Before the advent of unit-linked insurance plans, it was traditional insurance products such as endowment and money-back policies that were the most popular options. But once private insurers moved in, they changed the dynamics of the insurance sector with unit-linked insurance plans and are gradually eclipsing the traditional products.

However, the market meltdown in 2008, lower persistency ratio (number of years investors stay with the policy) and fast-paced regulatory changes in ULIPs have recently forced insurance companies to change their product mix and traditional plans are back again.

Features

Traditional products are considered to be long-term products. The final benefit amount is payable either at the end of the policy term or upon the death of the insured person, whichever is the earlier. Thus, traditional plans are a mix of insurance and savings. However, traditional products such as endowment policies usually yield low returns. Without including tax benefits on the premia paid, the IRR (internal rate of return) — a measure to evaluate the yield on the investment — may not even match inflation.

Bonuses

Traditional products such as endowment and money-back policies are “participating” policies. In a participating policy, the policyholders may get an addition to their policy by means of “bonus” declared every year based on the surplus available in the pool of money managed by the insurer. Besides that, they may become eligible for terminal bonus (based on insurers investment return) provided the policyholder continues to pay premium throughout the policy term.

So, in any traditional policy arriving at the maturity value is difficult.

Bonuses are further classified as simple reversionary and reversionary compounded. Under the simple reversionary bonus, the bonus declared will simply be added to your policy whereas in reversionary compounded bonus, just as in compounded interest, the bonus of previous year would also eligible for bonus in future years.

For instance for an individual who has taken a sum insured of Rs 1 lakh, suppose the bonus declared by the insurer for the first year is Rs 40 per thousand, then the bonus for the year will be Rs 4,000. During the second year of the policy, if company declares bonus of 4 per cent, on Rs 1.04 lakh the bonus works out to Rs 4,160 and it would be added to your policy.

A point worth remembering here is that in traditional plans bonus is not declared for the premium paid and is based on sum insured. In traditional plans the bonus is not guaranteed, but once the bonus is declared and added to your policy it will remain throughout the policy term.

Bonus history

Among the insurance companies, LIC has traditionally declared higher bonuses. In 2008-09 for instance, LIC declared simple reversionary bonuses varying between Rs 38 per thousand and Rs 40 per thousand for its endowment type products with a term of 15 years. Let us assume that a male aged 35 bought a Jeevan Mitra policy (double the sum insured) for a term of 15 years his annual premium commitment would be Rs 7311. Ignoring the tax benefits and risk premium paid towards life cover, if the policy declares Rs 40 per thousand bonuses through out the policy term the maturity value would be Rs 1.6 lakh.

That translates into an annualised return of 5.2 per cent provided you have paid all your premia in annual mode. If the premium is paid by any other mode such as half-yearly, quarterly and monthly the yield will drop proportionately due to higher premium.

Alternatively, if the bonus is declared at Rs 35 per thousand (most private insurers declare in such a band) the yield would be 4.5 per cent. If you deduct the entire risk premium paid (Rs 3500) for the sum insured of Rs 1 lakh the return would be 4.75 per cent.

Pros and cons

It is generally observed in traditional products that investors usually pay an average premium of less than Rs 10,000 a year, with the tenure of the policy being 15 years and above. For this premium the sum insured in most cases would be less than Rs 2 lakh. Such a low cover in traditional products would certainly not mitigate the financial risk of individuals.

The yields of 5 per cent generated by the traditional products too are far lower than 10 year average inflation of 5.5 per cent.

Effectively traditional plans may help you save regularly, but they certainly don't help you earn an attractive investment return. It is the tax benefits on such policies that make the returns better.

After accounting for the tax deduction on the premia, returns may go up to 9.6 per cent, 8 per cent and 6.5 per cent for those in tax slabs of 30 per cent, 20 per cent and 10 per cent respectively.

However if tax benefits are withdrawn in line with the new Direct Taxes Code, returns on traditional plans may drop. As per the Direct Taxes Code Bill if the premium paid is not one-twentieth of the sum insured, the premium paid would not be eligible for tax deduction.

Assuming an investor saves in PPF (interest is 8 per cent) the same amount every year at the end of 15 year his corpus would be Rs 2.15 lakh thus an additional return of Rs 55,000 (resulting in an IRR of 13.3 per cent for those in 30 per cent slab).

Hence small investors planning to achieve the financial goals would be better of with a combination of PPF and term insurance rather than buying a traditional plan.

Having said that small investors should understand that due to higher surrender charges in traditional plans lapses in such products are lower. That is why they may enforce discipline on savings.

Suresh Parthasarathy

Source : The Hindu Business Line