Indian investors shovelled a collective Rs 3.2 lakh crore (3.2 trillion) into traditional insurance plans in 2015-16, per IRDA’s latest report. I adduce this mammoth figure not as an argument in favour of traditional plans, but rather to illustrate just what a gaping hole many us digging for our financial futures. Traditional Insurance, after all, makes for a very poor investment.
Goaded by the promise of guaranteed returns, capital safety — plus the added sliver of life cover that these plans encompass, millions of investors continue locking their long-term savings into them, while all the time remaining largely clueless about the actual “return” they’re earning on their investment. Would you sign over your money into a fixed deposit or bond without clearly knowing, before all else, what the annualized rate of return from the said product is? Probably, no. And yet — this is precisely what millions of insurance buyers end up doing year on year!
Whether this trend is a by-product of mass hysteria, cognitive dissonance, habit, or simply a poor understanding of financial products, we’ll never know. But the one sure thing is that you, as an investor, will be doing yourself a big favour by gaining at least a cursory understanding of how these plans perform as an “investment”.
The typical structure of traditional plans involves either a periodic or lumpsum payment, and a fixed quantum of money paid back to you in predetermined tranches.
These cashbacks in toto add up to the “sum assured”, which is the minimum amount of money guaranteed by the insurance company over the term of the plan (we’ll leave the life cover component and its evaluation side for now, as this is an exploration of the investment merit of traditional insurance). Besides the minimum guaranteed “sum assured”, the insurer will, at their discretion, strap on other benefits such as maturity benefits or loyalty benefits from time to time.
Many an investor, is fooled by the opacity of the way these benefits are actually represented – usually as a percentage of the sum assured, or “Rupees per Thousand” of sum assured, and so on and so forth. But if one were to chart a simple cash flow table by plugging in the outflows (investments), guaranteed benefits and best-case discretionary benefits, a dismal figure of 5-7 per cent annualized returns would be arrived at. This is hardly an inflation beating figure; and given the time horizon, it would be sacrilegious to lock your money into investments that provide such poor returns, guarantees notwithstanding.
To understand why traditional plans are structurally incapable of delivering great returns, it’s necessary to peel a layer or two off the onion. Layer one; the hefty commissions. Most traditional plans pay agents close to 35 per cent as up front commissions from your premium — that’s a straight up cut of Rs 35,000 from your premium of Rs 1 lakh. Even from the second year onwards, your premiums could be compromised by 2-4 per cent as ‘trail commissions’, depending upon the plan. Net net — there’s a lot less of your money left to really invest, in the first place!
Layer two; the actual portfolio composition. Per the Insurance Regulatory and Development Authority of India, every insurer is required to invest at least 50 per cent of its investable surplus in government securities, with a cap of 35 per cent on equity investments. To that effect, traditional plans can function as ‘debt oriented, hybrid funds’ at best. It would appear that LIC, with roughly 4.75 lakh crore of its 21-lakh crore portfolio invested into equities, prefers to be more conservative than is mandated. With a 23 per cent equity allocation, even an early double digit return would constitute very good performance. Throw in administrative costs, death claim pay-outs and the like, and you’ve really got very little left to distribute by way of returns to investors!
The shorter term traditional plans (10 years or less) bear the higher brunt of the two above stated dynamics, often providing annualized returns that are lower than 4 per cent per annum. The longer-term ones can sometimes provide up to 7 or 7.5 per cent per annum; hardly a great return for a 20 or 25-year investment.
Given the near immutable nature of these two chief factors that contribute to diminished returns from traditional plans, it would be wise to avoid them. With a 10 to 20-year time horizon, there’s no justifiable reason for you to grow your portfolio at a snail’s pace.
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