Marketing Gimmicks In Term Insurance Policies Exposed
Today most individuals understand that term insurance is the only product that is a viable option for their life insurance needs. But term insurance policies offer a variety of options and features within themselves. Most such features seem attractive and beneficial. But in reality, they are highly toxic and would prove to be an imprudent choice. Therefore I will be talking about these features and explaining how they work today.
The TROP Trap
Term insurance with Return Of Premium (TROP) is essentially a rider offered with a term insurance policy. Here, the total amount of premium paid over the duration of the policy is paid back to the policyholder as a maturity benefit. If the policyholder passes away during the term of the policy, the death benefit is paid to their beneficiaries.
This may seem like an attractive proposition at first glance. But it offers suboptimal returns after accounting for inflation. The premium we pay on a TROP policy is significantly higher compared to a basic term plan. We would receive the maturity benefit a number of years into the future. So the real purchasing power of the amount we receive would be significantly reduced.
Finally, the differential amount of premium between a TROP policy and a basic term plan can be reinvested. The amount that is reinvested would have a reasonable chance of growing at a rate that matches or beats inflation over the long term. This can be understood better through a hypothetical example meant purely for educational and illustrative purposes.
Assume, hypothetically, that an individual purchases a 25-year policy at age 30 for a sum assured of Rs 1 crore. The annual premium on the basic term plan is Rs 20,000. The annual premium for the same plan with the return of premium benefit added would be Rs 45,000. Accordingly :
Total premium paid under the return of premium option = 45,000 × 25
= Rs 11,25,000
This amount would be returned to the policyholder after 25 years if they survive. Because of this, the real worth of the maturity benefit of Rs 11,25,000 would be reduced by inflation. Assume inflation to be 6%. The value of a rupee inflated at 6% for 25 years is 4.29. This figure is known as the inflation factor. The inflation factor tells us how much a certain sum of money to be received in the future is actually worth in terms of today's money. It is given by the formula laid out as follows :
Inflation factor = (1+rate of inflation in decimals)^investment period
Note that the symbol ^ is to be read as ‘to the power of’. Inflation reduces the value of our money. So the maturity benefit must be divided by the inflation factor to arrive at the actual worth of the amount in terms of today's money. Accordingly :
Inflation Factor = [(1+0.06)^25]
= (1.06)^25
= 4.29
Actual value of Rs 11,25,000 receivable after 25 years = 11,25,000/4.29
= Rs 2,62,237
So it is abundantly clear that the return of premium option represents a loss for the investor after accounting for inflation.
But by opting for the basic term plan, the individual saves a significant amount in annual premiums. Accordingly :
Annual savings in premiums = 45,000 - 20,000
= Rs 25,000
Total amount saved over the term of the policy = 25,000 × 25
= Rs 6,25,000
This amount can be calculated and kept ready as a lump sum in advance. It can be invested at present in a long-term portfolio that earns a post-tax return of say 8% over the next 25 years. We first need to find the value of a rupee invested at 8% post tax for 25 years. This figure would be known as the return factor. It is given by the formula laid out below.
Return Factor = (1 + rate of return in decimals)^investment period
In light of the facts of the instant case :
Return Factor = [(1+0.08)^25]
= 6.85
Returns increase the value of our money. The invested amount is therefore multiplied by the return factor to arrive at the final value of the corpus. Accordingly :
Final value of the corpus after 25 years = 6,25,000 × 6.85
= Rs 42,81,250
Therefore, opting for the basic term plan is a prudent choice for the individual.
The Limited Pay Option
Term insurance policies offer two options for payment of premiums. These are the regular pay option and the limited pay option. Under the regular pay option the individual is required to pay premiums during every single year of the term of the policy. Under limited pay option premiums are paid only for the first few years of the policy term. But the coverage would remain effective for the entire policy term. The limited pay option is often advertised as the better option between the two. This is because premiums are paid over a lesser number of years. This reduces the total amount of premium paid over the policy term.
It is advertised that policyholders save on premiums and finish premium payments faster. But this is not entirely true. The limited pay option typically proves to be an imprudent choice for most investors. Let us now understand the reason behind this with an example which is purely meant for educational and illustrative purposes. The securities quoted are for illustration only and are not recommendatory. Say hypothetically that a 30 year old individual purchases term insurance worth Rs 2 crore for 30 years with the Regular Pay and Limited Pay options offered to him.
On first glance the limited pay option seems to be the clear winner. The total premium paid under the limited pay option is lower. Accordingly :
Savings in total premiums under the Limited Pay option = 6,60,000 - 5,50,000
= Rs 1,10,000
But also consider this. By opting for the regular pay option the individual would save a significant amount in premiums over the first 10 years of the policy. Accordingly :
Annual savings in premiums over the first 10 years = 55,000 - 22,000
= Rs 33,000
Total savings in premiums over the first 10 years = 33,000 × 10
= Rs 3,30,000
Assume for ease of understanding that this amount has been kept ready as a lumpsum in advance. It can be invested at present in a long term portfolio that earns a post tax return of 8% over the next 30 years. The premiums paid from year 11 to year 30 under the Regular Pay option can be deducted from the final value of the corpus Accordingly :
Return Factor = [(1+0.08)^30]
= (1.08)^30
= 10.06
Final value of Rs 3,30,000 invested at 8% for 30 years = 3,30,000 × 10.06
= Rs 33,20,000
Total premium paid under the Regular Pay option between years 11 and 30 = 22,000 × 20
= Rs 4,40,000
Final value of the corpus after deduction of premiums = 33,20,000 - 4,40,000
= Rs 28,80,000
Therefore, the regular pay option is generally the more prudent choice for most individuals compared to the limited pay option. It is widely considered prudent to pay premiums on all term policies annually. The limited pay option may make sense only if the individual's income is highly unpredictable. Even so, it is considered prudent to opt for it only after sufficient forethought.
The Final Word
Both features discussed here are nothing more than marketing gimmicks used by insurers to sell their term insurance products. They leverage the hardwired Indian mentality of expecting something in return from every investment made. So we as policyholders are also partly at fault for these features being popular. The following features are all we need to look out for when purchasing life insurance :
Plain vanilla term insurance
Fixed policy term until retirement
Annual premium payments under the Regular Pay option
Avoid additional riders
Any features or options apart from the ones listed above are simply unnecessary in most cases.
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