Most folks starting out on their career end up committing to hefty premium payments on traditional insurance plans because they’re somehow led to believe that they offer much better returns than plain vanilla products such as bank deposits. But they’re making a mistake. Traditional insurance plans usually offer low returns that are obscured by the truckloads of jargon that insurance firms and agents use to describe their ‘benefits’. Here are four tips to decipher the true returns.
Death vs Survival benefits
The first step to understanding returns from a traditional insurance plan is to separate the two kinds of benefits it offers – the death benefit and survival benefit. Death benefit is the sum that your nominees will get if you die during the policy term. Survival benefits are what you’ll receive when the policy matures.
While product brochures and benefit illustrations may list both the death and survival benefits side-by-side, it stands to reason that you will never receive both at the same time.
Take the case of LIC’s Bima Jyoti, a recently launched savings-cum-insurance plan. The plan is available for terms ranging from 15 to 20 years and you’ll pay premiums for five years less than the policy term you choose. Consider 35-year-old Rao who buys a Bima Jyoti plan for 20 years. He’ll pay an annual premium of ₹78,770 plus GST (at 4.5 per cent for the first year and 2.25 per cent thereafter) for 15 years for a ₹10 lakh basic sum assured. The basic sum assured is the amount of life insurance that he chooses to buy.
This plan offers survival benefits in two forms. If he lives until 55, as he is quite likely to, he will get back his basic sum assured plus guaranteed additions at the rate of ₹50 for every ₹1000 basic sum assured, for every policy year. In effect, at 55, Rao would have paid ₹12.09 lakh as annual premium by 55 (₹82314 for the first year and ₹80542 for 14 years after including GST). He will receive ₹20 lakh as a lumpsum payment in return at 55. This will consist of ₹10 lakh in basic sum assured and Rs 10 lakh by way of guaranteed additions (calculated as ₹50/1000*1000000*20) that have been accruing each year. This ₹20 lakh return at maturity is what he should be looking at to evaluate this plan. Applying an IRR (Internal Rate of Return) to the survival benefits, the effective return for Rao works out to about 4 per cent.
Rao needs to be less bothered about the complicated death benefit calculations. The plan promises death benefits as “sum assured on death plus guaranteed additions till date”. Here, the “sum assured on death” is the higher of 125 per cent of basic sum assured, 7 times annual premium or 105 per cent of total premiums paid. So, if Rao unfortunately passes away at age 50, his nominees will receive Rs 20 lakh ((1.25*10,00,000) + (50/1000*10,00,000*15)). But this is irrelevant to him if he is mainly looking at this as an investment product.
Guaranteed or Participating
When traditional insurance products are pitched to you, insurers often make a big deal out of the attractive bonuses offered by the plan. However, you may not know that these bonuses, like the ones that you get from your employer, are conditional on the insurance company doing well.
Traditional plans usually offer three kinds of bonuses – simple reversionary bonus, final maturity bonus and loyalty additions. All three are paid out only if the insurer’s balance sheet is found to contain a surplus over its future liabilities, at the end of each year. At the end of each year, insurance companies hire an actuary (a professional mathematician) to calculate if their current funds (Life Fund) accumulated by way of life premiums will be sufficient to meet future claims from policyholders. Any surplus that the actuary finds is distributed to policyholders as the Simple Reversionary Bonus. In place of the Simple Reversionary Bonus, some plans may accumulate these surpluses and pay them as Loyalty Additions at the end of the policy term.
Yet other plans may also promise a Final Additional Bonus as a one-time payout at the policy maturity. While you can get a rough idea of the bonus rates declared by an insurer based on history, do note that there’s no guarantee that future bonus rates will be the same as the past.
While comparing traditional plans, be sure to distinguish between plans that offer guaranteed additions (which are not dependent on the insurer’s surpluses) and those that offer bonuses, which are optional. If you find the word ‘participating’ in the description, you’re buying a plan that depends on bonuses for returns.
Simple vs Compound interest
One of the key pitches to market such plans is that they offer steady guaranteed additions in a declining interest rate environment. Bima Jyoti’s Guaranteed Additions of ₹50 per thousand, for instance, are pitted against the 5 per cent interest on a bank FD. Many a time, agents point to the reversionary bonus rates of ₹40-50 per thousand declared by LIC to ‘prove’ that they are superior to other fixed income products. This is a fallacious comparison.
Traditional insurance products pay out their guaranteed additions and reversionary bonuses as simple additions to your sum assured. When a traditional insurance plan offers a guaranteed addition of ₹50 per thousand, it will add ₹50,000 a year to your kitty on a ₹10 lakh sum assured. But this sum does not compound or earn interest on interest. Interest rates on cumulative bank FDs or bonds, in contrast, earn interest on all your previous balances including your interest receipts. Given that compounding makes a huge difference to your long- term wealth from any investment product, comparing simple and compound return-earning products is like comparing chalk and cheese.
While most investment products pitched to you showcase the returns they’ll on the sums you invest, traditional insurance plans often don’t do this. They have a strange practise of promising ‘benefits’ not on the premiums you pay, but on the sum assured, which is usually the life cover you’re buying. Usually, guaranteed additions, reversionary bonuses and loyalty additions are all calculated on the sum assured you sign up for.
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