Exit Strategy From Life Insurance Policies
Unlike other investment avenues like stocks, bonds, mutual funds, etc. where we do need to have a pre-determined exit strategy, it is somewhat difficult in case of life insurance policies due to various terms and conditions along with losing life cover post-exit. The article provides insights about exit strategies with the help of a case study
In India, we see that life insurance policies – specifically the traditional ones – sell like hot cakes. Despite this, life insurance penetration in India stands below the global average numbers. As of March 2019, life insurance penetration in India was 2.82 per cent, whereas the global average stood at 3.35 per cent of the GDP. Also, during the Confederation of Indian Industry’s (CII) 22nd Insurance and Pensions Summit, Insurance Regulatory and Development Authority of India (IRDAI) Chairman, Dr. Subhash Khuntia remarked, “The Indian insurance industry currently services only 10-20 per cent protection requirements, indicating a huge insurance protection gap of 80-90 per cent in India.” This shows that a larger part of our population is quite underinsured.
Having said that, by large life insurance in India is often mis-sold. Also, the biggest reason for such mis-selling is the lack of understanding about the product and the actual objective of having a life insurance policy. When it comes to life insurance, people in India feel quite safe about their money as it is considered to be a sort of investment avenue rather than a risk-protecting avenue where you get a lump sum amount at maturity in case of any untoward event. And from the investment perspective, it is quite a long-term commitment. Therefore, unlike other investment avenues like stocks, bonds, mutual funds, etc. where we do need to have a pre-determined exit strategy, it is somewhat difficult in case of life insurance policies due to various terms and conditions along with losing life cover post-exit.
Therefore, in this article we would try to understand different situations and what should be your strategy of exiting a life insurance policy. It is to be noted that the exit strategy purely pertains to traditional life insurance plans such as endowment policy, money-back policy and Unit Linked Insurance Plans (ULIPs). But before we move on to understand what should be your exit strategy, let us first get the basics clear as to the purpose of having life insurance.
Purpose of Life Insurance
Life is beautiful, but at the same time it is quite uncertain. Therefore, in order to protect your family (dependents) financially against any uncertainties we have life insurance. Hence, the actual purpose of having a life insurance policy is to protect the bread-earner’s dependents financially in case where he or she dies during the policy period. Therefore, the main aim of life insurance is risk protection. However, in our country most of the life insurance policies that get sold are traditional life insurance policies where they are bundled with investments.
However, such a combination leads the insured deprived of both risk protection via life insurance as well as investment returns as investments in such policies barely beat inflation. So, it is quite important to understand the purpose of life insurance, which is risk protection. And such a purpose can only be fulfilled via pure (plain vanilla) term life insurance policy wherein you get life cover for the policy period and on maturity you receive nothing. A lot more on this is explained in the following paragraphs.
What is Term Life Insurance Plan?
Term life insurance plan is nothing but plain vanilla life insurance policy taken with the intention to protect your risk of life. We do have a lot of variations here as well such as term life plan with return of premium policy, whole life plan, and many more. However, such variations lack in cost benefit terms. Therefore, it makes more sense to avoid any such variations and go with the plain vanilla term insurance plan. This will not just help you to save on premiums but such saved premiums can be invested in mutual funds to get better risk-adjusted returns that can efficiently beat inflation.
Ways to Exit Life Insurance Polices
In this section of the article, we would discuss the different ways one can exit life insurance policies.
Initial Phase
This is the phase where you have either very recently purchased the policy or you have paid only a few premiums. There are two ways you can exit here.
Free Look Period: Free look period is the time given by life insurance companies to the policyholder so that he can rethink about his purchase decision. This time period is 15 days from the date of purchase. Therefore, in the first 15 days if you feel that you were mis-sold the policy or you are not happy with the policy, you can request for the return of premium. Once you request the same, premium amount is returned back to you after deducting medical test charges, stamp duty and service charges.
Letting the Policy Lapse: In case you have missed the free look period, letting your policy lapse is the only way to exit the policy in the initial phase. Insurance companies do not provide an exit option in the first three years. Therefore, it makes more sense to stop paying premiums and let the policy lapse automatically. Here is a word of caution: when the policy lapses, you remain uncovered for the amount of sum assured for which you have lapsed the policy. Furthermore, you will not get anything back. This means that you will lose all the premiums that you have paid earlier. In case of term plans, beyond the free look period there is no exit option as such. Hence, it is best to let the policy lapse.
Exiting after Three Years
As said earlier, life insurance companies provide no exit options before three years. However, post three years a policyholder has three options to exit the policy.
Surrender: Surrendering the policy is nothing but voluntary termination of the insurance policy before its maturity. Here the insurer pays you a lump sum amount which is known as surrender value or cash value upon surrendering the policy. From all the regular premiums that you have paid, a part of it goes towards investment and the remaining towards life cover. The invested portion accumulates as the cash value during the term of the policy and the net is paid upon surrendering. The cash value in the early years would be low, but as it gets closer to maturity the value increases. Further, the policyholder also gets what it is called as guaranteed surrender value, which is nothing but 30 per cent of the total premiums paid less the first year premium.
Paid-Up: This option allows you not to completely exit the policy. In fact, in this option you can stop paying your premiums and your policy wouldn’t become completely void. It will continue with the reduced sum assured, which is known as the paid-up value. The paid-up value is nothing but the total premiums paid by you. And the thing to remember is that all future bonuses, dividends and additional benefits will be lost if you let your policy become paid-up. However, bonuses accrued in the first three years will be paid upon maturity.
Redeeming Units: This is specifically for ULIPs wherein for the invested amount you get units allocated based on the net asset value (NAV) on the investment date. Therefore, while exiting as well you can sell the units at the respective NAV. However, ULIPs have a lock-in period of five years. This means that exit is available only after five years. Also, according to the new tax norms announced in the Union Budget 2021, ULIPs with collective premium above Rs 2.5 lakhs are subject to capital gains tax similar to that of mutual funds.
The Study
In order to understand what should be the correct exit strategy, we carried out a study. In this study we have considered an endowment plan and compared it with what if you had taken a term plan and invested in a debt mutual fund assuming 8 per cent rate of returns and equity mutual fund assuming 10 per cent rate of returns. Further, we have considered the option of what if you surrendered or paid up the policy and invested in equity mutual fund. For the purpose of this study, we have assumed a 30-year-old male who is a non-smoker. Moreover, we have assumed the policy period to be 30 years with sum assured being Rs 25 lakhs for both endowment as well as term plan and the study is divided into three periods in terms of exiting the policy. So, we would study the option of what if you exit the policy after paying premiums for eight years or what if you exit the policy post paying premium for 15 years and what if you exit the policy after paying the premium for 23 years.
The endowment plan would attract Rs 90,000 premium per annum for Rs 25 lakhs sum assured and for a similar sum assured term plan premium is about Rs 5,000 per annum. Therefore, the remaining Rs 85,000 would be invested in mutual funds. Endowment plan is eligible for revisionary bonus and loyalty bonus. But as loyalty bonus is difficult to calculate we have just assumed revisionary bonus which is Rs 49 per Rs 1,000 sum assured i.e. close to 4.9 per cent. Therefore, the revisionary bonus in our case would amount to Rs 36.75 lakhs at maturity and we have also assumed that the sum assured is returned at maturity. Therefore, the total maturity proceeds amount to Rs 61.75 lakhs. This amount indeed looks quite promising, but is it actually proving to be efficient?
As we can see, if you had preferred debt mutual fund or equity mutual fund over the endowment plan, you could have earned Rs 42.24 lakhs and Rs 92.05 lakhs more, respectively. Therefore, this shows us that investment in endowment plan is meaningless as it is not even able to beat inflation. However, if you have already made such an investment and are now looking to exit then first you need to find out how many premiums you have already paid and whether it make sense to exit and invest in an equity mutual fund.
“You will not turn bankrupt because of buying insurance, but you will cause your loved ones to turn bankrupt if you don’t."
- Jack Ma
"A man who dies without adequate life insurance should have to come back and see the mess he created."
- Will Rogers
The above tables and graph will help you make better exit decisions. In the first instance, where you have already paid 25 per cent (eight) premiums, it makes more sense to surrender the policy and invest in equity mutual funds. In the second instance, where half of the premiums are paid, it makes more sense to continue the policy as the benefit from surrendering or paying up the policy and investing until the policy maturity date fetches less than what you would earn if you continue the policy until maturity. The same is the case with the third instance. Therefore, we can say as a rule of thumb that if you have already paid 50 per cent or more premiums then it makes complete sense to continue the policy. Otherwise, it would make more sense to surrender the policy and invest in equity mutual funds.
Conclusion
It may have been clear by now the purpose of having a life insurance, which is actually meant to protect your risk of life and secure your dependents financially in your absence. Therefore, it is more prudent to avoid mixing your investments with that of insurance. Keep these two things separate to get benefits of both the worlds. So, if you have any traditional insurance policies such as endowment or money-back or ULIPs then it makes more sense to exit them. However, insurance being a long-term product, it is quite difficult to exit it. Hence, in order to understand the exit strategy, we carried out a study wherein we have assumed an endowment policy.
Our study has shown that if you have paid only 25 per cent of the premium, then surrendering the policy and investing in equity mutual funds makes more sense. However, if you have already paid 50 per cent or more of the premiums then it makes complete sense to continue the policy rather than surrendering it and investing in equity mutual fund. This is because in such a case, by maturity it becomes difficult for equity mutual funds to provide a maturity amount higher than that of the endowment policy. Therefore, in such cases surrendering the policy would lead to loss. As such, we would recommend avoiding investments in traditional life insurance policies. Rather, buy a term plan which would cost you 70-90 per cent less than a traditional life insurance plan.