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Insurance policy dilemma? Here's help
Sunil Dhawan, Outlook Money
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January 08, 2007

March is a difficult time for  Amit B., a manager in a software consultancy firm. Every year, it is then that this 37-year-old father of two has to make a choice between continuing to pay the premiums of some of his life insurance policies or simply junking them.

A few years ago, an insurance agent had saddled Amit with insurance policies which gave him a total coverage of just Rs 6 lakh (Rs 600,000) at a cost of Rs 60,000 as annual premiums. He overlooked the details of the policies and, in fact, even ignored the insurance covers provided to him. The plans are endowment in nature and for a term of 15 years.

"I am not creating wealth and if that's not bad enough, I am left underinsured despite paying a fairly huge premium," Amit says.

He is not alone facing this dilemma. Many of us are trapped in a similar situation and find ourselves either mechanically renewing the same old plan or reviving a lapsed one.

There are many questions that need to be answered before you write your next cheque to pay your premium. Some such questions are: How many years has the policy already run? What is your total coverage? Do you have any dependents? Are you in a position to generate a higher return than what an endowment plan can offer?

Remember, life insurance plans, especially endowment policies, are long-term contracts. If you have bought an endowment plan, offering almost zero flexibility with returns hovering between 5 and 7 per cent, it is a tough call to exit midway from it. In fact, the exit option does not exist in the first three years of a policy.

The earlier you exit a policy, the higher is the sunk cost (the penalty you pay for an early exit). However, unit-linked insurance plans, the counterparts of endowment policies, offer an exit route after five years at no cost.

If you are about to buy an endowment plan for yourself, it might be prudent to consider a combination of a pure term plan and a public provident fund (PPF). The term plan takes care of your insurance needs at the least possible cost while the PPF earns zero risk tax-free interest of eight per cent.

Endowment plans suit risk-averse individuals and inculcate a habit of forced savings. If you do not have the financial discipline to create wealth through mutual funds and PPF, endowment plans could work for you.

It would be better for someone who has already bought an endowment plan to gather some facts and then take a look at the available options before he decides to pay the premium for his existing policy or renew his lapsed one.

First, he should determine if he needs life insurance. If nobody, such as a spouse or a child, depends on his income, then it's pointless for him to continue with his insurance. Life insurance is protection against lost income -- no more, no less. Similarly, if he is well-off financially, his family may not need an influx of cash if he were to pass away.

Next, he should calculate how much coverage he will need. The amount of money that his beneficiaries will need and the period for which they will need it should be determined. Losing a loved one is difficult both emotionally and financially.

While the emotional void can never be fully filled, the financial loss can be minimised with some diligent planning. All expenses for the covered period, including big-ticket items like college fees and loans, as well as living expenses like clothes and food, should be calculated. As a thumb rule, life coverage should be about five to seven times the annual income.

The most crucial aspect comes now -- choosing a coverage that best suits one's needs. Insurance is first protection, then an investment. Think of insurance in terms of decreasing responsibility, as you get older. You need protection when you are younger and have children to look after and loans to service. You need less protection in the later stages of life when your children are settled and when you are likely to have few or no payments left on your mortgage.

Term life insurance is the simplest way to go -- you pay the premium and are covered for a specific benefit for the period during which you want coverage. When you stop paying, you stop being covered. Term is a much cheaper option in the long run, and you can invest the money you would have otherwise paid for endowment or whole life plans in mutual funds.

Having figured this out, Amit says, "My home loan already provides the tax benefit and a term cover is what I should go for now." The 'junk or not' dilemma is for those who have bought endowment policies and realised too late that despite paying a hefty premium, their long term goals and objectives are going unfulfilled. Those, like Amit, who are wondering whether they should discontinue their insurance policies are left with three options.

1. Let the policy lapse

If you have paid the premium for the policy for less than three years and decide to discontinue it, your policy will lapse and you will receive no benefit for the money you have paid as premiums. The insurance company will retain all the  premiums paid. The sunk cost you bear is the maximum in this situation as there is no cash-back and all your money simply goes waste.

2. Make the policy paid-up

If you have been a policyholder for over three years, you have the option to tell your life insurance company that you don't want to pay premiums anymore. This means that you would be halting future contributions to the policy, but still let it run to maturity.

So, if you discontinue paying premiums after three full years, then your policy can be converted into a paid-up policy for a reduced sum assured. The proportion this reduced sum is to the full sum assured is the same as the amount of premiums actually paid is to the total amount of premiums payable. Even if you make the policy paid-up, its life insurance protection will continue to the extent of the paid-up value until the end of the policy term.

The vested bonuses of this policy will remain attached in full. However, once this policy becomes paid-up, no further bonuses will be attached to it. The sum assured, plus bonuses, will go to the policyholder on the maturity date of the policy; they will go to the beneficiaries if the policyholder dies before the maturity date.

Take, for example, an endowment plan for a sum assured of Rs 10 lakh for a term of 20 years, which has an annual premium of Rs 46,500. Assuming an average bonus of Rs 50 per Rs 1,000 of sum assured over the term of the plan, the maturity value at the end of term would be approximately Rs 20 lakh (Rs 2 million), which yields an internal rate of return (IRR) of 6.83 per cent.

Now assume that the policy has run for six years. After six years, the total premium payout would be Rs 2.79 lakh (Rs 279,000) and the bonus accumulated would be Rs 3 lakh (Rs 300,000). This makes the policy worth Rs 5.79 lakh  (Rs 579,000) after six years. However, the policyholder cannot access the money till the term of the policy ends.

The sum available to the policyholder at the end of six years is Rs 6 lakh (Rs 600,000), including the paid-up sum assured and the bonuses till the sixth year. Now, suppose there is no premium payout from the seventh year till the twentieth year. The IRR then comes to 4.28 per cent.

Although the IRR that the policyholder might earn by continuing the plan would be higher than what he gets by going the paid-up way, it will be better for him to take the latter course of action if he has alternative avenues to earn a return higher than six or seven per cent. By making a policy paid-up, you get a lower payout on maturity, but you also avoid penalties that accrue if you stop the policy completely.

3. Surrender the policy

The surrender value of a policy is the cash value that you receive if you exit from the plan before its maturity date. Policies acquire a surrender value after premiums have been paid for three years. The closer you are to the maturity date of your policy, the higher is the amount you get when you exit. There is a guaranteed surrender value of 30 per cent of the total premiums paid subsequent to the first year. The insurance company may also pay a special surrender value, which is higher than the guaranteed surrender value.

In the example mentioned above, let us assume that the policyholder wants to surrender the plan in the sixth year. The premiums paid till the sixth year amount to Rs 2.79 lakh (Rs 279,000). Hence, the surrender value at the end of the sixth year is Rs 80,000, just 28 per cent of the invested capital.

Suitably impressed, Amit, on his part, has decided to dump the low-yielding endowments and get a term cover of Rs 25 lakh with a premium of Rs 10,000 per annum. "A major chunk of my investments would go into mutual funds now as I can invest for the long-term," says Amit.

The point to be noted here is that in an endowment plan, it takes eight to nine years for your policy to reach the break-even point. A word of caution: do not surrender your policy if it is approaching maturity, hold on to it instead.

If you feel that you may recover the premiums lost by actively managing your portfolio in the future or by other means, buying a term plan and investing in a mutual fund could be the ideal way of building wealth in long term. The sunken premiums can be considered a one-time cost.

Balance is key to life insurance. If someone has too little life cover, his family may face a financial crisis if he meets an untimely death. At the same time, having too much cover is an utter waste of money.

Therefore, knowing how much you need and what type of coverage is best for you is critical. If, after figuring these out, you find that you have policies that are only a strain on your resources, think about junking them. Carrying no baggage is anytime better than carrying bad baggage.

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