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Personal finance - Title : All You Want to Know About Life Insurance

Tags: Insurance policies, what is a traditional policy, what is a ULIP, What is a term policy

Meta description: A detailed article on life insurance. Talks about the policies that should be avoided. It talks about why term insurance is a good option.

Snippet: Insurance – an obvious, but neglected need Life insurance is something every bread-earner needs. After all, who has seen tomorrow? Wouldn’t you want your family to have a similar lifestyle even if there were to be an eventuality? Very likely your kids have several years of studies to go before they can stand on their own feet. Some of your may have retired and dependent parents. Some of your assets like home and car may have loans running. The thought of an eventuality is so unpleasant that we don’t want to think / hear about it. In the process, we often miss out on life insurance. But in reality, as a popular ad goes, it is insurance that will make us more worry-free and hence help us live healthier and longer! The important thing in insurance is (obviously) the life cover you have. There is no need for detailed calculation of how much insurance you need. There is ample reason to have about 4-8 times your annual income as life insurance. Four times is enough if you are unmarried or have fewer dependents. Eight times is needed if you have children and any loans being repaid. Contrary to what you may hear in some misleading ads, you don’t need life cover for children or for the aged in the family. They will often been nominees, not the life being insured. After all, life insurance is about protecting the income of the bread-earner – it is not about making a financial profit from death. Thus, the prime working age of between 25 and 55 years of age is when people require the maximum insurance. In this period, several people depend on you. You are still in the process of building assets and retirement savings. Thus, it is crucial to protect your life. Beware of being cheated! Life insurance being so critical to your life, it is unfortunate that this is the most poorly regulated, unethical and fraudulent market in the country. Products that are sold you to are irrelevant or outright harmful to your financial health. The good and appropriate products are never sold. This sad state of affairs has been brought about by a combination of poor customer literacy and an unscrupulous agent network that has been given wrong incentives. What you will often be sold by banks, agents and brokers of all hues are either traditional ‘LIC’ plans, or unit linked ‘ULIP’ plans. As we shall see in the next couple of sections, both

these are not only useless in giving you life cover, they actually amount to a swindle of your hard earned money. We shall see all of them in details: Why Traditional (Endowment / Whole-life) Insurance Plans Are A Bad Idea Traditional insurance plans have been sold to us by LIC for decades. Endowment and whole-life plans are two common types of traditional plans. Both are relatively similar for the purposes of our evaluation, so we will treat them together here. If you have a life insurance plan older than a decade, nine-on-ten it’s a traditional plan. Those were the days when every youngster getting a job was immediately advised to ‘take an LIC’. Agents of LIC were numerous, some of your neighbours or cousins counting among them. A traditional life insurance policy – an endowment or a whole-life policy – was promptly sold to you. You happily kept this policy for decades, paying premiums when reminded; unaware of how to make sense of it, let alone compute returns. Then, you had no choice. Some policy was better than no policy – after all, it atleast inculcated the saving habit in you. However, with a much broader choice today, we can look at why you better not go for such products any longer. What are Traditional policies? A traditional life insurance policy combines a life insurance cover with investment. It has a longish tenure with annual premiums – often 15 years or more. A small part of your premiums goes towards what is called ‘mortality charge’ – this covers your life. The rest goes into the company’s fund. In a traditional plan, this fund is only kept in debt (no equities). The focus is towards safety and keeping the corpus safe, even if this means lower returns. Such plans are therefore also called non-unit-linked or non-participating plans. A useful point to note is that it is not your money that is directly invested to earn a return. Instead, your money goes into a broader fund managed by the company, containing monies of several investors such as yourself. Also, there is no direct mapping between the performance of this fund and your returns (though indirectly there is an influence). What is finally paid out to you from this fund is called by different names in the market – accrued bonuses, guaranteed additions, etc. But remember, all this is in debt, so your expectations need to be tuned accordingly. Thus, only two factors matter for you as an investor to analyse such a scheme:

1. What life cover is provided, in lieu of your premium 2. What annual returns such funds are known give over the long term Let’s look at the performance of traditional plans on both these parameters. Insurance in a Traditional Policy Most traditional policies have life cover between 15 to 25 times your annual premium. To give you a benchmark, a term insurance plan has a cover exceeding 500 times your annual premium. The reason for this difference is the fact that most of your premium goes into the fund, leaving little for mortality charges. A second equally important reason is that most of your premium goes off to pay commissions to your agent, leaving little for the life cover. Whichever way, the net result is that your life is grossly under-covered. While a life cover of four times your annual income is the barest minimum your family needs, an endowment plan would often have less than a tenth of this. Unfortunately, your agent is paid based on the premium collected and no on life cover, so he won’t bother to recommend a better plan to you. Returns in a Traditional Policy Debt itself gives only 6%-7% annually in the long term. A traditional plan has a host of other charges to pay out, and has to pay hefty commissions to your agent. Thus, what is left for you as an investor is only 4% or less. What is worse is that this performance is completely opaque – you will never be given accurate information on how the fund has done and how bonuses are. You only have historical data of other investors and schemes to go by. And all these paint a dismal picture. The most optimistic estimate of your long term return is about 4%. A number only half that of fixed deposits, let alone market investments. Flexibility in a Traditional Policy A traditional plan scores very poorly on flexibility too. Your investments are locked in for a decade or more, with severe penalties on withdrawal. Even here, there is no clarity on what you would get if you surrender a policy. You can only fill the surrender form, hope for the best and be happy with whatever you get. Undoing damage of already existing Traditional Policy If you have the misfortune of having already started a traditional policy, you may need to act to limit the damage. As said above, the insurance company provides no transparency on what your policy is worth or what you would get on

surrender. Yet, based on our experience, we recommend the following:

Keep paying regular premiums in the policy for the first five years

Once five years are up, write to the insurance company for surrender

You will get most of your invested money back, or emerge with a minor loss. However, this is far better than keeping your money in such a losing proposition for another decade or two. You can quickly recoup your loss and put your money to far better use once it is out of this jam Summary In summary, traditional insurance policies are a disastrous idea – pushed by companies and agents to fatten their own wallets. They score very poorly on investment, insurance and flexibility metrics. You would do well to avoid them altogether. If you already have one, you should act to surrender after the first five years, thereby limiting your damage. Why Unit Linked Plans are a bad idea The last decade has seen an explosion in unit linked insurance plans (ULIPs) sold in the Indian market. These are known by various names – child plans, pension plans or even fanciful ones like ‘Platinum Premier’, ‘Highest NAV’, etc. We have seen aggressive ad campaigns in the media, persuasive selling by banks and powerful push by agents and brokers. Recently ULIPs have been in the news because the regulator has tightened the norms and reduced the rampant misselling that was happening. Does this mean these plans are good for you now? Let’s see how these plans work, why they are sold so aggressively and whether they make any sense for you. Basics of the ULIP A unit linked plan combines life insurance with an investment. A part of the premiums you pay goes towards what is called the ‘mortality charge’ that gives you a life cover. The rest of the premium goes into a fund in your name. This fund is usually invested in the equity market. Your investment corpus is then fully determined by how this fund does, and by what further charges are applied by the insurance company to manage this fund. Thus, while life insurance is provided by the insurance company, fund returns are not. For fund returns, the policy is only a vehicle. Your returns are simply a function of the markets, less the charges. Insurance in a ULIP ULIPs are notorious for carrying a very low life insurance cover. In fact, most policies carry only the minimum life cover that the regulator forces them to have. It is ironical, and indeed farcical, that a life insurance policy should have such a low cover, and should focus on investments instead. The earlier minimum cover specified by the regulator was five times the annual premium – and this is what most policies had. From 1 September 2010, for fresh policies, the cover is a minimum of 10 times annual premium. But even this is too small. In contrast, a simple term life insurance policy has a cover exceeding 500 times annual premium! Some unit-linked plans – like annuities and pension plans – may not have any life insurance at all. You should check for this carefully in their product brochure. If there is no life cover, the very phrase ‘insurance policy’ is a misnomer – you would rather invest in a mutual fund. Thus, even if you already own several insurance policies, you should add up the total life cover these give you. If it is less than four times your annual income (likely if there are too many ULIPs), it is highly inadequate. You should take an inexpensive term life insurance plan to give you this life cover first. Investment portion of the ULIP ULIP funds invest in equity, debt, or a mix of the two. In this, they are very similar to mutual funds. However, the charges that ULIPs levy on various aspects of premium allocation and fund management are often far higher than mutual funds. Thus, even if the two funds do similarly in the market, your returns on ULIPs are poorer. For instance, mutual funds charge no entry load – so every Rupee of your investment goes into the fund. In contrast, a ULIP charges anywhere between 10% and 60%. So, for every Rs. 100 that you pay as premium, only between 40% and 90% goes to the fund. These charges are especially high in the first three years of your policy. Thus, even if the ULIP fund does well, your returns often stay negative. Most of this money has gone to the pocket of your agent or bank who sold you the policy. No wonder they were pushing the product so hard! ULIPs hide this problem through a complicated reporting system. Unlike mutual funds, you will find it difficult to get a single page summary of what you have invested till date and what it is worth today. By the time you realise the

enormity of the fraud, it would be several years. Flexibility in a ULIP ULIPs are poor on the flexibility front. They offer the ‘flexibility’ to switch between investment funds several times a year – but this is a useless feature. Indeed, you will want your investment fund to stay consistently invested in equity over the long term, for you to make good returns. In terms of freedom to withdraw or even transparency of reporting, ULIPs score badly. Undoing damage of existing ULIP If you have already made the mistake of investing in a ULIP, you need to act to minimise the loss:

Make sure you pay premiums for the first three years

Thereafter, you should pay no further premiums

After the lock-in period is over, redeem the ULIP for whatever it fetches you, and invest in a mutual fund instead Needless to say, avoid any fresh unit-linked policy – no matter what fancy name it is called by, and how much the agent pushes you to buy it! Term Insurance Plans Term insurance plans are a great idea. Here, you pay a small premium every year, in return for a large life cover. All life insurance companies have a term insurance plan on offer. While they are great for the customer, they do not give your broker much commission. So do not be surprised if your agent / broker never mentions term plans to you, or tries to downplay their utility! There is no concept of investment or returns in a term plan – you get no money back as long as you live. While this sounds strange, the fact is that insurance plans are not meant for returns anyway! They are there to cover any eventuality. There are plenty of much better options to take care of your investments and returns, and we shall come to them in due course. Since term plans do not mix insurance and investment, they end up being cheaper, simpler and more flexible for you.

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