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Thursday, March 17, 2011

How to get out of a bad insurance

A life insurance policy is a key component of a financial plan. Chosen well, it safeguards the financial future of a family if the breadwinner passes away. If, however, it is bought for the wrong reasons, the same policy can become a drain on resources and prevents the policyholder from meeting crucial financial goals.

Bangalore-based marketing manager Jitendranath Patri is paying a premium of Rs 1.06 lakh a year for six policies that give him a combined cover of Rs 20.4 lakh. "I feel I have over invested in insurance. These plans take up a huge chunk of my savings. I must resort to some course correction here," he says.

In Kolkata, Meraj Mubarki is agonising over his inability to save enough for his dream house. "I'm in a financial mess. My insurance policies take up too much of my savings, leaving me with very little for my house," says the 33-year-old college professor. Worse, it leaves this sole breadwinner grossly underinsured.

Jitendranath Patri, 43 years, Bangalore

He is paying Rs 1.06 lakh as premium for six policies that give him a combined cover of Rs 20.4 lakh.
Low cover at a very high cost

Jitendranath Patri, 43 years, Bangalore

His problem: The high premium outgo not only prevents him from investing in other asset classes but also leaves him underinsured. His current life insurance is just one-fifth of the required cover of Rs 1 crore.

ET solution: Of his six policies, a Ulip offers him a reasonably high cover of Rs 12 lakh for a premium of Rs 30,000. If he discontinues the other policies, he will free Rs 76,000 every year. Of this, Rs 22,000 can be used to buy a term plan of Rs 90 lakh for 20 years, and the remaining Rs 51,000 can be invested in other asset classes.

Mubarki is covered for Rs 6.75 lakh, though he needs an insurance of at least Rs 60 lakh. In Mumbai, software professional Amit Kolambkar is thoroughly miffed with the returns from his Ulips and feels cheated. "The agent didn't explain how the plan works and how I can decide my allocation to equity," he says.

Getting stuck with an unsuitable insurance policy is a malady as widespread as the common cold. There's one wrong insurance policy in almost every household. A few buyers such as Patri and Mubarki realise their mistake, but most policyholders don't. You can, however, find out whether your insurance policy suits your needs. Many like Kolambkar blame the agents for their predicament. "Very few investors spend time on understanding their policies and features," says Mark Meehan, COO, Bharti AXA Life Insurance . "It is important to buy the right plan that suits your need," adds Nageswara Rao, MD & CEO of IDBI Federal Life .

Amit Kolambkar, 25 years, Mumbai

Bought Ulips on the basis of high returns projected by the agent. He didn't know of the high charges levied in initial years.
Didn't know of high charges

Amit Kolambkar, 25 years, Mumbai

His problem: Despite the rise in the stock markets, his fund value is lower than the amount invested by him. Besides, he does not need insurance because he is a bachelor with no dependents.

ET solution: He should stop paying the premium for Ulips and traditional plans and surrender them after five years. This will free Rs 67,500 a year. However, he can continue with the pension plan. When he gets married, he should buy a term insurance plan of Rs 1 crore for 30 years. This will cost him Rs 13,000 a year.

What do you do if you find that you have the wrong insurance? Escaping from an insurance policy entails a very high cost. You can lose up to 50% of what you have paid. In extreme cases, you might have to forfeit your entire investment. This is what keeps people from junking a plan, however unsuitable it is.

"There is a psychological barrier of losing money, which is why people avoid exiting an insurance policy. But it is better to incur a loss at the initial stage rather than continue and compound the mistake," says Arvind A Rao, chief financial planner, Dreamz Infinite Financial Planners.

We look at the options for policyholders who want to junk their insurance plans and explain the circumstances in which each should be exercised.

Meraj Mubarki, 33 years, Kolkata

In the past three years, he has picked four insurance policies to save tax. He pays Rs 42,000 for a cover of Rs 6.75 lakh.
Tax-saver plans are a burden

Meraj Mubarki, 33 years, Kolkata

His problem: The sole breadwinner of his family, he is grossly underinsured. He needs a cover of at least Rs 60 lakh. Three of his policies are traditional plans that offer very low returns. The fourth is a Ulip that provides a very low cover. The premium outgo prevents him from executing his plans to buy a house.

ET solution: He should convert his traditional plans into paid-up policies after paying the premium for three years. This will free Rs 26,000 a year. He should stop paying the premium in case of the Ulip and surrender after five years.

OPTION I - Let the policy lapse

Don't pay the premium and the policy ends automatically.

This is the easiest way to exit a policy. It is also the costliest if the policy has not completed three years. The premium paid in the first two years is forfeited and the policy ends. You also stand to lose the tax benefits availed of in the first two years on the premium payment. You get nothing, except freedom from the policy.

Financial planners say this option should be chosen only if you realise that the policy is grossly unsuitable to your needs. "If the policy doesn't meet your objective, it is better to let it lapse even though you stand to lose the premium for 1-2 years," says Pankaj Mathpal, managing director, Optima Money Managers . It's much like junking a bad stock to minimise the loss and move on to a better investment.

The rule is different for Ulips. Even if it is discontinued after the first year, the policyholder is entitled to some amount after paying surrender charges. However, this sum comes to him only after the lock-in period of five years (three years, if bought before 1 September 2010). The fund value, after imposing all charges and penalties, is frozen in the account and earns 3.5% returns till this period.
"The investor gets the money only after completion of five years," says Sanjay Tripathy, executive vice-president and head, marketing and direct channels, HDFC Life . The policies that are most likely to be allowed to lapse are traditional endowment and money-back plans. There's a widespread perception that they are a good way to save for the long term and cover against the risk of death. In reality, these plans offer very low returns and provide too little cover. "The return on traditional policies is 5-6%, which doesn't even beat inflation," says Kartik Jhaveri, financial planner and director of Transcend Consulting .

Patri bought a 20-year Ulip last year for an annual premium of Rs 34,000. It covers him for Rs 2 lakh. If he were to let it lapse this year, he will not lose the entire premium. He might be better off if he buys a term cover of `50 lakh for an annual premium of Rs 8,000 and invests the remaining Rs 26,000 in some other option such as a mutual fund or a fixed deposit as per his risk appetite.

OPTION II - Surrender the policy

After three years, an insurance policy fetches a surrender value.

If you have paid the premium for three years, your insurance policy would have built a reasonable corpus value. So, if the plan is surrendered after this period, the policyholder can get some money back. It will, however, be a fraction of what he has paid over three years because of the surrender charges levied by the insurer. In the third year, the surrender value is roughly 30% of the total premium paid, but this figure goes down as the term of the policy progresses.

Till last year, insurers used to levy very high surrender charges on Ulips in the first three years. But last year, the Insurance Regulatory and Development Authority (Irda) put a cap on these charges. This is Rs 3,000 or 20% of the annual premium in the first year. For plans with a premium of over Rs 25,000, the cap is higher at Rs 6,000 or 6% of the annual premium. The surrender charges come down progressively to zero in the fifth year. "No surrender charge is levied on insurance policies that are more than five years old," says Tripathy.

Surrendering a policy gives you some money back, but it also ends the life cover. So, before you decide to junk your policy, find out if you have enough cover. Also, calculate the cost of a fresh insurance policy at the time. You might discover that the premium is very high because you are older.

OPTION III - Turn it into a paid-up policy

Stop paying the premiums, but don't discontinue the policy.

A better alternative to surrendering your insurance policy and losing the life cover is to turn it into a paid-up policy. As in the case of surrendering it, you can use this option only if you have paid the premium for three years and the policy has built up a minimum corpus. Instead of returning the money to the investor, the insurance company uses it to offer him a life cover. 
 Every year, it deducts mortality charges from the corpus. However, in case of traditional endowment and money-back plans, this cover is proportionate to the number of years for which the policy was in force. For instance, if a policy offers a life cover of Rs 10 lakh for 20 years and the policyholder converts it into a paid-up plan after five years, the life cover will be reduced to about Rs 5 lakh. On maturity of the plan, the diminished corpus and the accumulated bonus will be given to the policyholder.

This feature has been widely exploited by agents to mis-sell Ulips to gullible investors. They would tell investors that they need to pay the premium for only three years and their life insurance policy would continue for the rest of the term. What they really meant was that even if you stopped paying the premium, the corpus would be big enough to sustain the deduction of mortality charges for the entire term. Last year, the Irda issued new rules for Ulips. If the premium of a plan bought after 1 September 2010 is stopped, the policy will be discontinued. This is meant to reduce the incidence of mis-selling.

When it comes to mis-selling, the charges on Ulips is the biggest point of contention. "Insurers have brought down premium allocation charges to nil under some plans, but they raise policy administration charges every year or make them a percentage of the sum assured. One should look at these charges too to weed out bad plans from the portfolio," says Pankaaj Maalde, a Mumbai-based financial planner.

The paid-up option is by far the best way to exit an insurance policy because it gives the policyholder the best of both worlds. He is freed from the burden of paying the premium that are a drag on his finances, but continues to enjoy the life insurance cover that was the primary objective of the plan.

OPTION IV - Let it continue

If close to maturity, pay the premium till the full term.

Of course, if the insurance policy is only 2-3 years away from maturity, one should continue with it for the full term. This is because the painful period of high charges in the initial years has already gone and it doesn't make sense to let go of the accumulated benefits at the fag end of the term. If you are finding it difficult to pay the premium, withdraw from the Public Provident Fund or any other long-term investment to pay the premium for your policy. In this manner, you will not lose the life cover and will be eligible for a tax-free lump-sum payment on maturity. You could also consider taking a loan for this. The Life Insurance Corporation of India , for instance, offers loans against the policy for paying the premium.

How to know if you have the wrong insurance

Low cover: Though insurance needs vary for individuals, a policy should give you a life cover of at least 40 times the annual premium. If it does not, you are paying too much for the cover.

High premium: According to a thumb rule, you need a cover of at least five times your annual income. The premium for this cover should not account for more than 6-8% of your annual income.

Tenure: An insurance is meant to replace the income of the policyholder and should, therefore, cover him for his entire working life. If the policy ends before he retires, it won't be of much help when he needs it most. Buying a fresh cover later will be costly.

Return projections: An endowment policy appears attractive because of the projected corpus on the maturity of the plan. But one must factor inflation into the calculation. In 25 years, a moderate 5% inflation will reduce the value of Rs 20 lakh to a mere Rs 5.5 lakh. 

Curtesy: This article first appeared in ET

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