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Saturday, August 1, 2009

Pitfalls in Life Insurance

Dear Readers
Thank you for huge response for my first blog post. I installed a reader count on blog page and result was a tremendous positive surprise! I received lot of comments through email; will appreciate if you insert your comments at end of posts.

This article was written couple of years back for a different context. It is relevant fully today, copy-pasting it here for my blog readers.

Preface: If you want to buy an insurance policy but are not able to reason for yourself and take an informed decision, this article is written for you. If you already are a policy holder and want to analyze whether you made right choice, this article is for you. This article is aimed at sharing with you pitfalls with various insurance policies based on my experience with different insurance agencies. This article is not intended to guide you on which insurance policy to buy, however it will tell you pitfalls which exist in insurance sector, various sales strategies from insurance agents. As an individual, you either have access to too much information over internet etc. or get skewed information from insurance agents. If you are want to get unbiased views, read on.


(Note: If you know these basics, skip this section)

· Premium – Money which you pay to insurance company in regular intervals.

· Sum assured – This is corpus money which you have decided that insurance company will give your nominee in case of an unfortunate eventuality of death.

· Term policy – In this kind of policy, you pay premiums for insuring life. In an unfortunate eventuality of death, nominee will be paid a particular sum assured. At maturity of policy, you will not get back money.

· Endowment policy – In this kind of policy, you will get back sum assured along with returns upon maturity of the policy.

· ULIP (Unit linked Insurance policy) – In this kind of policy, the premiums which you pay are distributed towards insuring your life and investing in stock market. Upon maturity of policy, you will get back money depending on stock market performance.

· IRDA – Insurance regulatory and development authority (governing body for insurance sector)

· SIP – Systematic investment plan


After deregulation of insurance sector in India, lots of companies now offer life insurance policies. Unlike the past when our parents had only Life Insurance Corporation of India for buying a life insurance policy, there are lots of private insurance companies offering competitive products for insuring your life. Earlier government of India used to guarantee the premiums you pay to LIC I.e. you can feel comfortable even if one corner of your mind might think that LIC might run away with your money. However after deregulating this sector, the government has offered a level playing field to private companies. LIC does not enjoy this special benefit from government anymore. IRDA has ensured that private insurance companies offer as much safety to your money as offered by LIC.

Understanding endowment

Insurance is simply a financial cushion for nominee in eventuality of death, then why is it so complicated? Why are there so many policies?

Insurance planning is often mixed with savings plan. Other than having an insurance policy, you need a sound savings plan to cover for your own pension and future family responsibilities. Insurance companies capitalize on this thought and have different policies insurance and savings needs. They have a different plan for people with different ideologies.

Person X thinks like this “I need to have a life insurance cover. I don’t want to lose my money which I invest regularly as premiums, they have to give back something to me” – An insurance agent will sell an endowment plan to person X. But what is the pitfall in an endowment scheme?

Assume X’s age is 30 years. X chooses an endowment policy for a sum assured of Rs.2.5 lakhs for next 20 years. LIC can offer this policy for an annual premium of ~Rs.6500.

There are two possibilities:

1. Assume that X dies after 19 years - A sum of Rs.2.5 lakh will be paid to X’s nominee. The value of Rs.2.5 lakhs after 19 years would have depreciated to a lesser value.

In today’s value, it will be equivalent to 250000/(1+.06)19 ~= Rs.83,000.

(assuming depreciation of 6% p.a)

When X bought the policy for Rs.2.5 lakhs, it might have appeared like a good amount of financial cover. But after depreciation, value is not as good! Considering that the basic premise of life insurance is to provide financial cushion to nominee, will it really serve its purpose? (Pitfall)

Given a second chance, X would have revised his policy to take a cover of Rs.1 crore (lets say). However he would have been charged a premium of ~Rs.2.6 lakhs/annum (clearly an expensive, unviable proposition for X). What should he do? Did he think of right kind of policy? It is for you to answer.

2. Person X survives for next 20 years, so the policy lapses - Being an endowment policy, X will get back his premiums additional with a bonus. X would probably receive ~4.5 lakhs (with minor variations from different insurance companies).

What will be its value after depreciating for 20 years? Equivalent to 450000/(1.06)20 ~= Rs.1.4 lakhs in today’s value. Is it a good return of investment over past 20 years? It is for you to answer.

(If the premiums were invested in PF with interest 8%p.a, X would have got ~ Rs.5.1 lakhs. If premiums were invested in a mutual fund giving interest 15% p.a, X would have got back ~ Rs.17.5 lakhs).

In any of above two possibilities, X will be forced to think if he made right choice. Is there a solution? Will X benefit by separating his insurance and saving needs?

Try an illustration: X buys a term insurance policy, decides to save separately with a mutual fund house.

For sum assured of Rs.2.5 lakhs in a term policy, premium charged from most insurance companies’ will be ~Rs.1500 p.a. Assume that he invests Rs.4000 p.a. in a mutual fund giving 15% p.a. returns, his returns after 20 years will be ~ Rs.10.8 lakhs.

Its value after 20 years will be depreciated to 1080000/(1.06)20 =~ Rs.3.5 lakhs in today’s value. Knowing value of such returns, is it better to separate insurance and investment? It is for you to answer.

If benefit of separating insurance and savings (investment) is so evident, why have so many of my relatives/friends bought an endowment policy? There can be 2 reasons:

1. Endowment policy will force you to save regularly as part of your insurance premium (although returns are lesser). However if you are a person with a regular savings regime, this argument is not for you.

2. Insurance premium is exempted from income tax under section 80c. If X buys an endowment policy, Rs.6500 will be exempted from income tax, whereas a term policy would have given only Rs.1500 as income tax exemption. However if you already have savings up to Rs.1lakh p.a. from other investments like PF, PPF, NSC, MF etc which gets covered under section 80c, you have reached the limit for exemption from income tax. You will not get additional income tax benefit from insurance premiums; this argument is not for you.

In summary, insurance and investment are two different things. You need a sound reason to mix both to buy an endowment policy. After reading this article if an insurance agent wants to sell you an endowment policy because it will suffice your retirement needs, you know what to answer. If an insurance agent says an endowment policy returns will suffice your child’s education/marriage expenses, you know how to make an informed decision. Endowment policies are sold mainly as savings/retirement plans. Is an insurance policy meant for this reason? It is for you to answer.

Note: Insurance agents get paid more commission for selling ULIPs, less commission for selling endowment policies, even lesser for selling term policies (pitfall).

Understanding ULIP

In a Unit Linked Insurance policy, a part of your premium is invested in stock market (terminology used is “loading”), some part is deducted as administration charges and rest is marked for insurance. You can choose your risk profile debt/equity/balanced based on your risk appetite and insurance company will invest your money accordingly. In eventuality of death, sum assured is guaranteed to be paid. Additionally, the value of funds invested in stock market will also be given. When you ask an insurance agent for advice, the first policy he will try to sell you will be an ULIP. Based on IRDA guidelines, he will show you growth projections based on 6% p.a and 10% p.a. A premium of Rs.100000 p.a at 10% returns p.a will can give you ~Rs.52 lakhs at the end of 20 years! The power of money compounding over 20 years is enormous and results can be clearly seen/demonstrated on a spread sheet. I have evaluated ULIP products from ICICI Prudential, Birla Sun Life, MetLife and Bajaj Allianz (through agents from Standard chartered bank) and all products are similar in their objectives and conditions applied. However they vary in percentage of premium they allocate for investment or insurance, portfolio of investment and administration fees. The administration charges usually include mortality charges, which is calculated based on various parameters like life expectancy etc. You may want to evaluate your choice of policy based on administration charges.

However you may also want to check what would be the returns if you managed to invest that money on your own, say in a mutual fund SIP. However there are few arguments:

1. Insurance agents will argue that returns from ULIP is tax free i.e. you don’t have to pay income tax on the money which you will get after 20 years (pitfall). Although it is a fact, don’t buy this as an argument because capital gains from long term (>1 year) investments in equity is also exempted from income tax. i.e. Even if you invest in equity Mutual Funds, returns after 1 year is tax free.

2. There is no difference between ULIP and MF in terms of liquidity i.e. you can withdraw your funds anytime after paying an exit load.

3. Insurance agents claim that while ULIP charge ~1.5% as management charges, Mutual fund houses charge ~2.25% as management charges. If true, they also claim that returns from ULIP will beat returns from MF if investment period > 8-9 years. You may want to evaluate this point for making the crucial decision.

ULIPs also come in different flavors like:

1. Pay premium for first 3 years and don’t pay any premium for rest of 17 years – The argument is that returns from your funds in the first 3 years will pay premiums for rest of 17 years. However the premiums are exorbitantly high for 3 years, making it financially unsound in the long term. It is however suitable for people like film stars who have ability to pay high premium in the short term but don’t have assured income in the long term to pay for premiums.

2. Take premium holidays for 3 years during the term, while policy will still continue based on returns of your previous years. This is a sound argument in eventuality of an unforeseen inability to pay premiums in the future. However if you are assured of a regular source of income for paying premiums, this clause will not help additionally.

Your decision on whether to buy a ULIP OR Term policy+MF SIP should depend on all these considerations. In addition, there are few other points to think before taking the final call:

1. ULIP is sold by insurance companies who have expertise with insurance. However MF houses are experts in investment. If you are a strong believer of giving responsibility of your money only to the experts of that field, invest in MF houses.

2. If you are a person who keeps track of stock market and continuously evaluate MF performances, you might want to divert your investments to best available instrument at that moment. A ULIP will not offer this fine control. If you are a person who wants to have this fine control, invest in MF houses.

The choice of endowment/term/ULIP is largely dependent on your long term savings needs, income tax planning and thinking style. Before choosing a policy, avoid known pitfalls to make an informed decision.

Understanding riders

Apart from life cover, insurance companies offer additional, optional riders.

1. ADB (accident death benefit) – IRDA mandates a maximum sum assured of Rs.10 lakh for this rider. If you opt for this rider, you will be charged an additional premium. In case of death due to accident, sum assured of policy will be paid in addition to sum assured of the rider. Even without buying ADB rider, basic sum assured is guaranteed in case of death due to accident. In summary, this rider only increases total sum assured in case of death due to accident. The additional sum assured comes at a lesser price when compared to the actual life cover, which is the only reason why people will want to buy this rider. However if you go for a very high sum assured for life (example: 1 crore), you might not want to buy an additional sum assured in form of ADB rider.

2. CI (Critical Illness) – IRDA mandates a maximum of Rs.5 lakhs sum assured for this rider. If you buy this rider, it will entitle you for sum assured in eventuality of a critical illness (not death). You may want to check out list of all illness which are classified as critical by the insurance company, this is not a standard list mandated by IRDA (pitfall). This rider is considered expensive and some insurance companies like Birla Sun Life do not offer this rider since determination of critical illness is always open to debate and confusion.

3. WoP (Waiver of Premium) – In case of inability to pay premiums in future, you don’t need to pay premiums. Insurance company will however keep your policy alive. In summary, it is insurance for your premiums. Again, this rider is not offered by all insurance companies.

You may want to check on these conditions before making the choice of additional riders. Riders will be given on top of any kind of insurance policy. So your choice of insurance policy is independent of choice of riders.

Closing notes

To make it little simpler for those who want to take a term policy for life cover, I will summarize all relevant points:

1. Buy a sum assured which can suffice financial requirements of your nominee in real value terms at term expiry.

2. You are a person who wants to take control of investments; you have a sound savings regime for long term including pension, child education/marriage etc.

3. Avoid ADB rider since basic sum assured itself is good enough to cover financial requirements of the nominee.

4. You are in touch with the stock market performance; you know which funds do well and are sufficiently informed to make sound investment decisions.

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