The recent spat between the Insurance Regulatory and Development Authority of India (Irda), the insurance regulator and the Securities & Exchange Board of India (Sebi), the stock market and the mutual fund regulator, seems to have hit the sales of unit-linked insurance plans (Ulips).
Agents and insurance companies are now promoting endowment insurance plans instead of Ulips. But these remain a bad form of investing. To know why, read on.
What is endowment insurance plan?
In an endowment policy, the policyholder is insured for a certain amount, referred to as the sum assured. A portion of the premium goes towards this insurance cover. Another portion helps meet the administrative expenses of the insurer. And a third portion is invested by the insurance company on behalf of the policyholder. The return the insurance company makes on the invested portion is distributed to policyholders as an annual bonus. The annual bonus is declared as a proportion of the sum assured. So if sum assured is Rs 10 lakh and a bonus of Rs 5 per Rs 100 sum assured or 5% is declared, the insurer is effectively declaring a bonus of Rs 50,000 (5% of Rs 10 lakh). The bonuses rarely go beyond 5-6% primarily because the investments are made in relatively safe debt securities. Since the risk taken is low, the return generated is also low.
How agents mis-sell it?
Let us consider an endowment policy of 25 years, with a sum assured of Rs 10 lakh, taken by 30-year-old individual. The annual premium on such a policy will work out to around Rs 40,000. So if an insurance company declares a bonus of 5% on the sum assured, it would mean a bonus of Rs 50,000. Now, Rs 50,000 is greater than the annual premium of Rs 40,000. And if a company continues to pay a bonus of greater than Rs 40,000 every year, the bonus being paid will be greater than the annual premium. This feature of the endowment plan it what the agents turn into a marketing gimmick. A typical agent is likely to tell you, "Sir, the insurance company always declares a bonus of more than 4% (Rs 40,000) every year. So the bonus you get every year will be more than the annual premium you pay to the company. Isn't that marvellous?"
Here's what the agent does not tell you
The agent works for the insurance company and not you. Hence, he does not tell you the real thing. What you, as policyholder, do not know is that the bonus, unlike a dividend, is not paid out every year. The bonus accumulates and the policyholder gets it along with the sum assured at the maturity of the insurance policy. So let's extend the example above. Assuming the policy declares a bonus of 5% every year, over 25 years, you will get a bonus of Rs 50,000 every year.So at the end of 25 years, you will get Rs 12.5 lakh as bonus (Rs 50,000 x 25). You will also get the Rs 10 lakh sum assured as well, for a total of Rs 22.5 lakh (Rs 12.5 lakh + Rs 10 lakh).
So what is the problem?
The biggest problem with the bonus is that it does not compound, and is merely an accounting entry that accumulates. What this means is that in the above example, the bonus of Rs 50,000 would stay at Rs 50,000 till the 25th year, when the policy matures. This would be true of all bonuses declared during the term of the policy (if they are declared). So if you survive the policy period, the insurance company would give you Rs 22.5 lakh in total.
What are the returns you can expect?
A payout of Rs 22.5 lakh at the end of 25 years, would imply a return of 5.78% per year, which isn't great shakes by any stretch of imagination. Even if we were to assume an average bonus of 6% every year, the total amount paid at maturity would amount to Rs 25 lakh (Rs 10 lakh as sum assured + Rs 15 lakh as bonus) with a return of 6.48% per year.
Is there a better way to go about it?
The moral of the story is that the point about bonus paid out during a given year being greater than the premium paid, isn't really relevant. It is just a mis-selling trick.
A better way to go about would be to take a term insurance policy of Rs 10 lakh and invest the remain-ing money (i.e. the difference between the premium being paid in case of the endowment policy and the premium paid on the term policy) into the Public Provident Fund (PPF), which guarantees an interest of 8% per annum. A term insurance cover of Rs 10 lakh in this case will cost around Rs 3,200. If the remaining Rs 36,800 is invested in the PPF account earning 8% every year, at the end of 25 years, a corpus of Rs 27 lakh will accumulate. This is Rs 4.5 lakh or 20.5% more than Rs 22.5 lakh.
Of course, the advantage of taking on term insurance is that by paying a little more money you can also increase the amount of life cover. By paying around Rs 4,600 per year, the policyholder can get a term insurance with a cover of Rs 15 lakh. This is Rs 1,400 more than the premium for a cover of Rs 10 lakh. An endowment insurance plan will require a premium of Rs 15,000-20,000 more over and above, the annual premium of Rs 40,000.
