Insurance is a contract which provides protection against a possible eventuality or risk. So, insurance in its purest form is an expense rather than an investment.
Unfortunately, many of us mix life insurance and investment. We expect Returns from our investment in Life Insurance. Investing in a Traditional Life Insurance Plan is one of the most common personal finance mistakes that many of us commit.
What are Traditional or Conventional Life Insurance Plans? – Traditional plans or conventional plans are the oldest types of insurance plans available. Term Insurance plans, Money-back plans, Whole-life Plans, Endowment plans etc., are considered as Conventional plans. Traditional policies are considered as risk-free, as they provide fixed returns in case of death (or) on policy maturity.
What is an Endowment plan? – It is a combination of insurance and investment. The insured will get a lump sum along with bonuses (if any) on policy maturity or on death event.
What are Money-back policies? – They provides life coverage during the term of the policy and the maturity benefits are paid in installments (at periodic intervals) by way of survival benefits.
What is Whole-Life Insurance Plan? – It is a life insurance policy which is guaranteed to remain in force for the insured’s entire lifetime. The Sum assured is paid to the Policyholder’s nominee in the event the insured dies.
The common thing with these policies is that they provide bonuses to the policyholder. Bonus is offered on traditional plans which are built in to the plan structure. These bonuses can be of different types like Simple Reversionary bonus, Loyalty addition, Final Additional bonus etc., So, traditional plans have two components i.e. i) Life cover & ii) Investment Component.
Traditional Life Insurance Plan & Premium amount
As discussed above, an insurance provides risk protection. You can get the risk cover by paying a certain amount as Premium. In a traditional life insurance plan a part of the premium goes towards mortality charges (for life cover) and the remaining is invested primarily in Debt or Fixed Income Securities.
(What are Mortality charges? – Mortality Charge is the amount charged every year by the insurer to provide the life cover to the policyholder on the life of the Insured. It is also known as Cost of Insurance.)
As these traditional plans have to pay BONUSES to the policyholders, they have to charge over and above the ‘cost of insurance’. This is the reason why the endowment plans or money-back plans are costlier than the pure term insurance plans.
For example : Arun pays a premium of Rs 10,000 towards his Endowment insurance plan for Sum assured (life cover) of Rs 1,00,000. His Life insurance company deducts a part of this Rs 10,000 premium as the ‘Cost of Insurance’ or ‘Mortality Charge’. This is kept aside by his insurance company and maintains a ‘Life Fund’. This Life Fund is not invested anywhere. Insurance company uses this Fund to pay out Death benefits.
Mortality Charge is usually a very small amount, say Rs 400 p.a. from the Rs 10,000 annual premium that Arun paid for his life insurance. From the remaining amount of Rs 9,600 (Rs 10,000 – Rs 600) various expenses like office administration, marketing expenses, policy maintenance etc. are deducted and the balance amount would go for investment.
- High Cost of Insurance & Low Life cover : As discussed above, the premium rates on Traditional plans are much higher than the term insurance plans. If you are buying an Endowment plan or money-back policy for life cover then kindly note that you are paying a very high premium for a low life cover.
- Low Investment Returns :
- The conventional plans can be of two types – i) Participating Insurance plans & ii) Non-participating insurance plans.
- In case of Participating plans, the investment returns are primarily dependent on the bonuses declared over the Policy term by the life insurance company.
- In case of Non-participating traditional plans, the death and maturity benefits are clearly mentioned upfront. That means a policyholder knows what he/she is going to get at maturity or on death.
- In both the cases, most of the traditional life insurance plans offer investment returns of around 3 to 5%.
- So, in terms of life cover you pay high premium & you get low life cover and at the same time in terms of Returns too, you get a meager return on maturity.
- Percentage of Returns are not guaranteed : The plans which fall under the category of ‘Participating plans’ the percentage of returns are not guaranteed. The rate of bonuses declared by a life insurance company can vary from year to year. The product brochures clearly state that the rate of return is for illustration purposes only. So, kindly be aware of this point.
- Terms & Conditions on Bonuses : Bonuses like Loyalty addition or Final additional bonus may or may not be applicable on all traditional plans. They can be applicable based on the quantum of sum assured and/or policy term.
- No Compounding effect : The bonus (simple reversionary bonus) declared by most of the Endowment plans or Money-back plans doesn’t compound itself. For example, let’s say your life insurance company declares bonus of Rs 40 per 1000 of sum assured for two consecutive years. If you have invested in an Endowment plan of sum assured Rs 1 Lakh, after 2 policy years you will receive a bonus of Rs 8,000 (Rs 4,000 + Rs 4,000). This Rs 8,000 would remain as Rs 8,000 till the maturity of the endowment policy. It is just accrued and compounding does not come into picture.
- High Penalty : If you decide to surrender a traditional life insurance plan in the initial years, you will end up paying a hefty penalty. You can surrender the policy for cash only after the premiums have been paid for at least three policy years.
- Tax saving is an additional benefit : Insurance is primarily for Protection and not for saving Taxes. Kindly note that Tax saving is an additional benefit, that’s it!
- Erosion of wealth – Life insurance policies are long-term contracts. When you are investing for long-term, would you like to get decent inflation adjusted returns or not? Your endowment or money-back plans are low-yielding investments. these may give you negative inflation adjusted returns.
Do not blindly go by projected illustrations given by your agents or advisors. A traditional policy may look attractive today by looking at the projected maturity corpus. But, always factor inflation into the calculation. For example: You may be offered a maturity value of Rs 50 Lakhs in 20 years. At 6% inflation the today’s value of it will be reduced to Rs 15.6 Lakh. (Read : What is Time Value of Money?).
Remember this simple point : “Any life insurance plan which pays money before a policyholder dies can be best avoided.” Else you may end up buying costly and unwanted life insurance plans. (Read : How to get rid off unwanted life insurance policy?)
Then, who can buy these traditional life insurance plans? If you already have adequate life cover, would like to safeguard your capital, and OK with lower (or negative , inflation effect) long-term returns then you may consider investing in a Traditional life insurance plan. Even in this case it is not an INVESTMENT OPTION but it is just a long-term SAVING option!
(Image courtesy of jscreationzs at FreeDigitalPhotos.net) (Post published on : 01-July-2016)