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Good in small doses

Though popular with investors, traditional plans have limited utility and should not be your only source of insurance.

R. Sree Ram        Print Edition: July, 2010

Who says you can't have your cake and eat it too? Dibyendu Kumar Roy, 32, thought he had done just that by buying a Ulip and a wholelife assurance plan. The policies gave him the best of both worlds, investment and protection. While the Ulip offered equity exposure, the wholelife assurance plan gave him guaranteed returns. However, four years later, Roy discovered that he had been shortchanged in one crucial aspect—insurance.

The Ulip's life cover is merely Rs 75,000, whereas the sum assured in the case of the traditional policy is a little higher at Rs 1 lakh. This, for a man whose annual income is Rs 8 lakh, 4.6 times the total sum assured, and who has two dependants. Obviously, it falls dreadfully short of covering his life.

Roy compounded his mistake by buying one more wholelife assurance plan, which offers a cover of Rs 5 lakh. Though his life cover increased to a reasonable Rs 6.75 lakh, the premiums for the two traditional policies zoomed to Rs 60,593 a year. "I want a policy that covers me for the longest possible tenure and returns my money on maturity. The income is low, but I am covered for a 100 years," says Roy. His second wholelife assurance plan offers to pay him Rs 11 lakh after the premium paying term of 11 years.

This is what makes traditional policies irresistible to the majority of investors—the premiums are not 'wasted'. Instead, they are returned to the policyholder with partial or fully guaranteed benefits. Of course, for these benefits to accrue, the person must survive the plan's tenure.

All three popular traditional policies—endowment plans, money-back policies and wholelife assurance plans—work on this principle, with variations in their payout strategies. But this additional benefit comes with an extra charge, making these plans costly.

What policyholders like Roy fail to realise is that the psychological comfort of getting back the money is not worth the financial imprudence. Roy could buy a bigger cover for a fraction of what he pays for his policies. A term plan with a cover of Rs 1 crore for 30 years would cost him only Rs 15,000 a year.

Agreed that no money is paid on maturity, but in case of an untoward happening, the family of the policyholder is financially secure with the sum assured. For a similar cover from a traditional policy, Roy would have to shell out a few lakhs a year.

The primary purpose of life insurance is to provide financial security to the family of the policyholder in case of his unfortunate death. From this perspective, a term plan is the cheapest way to cover the risk. "Indians are mostly underinsured because they buy savings plans and not a mixture of savings and term insurance plans," says Gorakhnath Agarwal, chief actuary, Future Generali India Life Insurance.

An insurance agent is likely to counter this argument by saying that the high cost of traditional policies is justified by their investment component. However, in Roy's case, his wholelife plans assure to give him around Rs 11 lakh on maturity, where the returns work out to around 7 per cent every year. This is lower than other instruments, such as the PPF, which offers 8 per cent per year.

So, should you stop paying the premiums of the endowment/money-back plans in your investment kitty? Not necessarily. Traditional policies complement term plans well, so unless they constitute the mainstay of your insurance portfolio, there is no reason to panic. "Traditional products are for customers who prefer long-term guarantees to achieve long-term goals such as children's education. These customers do not want to compromise on their child's education just because the equity markets run into losses when he is ready to go to college," says Amish Tripathi, national head (marketing & product management), IDBI Fortis Life Insurance.

However, do not go overboard and bet only on these plans for safe returns because other debt instruments (like mutual funds) may be better aligned to your shortterm goals. Endowment and money-back plans work in special circumstances, when the policyholder is extremely risk-averse but needs insurance. For instance, if a 55-year-old wants a plan that offers him ultra-safe income and simultaneously provides cover for a dependant, a traditional policy is a good choice. Andrew Cartwright, chief actuary of Kotak Life Insurance, says that endowment plans are better for building a retirement nest egg.

So, calculate the extra cover you need and buy a pure term plan that offers enough or extra cover. The general principle is that the cover should be sufficient to meet the costs incurred by the remaining family members during their lives.

Internationally, 10 times the annual income is considered an optimum level of protection. However, developed countries have a big social safety net, which is not the case in India. Hence, people in India are recommended to take higher insurance covers.

"The insurance cover need for an individual decreases as the age increases. For healthy individuals below 35 years, an insurance cover of up to 15-20 times the average annual income is recommended," says Yash Mohan Prasad, senior vice-president, sales and training, HDFC Standard Life. For those above 35-45 years, 10-15 times, and for people older than 45 years, a cover of 5-10 times the annual income is considered adequate.

As with any other financial product, if you are planning to buy one of these insurance plans, optimise its benefits by running them through a series of checks. The most important is the bonus that it offers. Some traditional policies offer guaranteed bonuses, which means investors are aware of the maturity amount. However, in profit plans (where they participate in insurers' profits), only a part of the bonus is declared, so it is difficult to estimate the total returns. The bonus depends on the financial performance of the insurance company and varies every year. "Bonuses for these products are not guaranteed, but once declared, it becomes guaranteed," says V. Viswanand, director, Max New York Life Insurance.

So if you want to buy such a plan, opt for one that has consistently delivered good bonuses in the past. You can also compare the historical data with the sales illustrations of the insurance agent to check the latter's authenticity. Also, find out if the bonus is calculated only on the sum assured (simple reversionary) or on the sum assured plus the previously declared bonus (compound reversionary). The latter is a better alternative as it factors in the benefits of compounding and generates higher returns. The idea is to buy the best cake from the baker's repertoire.

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