Terms, bonus, sum assured: Making sense of life insurance policies

Insurers' products are complex; investors must have a rational expectation about the returns they will get

An investor forwarded me a traditional life insurance product and asked me whether he should invest in it. I had to evaluate purely from the point of view of returns or suitability as a fixed income investment. The investor didn’t need life cover.

Breaking down a life insurance product is not easy. There are so many terms, bonuses, loyalty additions, sums assured and much more. There is a play on the timing of payments, too.

I wondered why these plans are so complex and what could have the insurance company done to make it easier for the investor to decide on his own (especially if the investor is assessing the suitability purely as an investment product)?

In this story, I will focus on the traditional plans: Participating and non-participating. I will specifically mention when I am referring to a ULIP. I have not named the product because the issues are relevant for the entire product category.

Life insurance products

These are not pure investment products and offer life cover. Hence, the cost of the life insurance product must be accommodated somewhere. In traditional plans, this is inbuilt into the product benefits. 

Yes, there is a maturity date but there are contingent payouts too. Or the policy may not continue until maturity. For instance, if a policy holder passes away during the policy term, the payment is made to the family and the policy is terminated. There must be an objective formula to calculate the payout in such cases. That’s why you have bonuses/loyalty additions etc. that gradually accrue to the policy. These numbers can be used to arrive at the final payout in the event of an untimely demise.

While these numbers (calculation of bonuses) may be opaque, the calculation of the final payout is quite unambiguous once you have these numbers.

Mutual funds or any other pure investment products don’t face such issues. In pure investment products, the nominee is paid the current value of the investment. 

Surrender (or paid up) option

I think this is the most difficult part. Even if I have the policy document, I will struggle to calculate the payable value if the investor were to surrender the policy midway. There are complex tables to arrive at the surrender values.

By the way, the front-loaded nature of the intermediary commissions makes the premature exit or surrender extremely expensive for the customer.

When you ask the insurance industry, you will get the usual refrain about how such penalties help investors maintain investment discipline and stick with the policy. 

ULIPs (at least the new age ULIPs) can also make a similar argument, but they don’t have heavy exit penalties.

The Insurance Regulatory and Development Authority (IRDA), the industry regulator, has not capped the surrender costs for traditional plans. On the other hand, IRDA does not permit exit charges for ULIPs after completing five years.

Tax angle

Life insurance maturity proceeds are exempt from tax only if the death benefit is at least the annual/single premium. Hence, in single premium plans, there are two variants. First, where maturity proceeds are tax-free and the other where they are not.

In regular premium plans too, you will see this aspect complicating things. You have multiple types of sum assured. One for demise (this one is usually at least 10X annual premium). Another to calculate your bonuses.

When you start adding these provisions in black and white, it adds to the complexity. Still, the insurance companies can make it simpler.

Most insurance companies have online calculators on their websites where the prospects can generate customised illustrations. Such illustrations show all cashflows/benefits or how bonuses will accrue to you during the policy term.

But the illustrations don’t reveal the XIRR (net returns) if the product is held until maturity. I have never seen an illustration that depicts XIRR. You would wonder why. After all, XIRR would make it easy to compare against other competing products.

I understand you cannot calculate returns upfront for the traditional plans and ULIPs. Why?

Because ULIPs are market-linked and we don’t know how the markets or ULIP funds will perform.

Participating plans have bonuses – reversionary and final – which can’t be determined upfront. But there is another category of traditional plans (non-participating plans) where you know everything when you buy the plan.

In a non-participating plan, you know down to the last penny about how much you will get (and when) if you hold the plan until maturity or if the demise happens during the policy term. And the insurance companies know this better than you do. Still, the insurance companies don’t show XIRR for illustrations in such plans.

If you want to understand the differences between the different types of traditional plans (participating or non-participating) and ULIPs and how to spot them in quick glance at a product brochure, refer to this post.

Why don’t insurance firms show XIRR?

There are two reasons. Firstly, for participating traditional plans, it is not possible to calculate XIRR upfront. However, IRDA mandates that the insurers depict the policy payouts for assumed gross returns of 4 per cent and 8 per cent per annum (p.a.). But we need the net returns. If the insurer could show how much net returns (XIRR) an investor would get for the assumed gross returns of 4 per cent and 8 per cent p.a., we can assess the impact of costs.

The investor I referred to earlier, is a senior citizen and had sent me illustration for a participating plan. I calculated the XIRR for the plan for him. It came out to around 3.5 per cent p.a. (for the assumed gross return of 8 per cent p.a.). Clearly, the plan has high costs. If the XIRR was mentioned in the document, he wouldn’t even have to reach out to me. He would have rejected the product right away. Not everybody has access to professional help.

In any case, the above excuse does not apply to non-participating plans. For such plans, XIRR can be calculated upfront and shared in the illustration.

And this brings me to the second reason: Low returns. Remember “low” is subjective.

Would you invest in an investment product where you know upfront that you will earn 3-7 per cent p.a. over 30-40 years?

Many would not.

I am not saying 3-7 per cent p.a. is a poor rate of return for a fixed income product. In fact, there have been instances in the past where I have asked investors to invest in a non-participating plan (due to their specific requirements). But clearly, a low return does not make for an exciting sales pitch. I do not deny the return expectations of investors can sometimes be irrational.

(The writer is a Sebi-registered investment advisor.)