Photo: iStock
Photo: iStock

3 things to ask before investing in an insurance plan

In the absence of market discipline that ensures companies have a standard and simple format, the onus is on the buyer to understand a product

Would you buy a financial product claiming to double your money? Before you get tempted, take a closer look at the product. The money will sure get doubled, but the question to ask is: after how many years? If this money is coming to you after, say, 15 years, it will translate into a net return of just around 5%.

In the absence of market discipline that ensures companies have a standard and simple format, the onus is on the buyer to understand a product, especially a bundled insurance plan because of its complex design.

While there is some information available, such as the fund performance of unit-linked insurance plans (Ulip), that’s not enough. Here are three questions to ask before buying a plan.

If it’s investment, it has to be about returns. But insurance plans that guarantee maturity benefit upfront deal with absolute numbers or ratios that don’t indicate the real rate of return.

For instance, a policy may promise to double your money but will never give you the rate of return. Although insurers call it simple communication, but head out in the market for a comparison and you will get stuck. “Without the rate of return, how do you compare it with any comparable product? You also need the rate of return to understand if it fits well with your goals and time horizon," says Nisreen Mamaji, certified financial planner and founder, Moneyworks Financial Advisors.

The missing piece in the example above is the time value of money, which is critical when calculating returns. So if you double any amount in a year, the rate of return is 100%, but if you double it in 15 years, the return is a mere 5%.

Ask a financial advisor or use online tools to find the net return of a product.

Regulations mandate insurance policies be explained through a benefit illustration (BI). BI is a year-by-year summary of the costs and benefits. This is very important when you are looking at a plan that doesn’t guarantee returns or where the returns are market linked.

The regulator has allowed insurers to assume rates of 4% and 8% to show returns in two scenarios. An illustration gives you an idea of the costs involved, death benefit and consequences of leaving a policy midway. For Ulips, the illustration will also disclose the net return. However, keep in mind that the published net return may not include all costs. For instance, insurers typically don’t factor in mortality costs while publishing the net return, but the older you are and higher the cover, the greater is the impact on your returns.

Don’t go by the published net return, glean the numbers (amount you invest and amount you get) and ask your financial advisor or take the help of online tools to calculate the net return.

An insurance policy is a long-term product where costs are front-loaded and quitting the policy midway can translate into huge losses.

In Ulips, the impact of early surrender is minimized because surrender costs are capped to a bare minimum and are applicable only in the first four years, but in traditional plans, this cost is still exorbitant. “People don’t understand the implications of taking out money midway. Most people like insurance plans because of tax benefits and park even their short-term savings in these. One needs to understand the time horizon and costs or else one can suffer huge losses," said Vinod Jain, principal advisor, Jain Investment Planner Pvt. Ltd.

Ideally, you should keep the needs of insurance and investment separate, but if you like the convenience of a bundled plan, do your due diligence.