Traditional plans of life insurance are those which are not linked to the market. Unlike ULIPs traditional plan gives a fixed maturity/survival benefit and bonus, barring the term plan. This looks lucrative and beneficial but the reality is very different. In this article, I will be explaining the cons of a traditional plan except for a term plan. I am a firm believer in keeping my insurance and investment separate, but during the initial years after college, I too bought into the promises of an endowment plan.
Traditional plans are usually promoted by advertising the exact amount of return and never the rate of return. So, what is wrong with traditional life insurance plans? Unlike mutual funds, the expense ratio determined by the regulatory authorities for traditional plans is quite high. Added to this a hefty commission given to insurance agents also eats into the premium paid. Both these factor adds up to a very low rate of return these plans offer to their customers. Even this low return is available after more than a decade and thus inflation further reduces the actual value of the return customer gets. The operational costs, commission and returns eat up a major chunk of premium so the insurance amount is very low in comparison to term plans.
What are traditional life insurance plans?
The life insurance plans are broadly divided into market-linked plans and traditional plans. This means that any insurance plan which does not include direct investment into equity/bonds is a traditional plan. The traditional plan offers a certain fixed maturity/survival benefit and bonus, which is declared yearly by the company.
The traditional plans itself has been divided into different types.
- Term plan
- Money back policy
- Endowment plan
- Whole life insurance
- Child plan
- Retirement plan
Though these might look different but based on how they work they are only of two types. The term plan is a pure insurance plan where you pay the premium and you are insured for the time period of the policy. No amount is available at the maturity of term plans. Whereas all the other plans provide a certain fixed amount paid at maturity or on completion of a pre-decided benchmark and insurance. A bonus is also added to the amount paid to the customer which is not fixed and is declared by the insurance company.
Term insurance plans are the most basic plans and I highly recommend, you go for them only. There are minor differences between the term plans of different companies. The simplicity of these plans makes possible for all customers to compare them and make an educated purchase. For this article when I say the traditional plan, it means all traditional plans except term plans.
What is wrong with traditional plans?
You might have gotten a chance of meeting an insurance agent. I myself have sold a few traditional insurance plans. A uniform pattern of marketing the traditional life insurance plan is to talk in the exact amount. What I use to do and what most agents do is mention the amount of premium, no. of years of premium payment, and the amount you will be getting back. Nobody tells you what is the rate of return. In reality, return that traditional plans provide are around 5 – 6%, sometimes 8% and some have even provided 2 – 3% returns.
When you take a look at the actual rate of return and then compare the insured amount with term plans, the euphoria vanishes. What causes this low return and why it is good to avoid traditional plans?
The high rate of commission
IRDAI in the past few years has made the commission structure for traditional plans uniform. The upper limit for the commission is decided by IRDAI and company can give any commission within this limit. But, if we look at the things from the perspective of customer these commission rates are quite high. An insurance company can pay around 30 to 35% of the premium as commission in the first year, depending on the premium payment term. After the first year, the commission is around 7% of the premium paid.
What this result is that insurance company has less amount to invest and thus can offer less return to the customer. Take an example, you paid Rs 10,000 as a premium for a policy. If you expect 7% return from first-year premium, i.e. Rs. 700, the insurance company invest only Rs 7000 and has to make a 14% return.
Expense limit for insurance companies
An insurance agent would clearly defend the commission structure. Even a common person can argue that after the first year the commission comes down. But the commission is only one part of the problem. Any financial institution which collects money from its customer and invests it, thus making money for the company and the customer, incurs some expenses. These expenses include commission but are not limited to it. In case of mutual funds the expense limit is set by SEBI and in case of insurance it is set by IRDAI.
SEBI keeps updating the expense limit for mutual fund and currently, it is lower than 2%. But in case of insurance, the expense limit can be up to 90% of the first-year premium and anywhere from 15 to 20% in subsequent years. This means that the insurance company can use up to 90% of your first-year premium for management expenses, commissions, promotion, etc.
Let’s go back to our example, this time let us assume you pay Rs 10,000 for 3 years, i.e. total Rs 30,000. You expect 7% return, i.e. Rs 2,100, but the company has only 1000 + 8500 + 8500, i.e. Rs 18,000. The company has to make a 78% return. This is based on absolute return, the third premium will have less time thus will have to make way more return. The first premium which is invested for the largest period is the smallest amount.
Actual expenses are usually lower than this limit, and the term is way more than 3 years, thus the rate of return required decreases. But, in any case, it is quite high
Very low rate of return
The high expense ratio (a large chunk of which goes in commission) result in less amount left with the company to invest. The insurance company cannot and should not pay you returns out of their pocket. Insurance company subtract the expenses from your premium and invest the remaining amount. The return that the company makes, a part of it forms the profit of the company and the rest is given to customers.
The requirement of making huge returns just to provide a 6 – 7% return to customers puts a limit on an insurance company for what they can offer. In reality, many traditional insurance plans offer rates even lower than Fds, Rds, and PPF.
Long maturity period
The traditional plans are of very long durations. If you take a look at LIC the maturity term of their most popular traditional plans ranges from 15 to 20 years. A return of 6 – 7% that also after 2 decades make these policies even more absurd. What many people don’t realize is that the value of money reduces every year, this is due to the rate of inflation. A return Rs 50 lakh may sound tempting, but you will get these after 20 years. At 4% rate of inflation, the actual value of Rs 50 lakh after 20 years comes out to be around 11 lakh.
This further minimizes the value of a small return that you are making. There are short-duration plans which minimize this. Money-back policies also minimize the effect of inflation by providing regular payment during the term of the plan. But even then the effect of inflation plays a major part.
Low amount of death benefit
The prime purpose of an insurance policy is to provide a set amount to dependents, on the death of the insured person. This should be the benchmark on which insurance plans should be compared. But, this the benchmark on which traditional plans fails substantially. The cost of expenses, the assured amount, and the bonus all make the premium so high that the amount of death benefits has to be reduced. Term insurance of Rs 1 crore cost around Rs 500 monthly, you can compare this with any traditional plan of any company, the results are not at all rosy.
Low returns, large maturity period and low death benefits leave a lot to desire on every parameter. The lure of tax saving, doubling of money, and other marketing gimmicks have made these plans very popular. In reality, they offer so little that I recommend you to stay as far away as possible from them.
How to calculate the return of traditional plans?
After reading all this, there will be some people who will question my calculations about the rate of return. To these people I say, congratulations you are on the right path, just remember to ask these types of questions to insurance agents too. To help you in being well equipped for judging and deciding about financial products, let’s discuss how the rate of returns s calculated.
When you make an investment and receive a return, the simplest way is to calculate the absolute return. You can do this using this formula.
Absolute return = (amount received – amount invested) / amount invested * 100
But, there is a problem. An investment which gives 10% absolute return in 5 years cannot be equal to investment doing this in 1 year.
In this situation we calculate CAGR (compounded annual growth rate), it gives us an annual rate of return. You can calculate CAGR using this formula.
CAGR = (((amount received / amount invested) ^ (1 / number of years)) – 1) * 100
But, still, a problem remains. What to do when there are multiple payments for different time periods? This is a case with insurance plans and mutual fund SIPs. For these, we calculate XIRR (extended internal rate of return). If you check the return of any SIP this is what is mentioned under the rate of return. Even if you don’t calculate the above two rates, and just calculate XIRR it will be enough, in fact, XIRR presents the most realistic rate.
The formulae for XIRR is this.
Put this equation equal to 0 and the rate calculated is XIRR.
Wait, before you close this article there is a simple method using excel or any other spreadsheet software.
Let’s take an example, we pay a premium of Rs 50,000 for 5 years and get Rs 4 lakh after 10 years from the start of the policy. Put all the dates of transaction in column A of the spreadsheet. Put the amount of transaction in front of the date in column B. Add negative sign before amount for every transaction you paid to the insurance company. After this use the following formula in a blank cell.
If you have more than 6 transactions, write them according to this pattern. In the formulae just change the starting and ending cell of amount (in this case B1 to B6) and starting and ending cell of dates (in this case A1 to A6).
An agent would have sold this product by saying that you are almost doubling your amount. But, the actual rate comes out to be just 6.87%.
What to do with my policies?
Well if you have realized the reality of traditional plans you must be thinking about all those policies that have been sold to you. You might also be angry with me for ruining your day. First of all, I will apologize and then will help you to decide what to do with your policies.
We will need some figures and will be required to do some calculations.
First of all find out the following details.
- Maturity amount of your policy (MA)
- Surrender value at present (SV)
- Amount of premium still to be paid (PA)
- Number of years left till maturity (T)
- XIRR of your policy (R)
- The premium of term insurance for T years and equal insurance amount (PT)
Now select an investment instrument which can provide more rate of return than R. This can FD, RD, and PPF if you are risk-averse. A debt mutual fund if you can handle some risk. An equity mutual fund for a person with a higher risk appetite.
Find out the value of the amount available for investment (IA), using this equation.
IA = SV + PA – PT
Calculate the maturity value (MV) if you invest IA for T years in the investment instrument of your choice.
If the maturity value of a traditional policy is less than the maturity of your investment instrument, i.e
MA < MV
Surrender the policy, buy term insurance and invest the remaining amount (IA) in an instrument you prefer.
But if, MA > MV, let the policy continue as it is.
I strongly recommend that you learn about different types of investments, return they can offer, level of risk, etc. This will greatly help you in our final recommendation.
KEEP INVESTMENT AND INSURANCE SEPARATE.