The standard response of Mint Money to an endowment, or money-back insurance, plan is ‘no’. There are three major reasons we recommend that our readers avoid traditional insurance cum investment plans. First, of course, is the complexity of the product. Pick up the brochure of any bundled insurance policy and read it. You are likely to have more questions than answers. Second, the returns from these plans are low in the range of 0.5-6%. Given these are long-term products, we don’t recommend them as they can generate negative real rate of return (investment rate minus the inflation rate). And third, of course, is the premature surrender penalty, which hurts the most. This is the money you forfeit when you stop funding the policy prematurely.
The surrender penalty is fixed depending on the premium payment term: number of years for which you pay a premium. So, for a premium payment term of less than 10 years, the guaranteed surrender value is 30% of the premiums, provided two annual premium instalments were paid. In other words, if you quit before the second premium, you get no money. If you quit in the third year, you get just 30% of the premiums. In other words, the insurer keeps 70% of your premiums. For policies of tenure of 10 years or more, you get nothing back if you quit the policy before the third premium. If you quit after paying three premiums, you get 30% of the money. So if you paid Rs1 lakh for 3 years, you get only Rs90,000. After that, if you quit between the 4th and the 7th year, you get half your money back. After that, the insurer has to file with the regulator and then decide what you will get paid.
But it is not as if you get all your money back. I picked up benefit illustrations of two policies at random and none of them had a zero surrender charge at any point of surrender before the maturity date.
These exorbitant surrender costs make buying a traditional policy and then surrendering it a mistake, more so when you surrender towards the later years. But the industry has held on tightly to these surrender costs. Even the product reforms that took place in 2013 didn’t reduce surrender costs in traditional plans by much; though, in unit-linked insurance plans (Ulips) the costs were clipped sharply. Read here to understand these costs at length. The industry predictably moved to selling traditional policies. They pegged this shift to two events: market volatility that made Ulips unpopular and low surrender charge in Ulips that make lapsing policies much easier. Traditional plans were projected as sticky products: given the high surrender costs, customers would stick around, and also for guaranteed returns, which customers prefer.
But persistency figures don’t support the claim. As per the latest Handbook on Indian Insurance Statistics for 2015-16 released by the Insurance Regulatory and Development Authority of India (Irdai), the life insurance industry, on an average, had a persistency of 61% in the 13th month. One year after the sale, only 61 out of a 100 policies were renewed. In other words, 39% policyholders drop out. Given that the markets have moved to selling traditional plans (roughly 87% of the market is traditional), nearly 35% of the policyholders saw a complete destruction of their wealth. In terms of the number of policies, here is some rough calculation. In 2015, the life insurance industry sold about 25.9 million policies. So, at a persistency rate of 61% for FY16, nearly 10 million policies didn’t come back for renewal.
The numbers don’t inspire confidence in the “high surrender charges deter early surrender” argument. For the industry though, this argument has resulted in profits: exit penalties are so high that insurers actually make profit from lapsed policies. This was the case for Ulips too when the surrender costs were exorbitant and more than 90% of the market sold Ulips. A Goldman Sachs report stated that profits from lapsed policies contributed 10-80% to profit before tax in FY2012. Subsequently, Ulips went under the scalpel and the surrender costs were shaved off to a maximum of Rs6,000 in the first year, tapering to zero by the fifth year.
Traditional plans need to be next. The good news is that reducing the surrender cost seems to be an important item on the menu of the eight-member product committee that was set up in January this year to review product reforms. We spoke to a few members of the committee and, on condition of anonymity, all agreed that one of the main talking points was reducing the surrender costs in traditional plans. However, the house seemed to be divided with a strong pushback coming from traditional insurers.
Traditional plans work on the concept of shared pool: premiums go into a pool, and costs, insurance and investments are met from it. So, surrender with no exit load from that pool means depressing the returns for existing members. This has been the pushback argument, but, if anything, it points out the flawed structure of the product where the fate of investors is tied to the behaviour of others. Instead of products having huge exit barriers, it should be the job of the sales force—which gets large commissions—to ensure that customers stick for the long term, by selling the products right.
The committee is deliberating on a time period after which the surrender cost will come to zero and the entire money would be refunded. There are two time frames being discussed: one, a full refund after 3 years and nothing if surrender happens before that, and second, a full refund after a waiting period. There is good reason to believe that surrender costs will improve as even the regulator is understood to have weighed in on the side of reducing surrender costs. It is in the interest of consumer protection that these charges be brought down.
Deepti Bhaskaran is insurance editor, Mint Money.