Traditional policies: 5 things your insurance agent won't tell you

It's not always 'tell and sell'



Traditional policies make for a large chunk of the business for life insurance companies. But unlike ULIPs (unit linked insurance plans), these policies are opaque — the investment book is kept in the dark and costs are not disclosed. Your agent may not tell you several things while trying to draw you with the candies of ‘doubling money’ and saving tax.

Demystifying traditional policies

Every life insurance company has a few plans in its portfolio under the savings category.

Savings (or endowment) products include ULIPs — unit-linked products where returns are linked to market, and traditional plans — which are categorised as participating and non-participating plans.

In participating plans, policyholders get a share of profits from the investments of the insurance company that is declared as bonus. In non-participating plans, policyholders don’t get to share profits, but returns are guaranteed upfront.

In traditional plans, since the risk cover is minimal, they are not the best option for people looking for life protection.

The life cover that traditional plans offer may be, at best, 10 times the premium. But if you take a plain-vanilla life insurance policy (where there is only insurance and no ‘savings’), the risk cover could be substantial.

Here are a few things that the agent may not discuss with you when coaxing you to sign up for a traditional plan.

The hidden costs

Insurance companies are not mandated to disclose agent commissions to policyholders. In fact, in traditional policies, you cannot even know the premium allocation charge, the administrative costs or mortality charges on the policy.

The difference between the gross (which is the 4 per cent or 8 per cent) and net return (IRR) that can be deciphered from the benefit illustration can give you an idea about the expense ratio, but you won’t get to see the break-up of costs.

Agents may also not discuss surrender charges with you. In traditional policies, there is no ‘lock-in’ on the investment, but surrender costs are high. They may be as high as 70 per cent in the initial years as all costs are front-loaded (unlike in ULIPs where they are spread out). Surrender charges are disclosed upfront in the policy document, but do not find a mention by agents.

IRR: the real return

In case of traditional insurance plans, agents make tall claims of doubling money. This is not true.

The average returns of most non-participating endowment plans come to about 4-5 per cent. In HDFC Life’s Sanchay, a non-linked non-participating plan, for instance, a 45-year old male who pays ₹1.5 lakh per annum premium for 10 years, will get maturity proceed of ₹28 lakh at the end of 20 years, which works out to an IRR of 4 per cent.

Agents mislead customers by holding the maturity value of the policy against the premium for comparison.

In endowment insurance policies, as the premium payment (cash outflow) happens in the initial years and the maturity proceed is received in instalments spread over a 5-10 year period or as lumpsum after 10-20 years, one should also account for the time value of money.

The IRR (internal rate of return) is apt for capturing the actual returns in endowment policies as it calculates the net present value of all benefits received at different points in time and then compares it with the initial investment. Calculating IRR is no big deal. Many online calculators are readily available. You can even do it on the spreadsheet in your computer through the IRR function.

BI, a mere illusion

In any savings product, it is the return that attracts investors. Both participating and non-participating plans give a ‘benefit illustration’ (BI) in the policy document to give investors an idea about the maturity benefits.

In non-participating plans, since the maturity benefit is fully guaranteed, the value of investment at the end of the term is disclosed in the BI. However, in case of participating plans, insurers show two scenarios — of 4 per cent and 8 per cent return — to indicate the likely benefits under the plan.

Beware! Do not take this return at face value. It is only for illustrative purpose and, not what the insurer guarantees on your investment. Until 2013, insurers used to draw the illustration based on the assumption of 6 per cent and 10 per cent growth.

In participating plans there is actually no way of knowing the returns as it depends on the bonus the insurer will declare.

The benefit illustration in these policies will be useful only to understand the expenses under the policy. Say, on the assumed 8 per cent return for a policy, the IRR works out to 5 per cent, it means that the product eats away 3 per cent of your return on various expenses.

This 3 per cent is the product’s expense ratio and can be used to compare with other endowment plans on how they fare on the cost front.

Bonus not guaranteed

It is the bonus which insurance companies declare out of their life fund that makes up for returns of policyholders of participating plans. They get some guaranteed additions (GA), but that is very little, that generates a 1 per cent IRR.

While agents project bonus as a guaranteed benefit, it is not. Insurance companies are required to declare bonus to their participating policyholders only when they make a surplus in their investment fund.

In accordance with IRDAI regulations, insurance companies have to share the surplus between policyholders and shareholders on a 9:1 ratio.

So, you get bonus only in good years of the company. The bonus rate may also differ each year depending on the profits of the insurer. Bonus rates also depend on the interest rate cycle in the economy as participating policies invest their money largely in debt instruments.

In the last few years, with G-sec yields dropping, the bonus declared by insurance companies has also been moving south. Sample this: Between 2014 and now, the yields on 10-year government bonds have fallen from 9 per cent to 6.8 per cent.

In case of ICICI Prudential’s Savings Suraksha — a non-linked participating insurance plan, the reversionary bonus (for regular pay policies) has fallen from 2.25 per cent in 2014 to 1.75 per cent in 2017.

The bonus declared by insurance companies is generally a percentage of sum assured (SA). Most companies give a simple reversionary bonus. Only a few, including ICICI Prudential, give a compound reversionary bonus where, from the second year, the bonus declared is on the SA plus the previous year’s bonus.

Generally, there are two types of bonus — reversionary (which is the regular annual bonus declared every year) and terminal bonus (which is declared upon surrender or maturity of the policy or on the death of the policyholder).

At the end of the policy term, the sum assured on maturity along with GA and the reversionary bonus accumulated over years and terminal bonus will be paid.

Debt-heavy portfolio

Investors need to understand that traditional endowment plans can’t give sky-high returns for the simple reason that they invest only in debt instruments.

IRDAI rules have it that at least 50 per cent of the total assets of life insurance companies should be invested in government securities (G-secs) or government-approved securities and at least 15 per cent in approved housing and infrastructure bonds. Only 35 per cent or less is allowed in equity.

In traditional plans, however, a substantial portion (almost 80-85 per cent) of the investment is in fixed income securities.

In non-participating plans, since the return is guaranteed, insurers put even higher sums into debt instruments.

Should you go for guaranteed products?

With falling interest rates, long-term bank FDs today offer just 6.5 per cent interest, forcing investors to look for alternatives. Among insurance products, guaranteed products that offer 4-5 per cent returns now, are an option. Since the maturity proceeds are tax-exempt, the effective return is a tad higher.

But these guaranteed plans, given their bundled nature (of insurance plus investment), are high-cost products.

Here’s taking a look at what these products offer and how to choose between them.

What is it?

Every life insurer has at least one guaranteed return product. People who are nearing retirement and do not want to actively track their investment may look at these products.

But, mind you, these products can give only 4-5 per cent. If your agent has promised doubling your money, it’s a big lie!

If an investment product doubles your money in one year, the return is 100 per cent, but if it doubles your money in 20 years, the return is only 3.5 per cent.

Inflation erodes the value of money. One rupee in your hand now is worth more than the one rupee that comes, say, 10 years later. This is precisely the reason why the article above stresses the need to use IRR when studying the returns of an endowment product.

Now, coming back to who can look at these products, it is for those who do not want to take a chance with their investment and are looking for capital protection. Unlike debt/hybrid mutual funds, these policies don’t require active tracking, either.

But if you are in the age bracket of 30-40 years, you should ideally look at an equity oriented product as you have a longer time to build your retirement kitty and you can take more risk.

Keep in mind that guaranteed endowment products are expensive investment tools. The Chief Actuary of a private life insurance company disclosed that insurers make more margins on non-participating plans than participating plans.

In the latter we know that insurance companies charge about three percentage points of the gross return for various expenses and to cover their own margin. Now, if in non-participating plans, insurers are making more margin, it implies that the cost charged to you is higher than three percentage points. Hence a guaranteed return comes at a higher cost to you.

What’s on offer?

Over the long term of 10 years, inflation may average at 4-5 per cent, so these guaranteed-return products from insurers are effectively only capital protection products. In case of Max Life’s Guaranteed Income Plan, the return is 4-4.7 per cent. In Edelweiss Tokio Life’s GCAP, the return is about 5.15 per cent. With SBI Life’s Smart Guaranteed Savings plan, the IRR comes to 4-4.5 per cent.

The variance in returns of about 40-50 basis points is due the difference in the age of the individual and also the policy and premium payment term chosen.

Not many insurers offer more than 20-year term on their guaranteed products. Some such as SBI Life restrict it to 15 years and Max Life to a maximum of 12 years.

The longer the tenure you ask for, the lower will be the return the insurer can guarantee. There is a risk in locking in for a longer period, as the interest rate cycle can reverse any time.

What also matters to the IRR in a guaranteed return product is the premium payment term you choose.

With most insurers, regular premium products where you keep paying premium till end of the term and payouts start immediately from the next year, fetch a lower return compared to limited pay products (or products where the premium payment term is much shorter compared to the policy tenure).

If you are under 40, your IRR may be a tad better than older prospects as the mortality expense on your account will be lower.

Other options

There are only a few guaranteed return products in the market of which bank FDs and PPF are the most popular. In Bank FDs you get only 6.5 per cent for 10 years today and the interest income is taxable. In case of PPF, the contributions and maturity proceed are tax-exempt.

The interest currently is 7.8 per cent, but this is not fixed till maturity — it will be revised every quarter.

Also, the maximum amount you can put into PPF is only ₹1,50,000 a year (linked to the maximum benefit under section 80C).

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