After the insurance regulator forced the industry to cut expenses on unit-linked insurance plans (Ulips) last year, traditional investment-cum-insurance plans are back in the limelight. With the industry coming up with new launches in this category and offering guarantees, traditional plans are looking attractive to customers. But a closer look may tell a different story.
Unlike Ulips that come with a transparent cost structure, traditional plans don’t disclose costs. Apart from its opaque structure, what pinches in traditional plans is the returns. They invest largely in debt products and after factoring in the costs are able to offer little or no real rate of return (inflation-adjusted returns).
If you are into one such plan and have only realized now that the returns are not what you were looking for, you may want to look at options to surrender. But once you are into a policy, it may not always make sense to get out of it. Here’s what you will get if you surrender and when and how it would make sense to do so.
Also See Early Surrender or Stay with Your Plan (PDF)
When and what you get
Most traditional investment-cum-insurance policies are front-loaded—a large chunk of the costs is deducted in the initial years. This effectively means that in the first three year, most policies don’t have a surrender value. Says Anand Pejawar, executive director-marketing, SBI Life Insurance Co. Ltd: “Costs are very high in the initial years. In fact, the costs can go up to 100%. For this reason, the policy does not acquire a surrender value immediately.”
So if you choose to surrender your policy within this period you get nothing back, but usually after three years your policy assumes a surrender value. Though some policies acquire a surrender value after two years, it is payable only after the minimum lock-in of three years that most traditional policies have.
Insurers have different methods to arrive at the surrender value. Most insurers offer two options: a minimum guaranteed surrender value (GSV), which is a regulatory requirement, and a non-guaranteed surrender value (NGSV). While GSV is a fixed percentage of your premiums, usually around 30-35% of all the premiums paid minus the first year’s premium, NGSV is arrived at more scientifically and indicates the value of your investments. NGSV may depend on the sum assured, bonus, policy term and the number of premiums paid. Says Rajeev Kumar, vice-president (product and pricing), Bharti AXA Life Insurance Co. Ltd: “The non-guaranteed surrender value is the current market value of the assets held against the policy and hence is higher than the guaranteed surrender value. However, usually in the industry, it is the minimum guaranteed surrender value that is paid out.”
Since NGSV is a better reflection of your investments, it is usually higher than GSV and is tougher to get. Says Pankaj Mathpal, Mumbai-based financial planner: “In my experience, investors who have traditional savings plans only get the minimum guaranteed surrender value which is about 30-35% of all premiums paid excluding the first-year premium, if the policy is surrendered in the first few years from its commencement. It is only as one approaches maturity that NGSV or higher surrender value is paid.”
Ask what you will get as surrender value.
When it makes sense to surrender
This depends entirely on why you want to stop your policy. If you wish to surrender to get surplus income to tide over a temporary cash crunch, dipping into your traditional plan is a bad idea.
Don’t use surrender value immediately: Since costs are not mentioned explicitly and you don’t know how your investments are doing, we follow a basic thumb rule when it comes to traditional plans: as the policy moves towards maturity, costs decrease and returns increase and become more in line with the final maturity value. In other words, the value of the policy will go up as the term progresses.
For instance, if a 30-year-old buys an endowment plan for a sum assured of Rs 10 lakh and a term of 20 years, he will have to pay a premium of around Rs 46,931 per annum. The endowment policy that we have taken in the example pays the sum assured along with any bonuses as the maturity value. It acquires a surrender value after three years and offers a GSV of 50% of all the premiums paid minus the first year’s premium. The plan also offers an NGSV, but the wording of the policy places the decision firmly in the hands of the insurer. The policy states: “If the investment conditions allow, then we may pay a discretionary surrender value which is higher than the minimum surrender value.” We have taken GSV in the example. If you surrender in the third year, you get only Rs 46,931. This means you will run a loss of 46% on the premiums you have paid till then. It is only as you near maturity that your surrender value gets closer to the actual return of the policy.
If you surrender early and invest: If you want to surrender it only to simplify your investments (keeping investments and insurance needs separate), the sooner you surrender the better it would be for you. Says Mathpal: “Inflation-adjusted returns from traditional plans are quite negligible and if you are a conservative investor you can do better by investing in debt products such as Public Provident Fund (PPF) or even fixed deposits.”
But if you have already invested in a traditional policy, you should either surrender early or stay with the policy till maturity. Adds Mathpal: “If you have just bought a traditional plan you can surrender early and still better your portfolio. However, if you surrender later, the policy would have already eaten a major chunk of your investments and you will find it hard to better your investment. In this case, it is advisable to stay invested in the policy till maturity.”
In the example above, at a 6% growth rate, the maturity value of the policy after 20 years comes to about Rs 14.21 lakh. The insurance regulator allows two rates of return—6% per annum and 10% per annum for the purpose of illustration, but since traditional plans invest largely in debt products we have taken the growth rate at 6% per annum. Assuming that an individual surrenders his policy in the third year, he will get a minimum guaranteed surrender value of Rs 46,931. Assuming he uses this surrender value to invest in a debt instrument such as a PPF yielding 8% and splits all future premiums to make regular investments in the PPF and fund a term plan for Rs 10 lakh of sum assured, the investor will be richer by Rs 3.54 lakh in not continuing with the traditional plan. Taking even a modest rate of return of 6% on his investment, the individual will gain Rs 18,722 extra by surrendering the policy after three years. If you take NGSV, which is typically higher than GSV, you will do even better since you will have more capital to invest.
If you surrender late and invest: Usually when you move towards maturity, surrendering your policy is a bad idea for two reasons. First, the term plan that you buy to compensate the cover under the traditional policy will be more expensive as you grow older and you will have fewer years left for the power of compounding to work its magic on your investment. In the above example, if the investor makes the decision to surrender late, say in the 10th year, and chooses the term plus debt product option where the debt product returns a modest 6%, he will stand to lose by Rs 4.57 lakh, assuming he gets GSV. Even if he chooses a PPF giving 8%, he will run a loss of Rs 3.09 lakh.
What to do
Traditional policies are opaque in nature and Mint Money advises caution against any financial product that does not work transparently. If you have bought a traditional policy and wish to surrender it, do so early and invest your future premiums in a better yielding debt product such as a PPF or even fixed deposits, if you are in the lower tax bracket. But if you are nearing your maturity period, we suggest you remain with the traditional policy.
Graphic by Ahmed Raza Khan; illustration by Shyamal Banerjee/Mint