Nobody gives u sky-high returns for the simple reason... It’s not always tell & sell

Traditional policies make for a large chunk of the business for life insurance companies. But unlike ULIPs (unit-linked insurance plans), these policies are opaque — the investment book is kept in the dark and costs are not disclosed. Your agent may not tell you several things while trying to draw you with the candies of ‘doubling money’ and saving tax.

Demystifying traditional policies

Every life insurance company has a few plans in its portfolio under the savings category.

Savings (or endowment) products include ULIPs — unit-linked products where returns are linked to the market, and traditional plans — which are categorised as participating and non-participating plans.In participating plans, policyholders get a share of profits from the investments of the insurance company that is declared as a bonus. In non-participating plans, policyholders don’t get to share profits, but returns are guaranteed upfront. In traditional plans, since the risk cover is minimal, they are not the best option for people looking for life protection.The life cover that traditional plans offer may be, at best, 10 times the premium. But if you take a plain-vanilla life insurance policy (where there is only insurance and no ‘savings’), the risk cover could be substantial.

Here are a few things that the agent may not discuss with you when coaxing you to sign up for a traditional plan.

The hidden costs

Insurance companies are not mandated to disclose agent commissions to policyholders. In fact, in traditional policies, you cannot even know the premium allocation charge, the administrative costs or mortality charges on the policy. The difference between the gross (which is the 4 percent or 8 percent) and net return (IRR) that can be deciphered from the benefit illustration can give you an idea about the expense ratio, but you won’t get to see the breakup of costs. Agents may also not discuss surrender charges with you. In traditional policies, there is no ‘lock-in’ on the investment, but surrender costs are high. They may be as high as 70 percent in the initial years as all costs are frontloaded (unlike in ULIPs where they are spread out). Surrender charges are disclosed upfront in the policy document but do not find a mention by agents.

IRR: the real return

In case of traditional insurance plans, agents make tall claims of doubling money. This is not true. The average returns of most non-participating endowment plans come to about 4-5 percent. In HDFC Life’s Sanchay, a non-linked non-participating plan, for instance, a 45-year old male who pays ₹1.5 lakh per annum premium for 10 years, will get maturity proceed of ₹28 lakh at the end of 20 years, which works out to an IRR of 4 percent. Agents mislead customers by holding the maturity value of the policy against the premium for comparison. In endowment insurance policies, as the premium payment (cash outflow) happens in the initial years and the maturity proceeds are received in instalments spread over a 5-10 year period or as a lump sum after 10-20 years, one should also account for the time value of money. The IRR (internal rate of return) is apt for capturing the actual returns in endowment policies as it calculates the net present value of all benefits received at different points in time and then compares it with the initial investment. Calculating IRR is no big deal. Many online calculators are readily available. You can even do it on the spreadsheet on your computer through the IRR function.

BI, a mere illusion

In any savings product, it is the return that attracts investors. Both participating and non-participating plans give a ‘benefit illustration’ (BI) in the policy document to give investors an idea about the maturity benefits. In non-participating plans, since the maturity benefit is fully guaranteed, the value of the investment at the end of the term is disclosed in the BI. However, in case of participating plans, insurers show two scenarios — between 4 percent and 8 percent return — to indicate the likely benefits under the plan.

Beware! Do not take this return at face value. It is only for illustrative purpose and, not what the insurer guarantees on your investment. Until 2013, insurers used to draw the illustration based on the assumption of 6 percent and 10 percent growth. In participating plans, there is actually no way of knowing the returns as it depends on the bonus the insurer will declare. The benefit illustration in these policies will be used only to understand the expenses under the policy. Say, on the assumed 8 percent return for a policy, the IRR works out to 5 percent, it means that the product eats away 3 percent of your return on various expenses. This 3 per cent is the product’s expense ratio and can be used to compare with other endowment plans on how they fare on the cost front.

Bonus not guaranteed

It is the bonus which insurance companies declare out of their life fund that makes up for returns of policyholders of participating plans. They get some guaranteed additions (GA), but that is very little, that generates a 1 percent IRR. While agents project bonus as a guaranteed benefit, it is not. Insurance companies are required to declare bonus to their participating policyholders only when they make a surplus in their investment fund.

In accordance with IRDAI regulations, insurance companies have to share the surplus between policyholders and shareholders on a 9:1 ratio. So, you get the bonus only in good years of the company. The bonus rate may also differ each year depending on the profits of the insurer. Bonus rates also depend on the interest rate cycle in the economy as participating policies invest their money largely in debt instruments. In the last few years, with G-sec yields dropping, the bonus declared by insurance companies has also been moving south. Sample this: Between 2014 and now, the yields on 10year government bonds have fallen from 9 percent to 6.8 percent. In case of ICICI Prudential’s Savings Suraksha — a non-linked participating insurance plan, the reversionary bonus (for regular pay policies) has fallen from 2.25 percent in 2014 to 1.75 percent in 2017. The bonus declared by insurance companies is generally a percentage of sum assured (SA). Most companies give a simple reversionary bonus. Only a few, including ICICI Prudential, give a compound reversionary bonus where, from the second year, the bonus declared is on the SA plus the previous year’s bonus. Generally, there are two types of bonus — reversionary (which is the regular annual bonus declared every year) and terminal bonus (which is declared upon surrender or maturity of the policy or on the death of the policyholder). At the end of the policy term, the sum assured on maturity along with GA and the reversionary bonus accumulated over years and terminal bonus will be paid.

Debt-heavy portfolio

Investors need to understand that traditional endowment plans can’t give sky-high returns for the simple reason that they invest only in debt instruments. IRDAI rules have it that at least 50 percent of the total assets of life insurance companies should be invested in government securities (G-secs) or government-approved securities and at least 15 percent in approved housing and infrastructure bonds. Only 35 percent or less is allowed in equity.

In traditional plans, however, a substantial portion (almost 80-85 percent) of the investment is in fixed income securities. In non-participating plans, since the return is guaranteed, insurers put even higher sums into debt instruments.

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