Why Traditional Life Insurance Products are so complex?

An investor forwarded me a traditional life insurance product and asked me whether he should invest in that product. I had to evaluate purely from the point of view of returns or suitability as a fixed income investment. The investor didn’t need any life cover.  

Breaking down a life insurance product is not easy. There are so many terms. Multiple types of bonuses. Loyalty additions. Guaranteed. Non-guaranteed. Basic Sum Assured. Sum Assured on Maturity. Sum Assured on Death. And so much more. There is a play on the timing of payments too.

I wondered why these plans are so complex.

And what could have the insurance company done to make it easier for the investor to decide on his own (especially if the investor is assessing the suitability purely as an investment product)?

In this post, I will focus on the traditional plans. Participating and Non-participating. I will specifically mention when I am referring to a ULIP. I have held back the name of the product because the issues are relevant for the entire product category.

Life Insurance Products have to be complex

#1 These are not pure investment products

These plans offer life cover. Hence, the cost of the life insurance product must be accommodated somewhere. In traditional plans, this is inbuilt into the product benefits. Opaque for traditional plans. Transparent for ULIPs.

#2 Not all policies continue until maturity.

Yes, there is a maturity date but there are contingent payouts too. Or the policy may not continue until maturity. For instance, if a policy holder passes away during the policy term, the payment is made to the family and the policy is terminated. There must be an objective formula to calculate the payout in such cases. That’s why you have bonuses/loyalty additions etc. that gradually accrue to the policy. These numbers can be used to arrive at the final payout in the event of an untimely demise.

While these numbers (calculation of bonuses) may be opaque, the calculation of the final payout is quite unambiguous once you have these numbers.

Mutual funds or any other pure investment products don’t face such issues. In pure investment products, the nominee is paid the current value of the investment. Consider any product. Mutual funds, ETFs, Bank Fixed Deposits, PPF, EPF, Bonds etc. The mutual fund company or the bank does not have to worry about calculating any value. They just have to pay the current market value.

#3 There is surrender (or paid up) option too

I think this is the most difficult part. Even if I have the policy document, I will struggle to calculate the payable value if the investor were to surrender the policy midway. There are complex tables to arrive at the surrender values.

By the way, the front-loaded nature of the intermediary commissions makes the premature exit or surrender extremely expensive for the customer.

When you ask the insurance industry, you will get the usual refrain about how such penalties help investors maintain investment discipline and stick with the policy. Don’t fall for this.

ULIPs (at least the new age ULIPs) can also make a similar argument but we don’t have heavy exit penalties in ULIPs.

The only 2 reasons I can foresee are:

1. IRDA, the insurance regulator, has not capped the surrender costs for traditional plans. On the other hand, IRDA does not permit exit charges for ULIPs after completing 5 years.
2. And the front-loaded nature of commission payouts. The commissions have already been paid. If you surrender the plan, either you must incur the cost, or the commissions must be clawed back. The intermediaries won’t like the second option.

And these two reasons go hand-in-hand. If the IRDA were to cap/rationalize surrender charges in case of traditional plans, the front-loaded nature of the commissions will have to go away or there will be strong claw back provisions in case of surrender.

Yes, some ULIPs may have heavy administration charges, which will eventually impact your net returns. And you cannot close your ULIP before completing 5 years in the plan.  If you want to close your ULIP before completing 5 years, your accumulated funds will be moved to a discontinuance fund. After completion of 5 years, you can take out the money. There is no exit cost for closing/surrender your ULIP after 5 years.

#4 Tax angle

Life insurance maturity proceeds are exempt from tax only if the Death Benefit is at least the annual/single premium. Hence, in single premium plans, there are two variants. First where maturity proceeds are tax-free. The other where maturity proceeds are not tax-free.

In regular premium plans too, you will see this aspect complicating things. You have multiple types of Sum Assured. One for demise (this one is usually at least 10X annual premium). Another to calculate your bonuses.

When you start adding these provisions in black and white, it adds to the complexity.

Still, the insurance companies can make it simpler

Most insurance companies have online calculators on their websites where the prospects can generate customized illustrations. Such customized illustrations show all cashflows/benefits or how bonuses will accrue to you during the policy term.

But the illustrations don’t reveal the XIRR (net returns) if the product is held until maturity. I have never seen an illustration that depicts XIRR. You would wonder why. After all, XIRR would make it easy to compare against other competing products.

I understand you cannot calculate returns upfront for the traditional plans and ULIPs. Why?

Because ULIPs are market-linked and we don’t know how the markets or ULIP funds will perform.

And participating plans have bonuses which can’t be determined upfront. Both reversionary and final bonuses. Fair enough.

But there is another category of traditional plans (Non-participating plans) where you know everything when you buy the plan.

In a non-participating plan, you know down to the last penny about how much you will get (and when) if you hold the plan until maturity or if the demise happens during the policy term. And the insurance companies know this better than you do. Still, the insurance companies don’t show XIRR for illustrations in such plans.

If you want to understand the differences between the different types of traditional plans (participating or non-participating) and ULIPs and how to spot them in quick glance at a product brochure, refer to this post.

Why don’t insurance companies show XIRR?

Two reasons.

Firstly, for participating traditional plans, it is not possible to calculate XIRR upfront. However, IRDA mandates that the insurers depict the policy payouts for assumed gross returns of 4% and 8% p.a.  But we need the net returns. If the insurer could show how much net returns (XIRR) an investor would get for the assumed gross returns of 4% and 8% p.a., we can assess the impact of costs.

Note:  ULIPs also face a similar problem as traditional plans. Not possible to calculate XIRR upfront since the returns are market-linked. For ULIPs too, the insurer must provide illustration for gross returns of 4% and 8% p.a. For ULIPs, it is mandatory to specify both gross yield and net yield. However, the net yield is before adjusting for mortality charges or any underwriting charges or taxes. Since these charges are recovered through cancellaton of units (and the number of units cancelled will also depend on the fund NAV which in turn will depend on market performance), it is not possible to calculate exact net yields upfront.

The investor I referred to earlier, is a senior citizen and had sent me illustration for a participating plan.  I calculated the XIRR for the plan for him. Came out to ~3.5% p.a.  (for the assumed gross return of 8% p.a.). Clearly, the plan has high costs. If the XIRR was mentioned in the document, he wouldn’t even have to reach out to me. He would have rejected the product right away. Not everybody has access to professional help.

In any case, the above excuse does not apply to non-participating plans. For such plans, XIRR can be calculated upfront and shared in the illustration.

And this brings me to the second reason. Low returns. Remember “low” is subjective.

Would you invest in an investment product where you know upfront that you will earn 3%-7% p.a. over 30-40 years?

Many would not.

I am NOT saying 3%-7% p.a. is a poor rate of return. For a fixed income product. In fact, there have been instances in the past where I have asked investors to invest in a non-participating plan (due to their specific requirements). But clearly, a low return does not make for an exciting sales pitch. I do not deny the return expectations of investors can sometimes be irrational.

Any ways from the perspective of insurance company, it helps to obfuscate.

Important note: The returns from a traditional plan (both participating and non-participating) also depend on investor’s age.  Thus, old investors must avoid ULIPs and traditional plans.

Make it so complex that most can’t understand or calculate. Most investors just look at bonuses and loyalty additions (nomenclature may vary) and feel good about what they are buying. Our brains are not wired to do such complex return calculations without any help.

It would help if IRDA, the regulator, makes it mandatory to disclose XIRR for investors in the product illustrations (if the product is held until maturity). For non-participating plans, this is quite easy. For participating plans, the net returns (XIRR) can be shown for assumed gross returns of 4% and 8% p.a.

What do you think?

Additional Read

IRDA (Unit Linked Product Regulations), 2019

IRDA (Non-Linked Product Regulations), 2019

Disclaimer: Registration granted by SEBI, membership of BASL, and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors. Investment in securities market is subject to market risks. Read all the related documents carefully before investing.

This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.