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Why smart customers dodge the investment-cum-insurance policy trap
Do not believe the sales pitch regarding any traditional plan. Buy term if you need insurance
You are doing great harm to your financial well-being if you continue to fall into the trap laid down by life insurance companies, their agents and now the shareholders of these companies, under the benevolent gaze of the insurance regulator. How many of us are still buying these traps? In financial year 2018-19 (that is the latest data available), individuals bought almost 30 million new life insurance policies, pumping almost ₹1 trillion of household savings into them.
Which policies are the most harmful? Traditional plans that include with-profit money-back, whole-life, endowment policies and guaranteed plans are the worst. These make up 85% of the entire market. Ulips are not traps and are much better products but don’t do well on disclosures and flexibility as compared to mutual funds. Term cover, the best kind of life insurance that you must have, are hardly sold. They are largely self-bought as smart people figure out what to buy. They buy online, cutting out the agent.
Why are traditional policies harmful? Because they give neither good insurance nor good returns. The typical policy gives a sum assured of 10 times the premium. Sum assured is the money the family gets in case of an untimely death of the principal income earner—remember that is the real purpose of a life insurance policy. The average sum assured for the Indian life insurance industry is ₹3.5 lakh. How much should it be? The thumb rule for buying a life cover is 10 times the annual income. So, if we use the Indian per capita income number, we come to an insurance cover need of ₹15 lakh on an average. Data shows that Indians are buying life cover, but it is not giving them the protection they need. Nor does the typical traditional policy give a good return since they average a return of between 2% and 4%. Government bonds do better, PPF does even better.
Why do we continue to buy them? Because they are hard sold. Sellers lie, cheat and do what it takes to shove them down the throats of customers. Why would they do that? Follow the money and you see that the first-year commission on selling such a policy is up to 42%, but from the second year, the commission drops to up to 7.5%. The incentive is to hit and run. Once you have been hit, you are trapped. If you stop paying premiums anytime before almost the end of the policy term, you don’t get a large chunk of your invested money back. If you pay the first premium and don’t pay the second, you get nothing back. If you pay two premiums and don’t pay the third, you can lose 70% of your investment. If you pay five years of premium and don’t pay the sixth, you can lose half your money. See the graph to understand what you get if you lapse or surrender the policy after the first premium.
Who benefits? The agent who takes the hefty first-year commissions that are, illegally, almost the full first-year premium. He encourages you to pay for the next few years so that the company can also make money. Then he sells you a new policy after four or five years to start the cycle again. The company benefits since it is allowed to book “lapsation profits” from your lapsed policies and is allowed to charge very high “surrender” costs—the cost of exiting a policy you don’t want anymore. The shareholders of insurance firms benefit as they see the profits are increased share prices. Who loses? You, the investor in the insurance policy.
How do we know that people don’t continue their policies and get at least a tax-free 3% return? Irdai discloses only the 61st month persistency and that is less than 50%. This means that half the polices sold in a year don’t survive five years. Industry insiders say that the persistency numbers for the 12th year and beyond are between 10% and 20%. This means very few people hold their policies till maturity, giving insurance firms plenty of cream to eat off the savings of households.
This is a gigantic regulatory failure. At the minimum, we need better disclosures from Irdai. Why can it not disclose the number of policies that complete the term they were bought for. The old insurance blame game that points a finger at the investor is past its sell-by date. It may have worked in the 60s and 70s, but it is fully unfair to blame the victim in 2020. Why can’t Irdai use the metric of sum assured rather than premium gathered to rank companies? Why can’t the regulator ask firms to give a disclosure of an annual rate of return that people can understand rather than the gobbledygook they currently use to obfuscate, cheat and rip off safety-seeking households.
What you should do? Just do not believe any sales pitch to do with traditional insurance plans. The only product you need is a term plan. And those over 60 do not need any insurance policy at all. So please stop your parents’ retirement money getting stuck into these traps. Just stay away.
Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation
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First Published:2 Sep 2020, 11:06 AM IST
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