rs 10 lacs for a policy term of 15 years, the annual premium is Rs 67,070 (exclusive of service tax). We will assume simple reversionary bonus to be Rs 38 per thousand of SA and FAB to be Rs 20 per thousand of SA.
You can see PPF and term plan combination outperforms a participating plan in every possible scenario. So, we do not see any rationale in purchasing participating life insurance plans. The participating plans are no good either as an insurance product or as an investment product.
Traditional life insurance plans have heavy surrender penalty
A traditional plan (whether participating or non-participating) acquires surrender value after premium has been paid for three years if the premium payment term is 10 years or more. That means you get nothing back if you surrender your policy before premium instalments have been paid for three years. Even if you surrender after 3 years, you get back only a fraction of your total premium payments. If the premium payment is less than 10 years, the plan acquires surrender value if the premium has been paid for two consecutive years. So, the penalty for surrendering/cancelling traditional plans is extremely high.
We advise to keep your investment and insurance needs separate. By mixing these two, not only do you consign yourself to lower returns but also run the risk of remaining underinsured.
The only reasons why you can end up purchasing a traditional life insurance plan are the lack of knowledge on your part or remarkable salesmanship on part of the salesman or both. Insurance products require long term financial commitment. So, if you purchase such products, you will be reminded of your mistake every year at the time of premium payment.
Though we do not recommend unit linked insurance plans (ULIPs), you can still make a case for investment in ULIPs as the cost structure becomes quite competitive after a few years.
With traditional insurance plans, you do not have to think much. Simply say NO. There is no element of subjectivity. Such plans offer poor returns and provide low life cover. There is no reason why you should purchase a traditional insurance plan. Stay away from traditional life insurance plans. These are neither good as an insurance product, nor any better as an investment product.
What do you do if you have already purchased a traditional plan? You do not plan to continue paying the premium. However, if you surrender/cancel the plan, you face heavy surrender charges and a possibility of reversal of tax benefits availed under Section 80C. Heavy surrender charges eat away most of your premium instalments already paid. You don’t want to continue and you don’t want to cancel. What should you do? We will address this issue in one of our subsequent posts.
Please understand the problem does not lie with ICICI Prudential Life Insurance Company or LIC or HDF Standard Life. The problem lies with the product structure itself. You can pick up a traditional life insurance plan from any life insurance company. The plan will be as bad. However, the insurance companies will keep selling as long as you keep buying such plans. So, you have to learn to say NO.
Image Credit: Moolanomy, 2012. Original Image and information about usage rights can be downloaded from Flickr.com
Deepesh is a SEBI Registered Investment Adviser and Founder, PersonalFinancePlan.in