At Personalfn, we come across many individuals who either have not been able to cough up the high premiums on their unit linked insurance plans (ULIPs) or they do not wish to pay the premiums on their low yielding traditional insurance policies. Either ways, they are not clear about the impact of discontinuing the policy. In this article, we explore this scenario at length and the implications involved.
Having obtained a life insurance policy, you are required to pay the premiums on the due dates as mentioned in the policy document. However, insurers do allow for a "grace period" for the premium payment. Payments within the grace period are stipulated to be "on time" payments. The grace period usually lasts for one month for yearly, half yearly and quarterly premium payment modes and 15 days for the monthly payment mode. The trouble begins if the premium is not paid even within the grace period or if you decide to discontinue the policy like many ULIP investors have done in the recent past, after realising that the policy doesn't quite fit into their scheme of things.
In such a scenario, the policy is considered to have lapsed and all the premiums paid are forfeited. More importantly, the insurer doesn't entertain any claims once the policy lapses. However, it should be understood that the policy is not necessarily forfeited i.e. the policy's value doesn't become nil. The Insurance Act does not allow for forfeiture as every policy acquires a reserve based on the premiums already paid.
The Insurance Act provides for a return to the policy holder of an amount that is representative of the reserve and this is referred to as the 'Surrender Value' or the 'Cash Value'. The Insurance Act stipulates that every insurance policy shall have a guaranteed Surrender Value, if at least 3 years' premiums have been paid. This reserve arises due to the following:
Premiums in the early years of the policy being more than what is justified. Savings element in the premium. Apart from the option of surrendering your policy, insurers like LIC also provide other options like making a policy 'paid-up', whereby the policy remains in force with a reduced sum assured, depending upon the number of premiums paid. Another option is to keep the policy in force by deducting future premiums, from the Surrender Value. A third option is to provide term insurance subject to the condition that the Surrender Value is more than the sum assured.
Since surrendering the policy is the option most commonly availed by policy holders, let's explore how the Surrender Value (obtained at the end of 3 years) is calculated.
The following table illustrates the returns that a policy holder can clock from a ULIP, if the same is surrendered after premium payments have been regularly made for the first 3 years. We have assumed that the policy holder pays an annual premium of Rs 30,000 and that his investments (after adjusting for the expenses) grow at 15% per annum.
Surrender value of an ULIP
Given the above-average returns provided by ULIPs over the last few years, thanks to the stock market rally, our assumed rate of return (15%) may seem rather conservative. However, this is the return we expect domestic equity markets to generate over the long-term.
As is evident from the above calculations, the portfolio value of a ULIP in the intial years can be rather disappointing; in effect the Surrender Value, which is a percentage of the portfolio value, could be even smaller. The prime reason for this is that in the initial few years, a substantial proportion of the premium paid is utilised for servicing the various expenses related to the policy -- as high as 70% in some cases. This means that the proportion of the premium used to provide for the Surrender Value is not the entire premium amount, rather it is the premium net of expenses.
It is evident that surrendering a ULIP after having paid the premiums for the first three years may be an unwise option. But then, continuing with high ULIP premiums only at the behest of your agent is even more unwise and over the long-term this could hurt your finances a lot more.
The solution lies in exercising due care and making an informed decision at the outset while deciding to take life insurance. However, for individuals who are saddled with the wrong policy it's an unenviable situation. We recommend that they consult their financial planners/insurance advisors and then decide on continuing the policy based on the merits of the case and their finances, among other factors.
Year 1
Year 2
Year 3
Annual premium (Rs)
30,000
30,000
30,000
Expenses
30%
5%
5%
Amount invested (Rs)
21,000
28,500
28,500
Assumed returns
15%
15%
15%
Portfolio value (Rs)
24,150
60,548
102,405
By Personalfn.com, a financial planning initiative. It can be reached at info@personalfn.com. Personalfn.com also publishes a free-to-download financial planning guide, Money Simplified. To get a copy of the latest issue - How ULIPs fit in - please click here.
