January 30 , 2013
Traditional insurance plans have been sold to us by LIC for decades. Endowment and whole-life plans are two common types of traditional plans. Both are relatively similar for the purposes of our evaluation, so we will treat them together here.
If you have a life insurance plan older than a decade, nine-on-ten it's a traditional plan. Those were the days when every youngster getting a job was immediately advised to 'take an LIC'. Agents of LIC were numerous, some of your neighbours or cousins counting among them. A traditional life insurance policy - an endowment or a whole-life policy - was promptly sold to you. You happily kept this policy for decades, paying premiums when reminded; unaware of how to make sense of it, let alone compute returns.
Then, you had no choice. Some policy was better than no policy - after all, it atleast inculcated the saving habit in you. However, with a much broader choice today, we can look at why you better not go for such products any longer.
What are Traditional policies?
A traditional life insurance policy combines a life insurance cover with investment. It has a longish tenure with annual premiums - often for 15 years or more. A small part of your premiums goes towards what is called 'mortality charge' - this covers your life. The rest goes into the company's fund. In a traditional plan, this fund is only kept in debt (no equities). The focus is towards safety and keeping the corpus safe, even if this means lower returns. Such plans are therefore also called non-unit-linked or non-participating plans.
A useful point to note is that it is not your money that is directly invested to earn a return. Instead, your money goes into a broader fund managed by the company, containing money of several investors such as yourself. Also, there is no direct mapping between the performance of this fund and your returns (though indirectly there is an influence). What is finally paid out to you from this fund is called by different names in the market - accrued bonuses, guaranteed additions, etc. But remember, all this is in debt, so your expectations need to be tuned accordingly.
Thus, only two factors matter to you as an investor to analyze such a scheme:
1. What life cover is provided, in lieu of your premium
2. What annual returns such funds are known to give over the long term
Let's look at the performance of traditional plans based on these parameters.
Insurance in a Traditional Policy
Most traditional policies have life cover between 15 to 25 times your annual premium. To give you a benchmark, a term insurance plan has a cover exceeding 500 times your annual premium. The reason for this difference is the fact that most of your premium goes into the fund, leaving little for mortality charges. A second equally important reason is that most of your premium goes off to pay commissions to your agent, leaving little for the life cover.
Whichever way, the net result is that your life is grossly under-covered. While a life cover of four times your annual income is the barest minimum your family needs, an endowment plan would often have less than a tenth of this. Unfortunately, your agent is paid based on the premium collected and not on life cover, so he won't bother to recommend a better plan to you.
Returns in a Traditional Policy
Debt itself gives only 6%-7% annually in the long term. A traditional plan has a host of other charges to pay out, and has to pay hefty commissions to your agent. Thus, what is left for you as an investor is only 4% or less.
What is worse is that this performance is completely opaque – you will never be given accurate information on how the fund has done and how bonuses are. You only have historical data of other investors and schemes to go by. And all these paint a dismal picture. The most optimistic estimate of your long term return is about 4%. A number only half that of fixed deposits, let alone market investments.
Flexibility in a Traditional Policy
A traditional plan scores very poorly on flexibility too. Your investments are locked in for a decade or more, with severe penalties on withdrawal. Even here, there is no clarity on what you would get if you surrender a policy. You can only fill the surrender form, hope for the best and be happy with whatever you get.
Undoing damage of already existing Traditional Policy
If you have the misfortune of having already started a traditional policy, you may need to act to limit the damage. As said above, the insurance company keeps no transparency on what your policy is worth or what you would get on surrendering. Yet, based on our experience, we recommend the following:
Keep paying regular premiums in the policy for the first five years
Once five years are up, write to the insurance company for surrender
You will get most of your invested money back, or emerge with a minor loss. However, this is far better than keeping your money in such a losing proposition for another decade or two. You can quickly recoup your loss and put your money to far better use once it is out of this jam.
In summary, traditional insurance policies are a disastrous idea – pushed by companies and agents to fatten their own wallets. They score very poorly on investment, insurance and flexibility metrics. You would do well to avoid them altogether. If you already have one, you should act to surrender after the first five years, thereby limiting your damage.