Insurance: The good, bad and ugly

New Delhi: In a bid to attract customers, several life insurance companies are providing guaranteed returns. As a customer, you need to understand whether the guarantee is really worth it.

The Life Insurance Corporation (LIC) of India has, over the years, been doing away with its guaranteed return products, thanks to the low interest rate scenario. Nevertheless, in a bid to attract customers, several life insurance companies are providing guaranteed returns.

As a customer, you need to understand whether the guarantee is really worth it and what price you would pay for that guarantee.

Moneycontrol takes you through the points you should watch out for while buying a guaranteed return product.

Don’t look at absolutes

Absolutes are deceptive. A 5% guaranteed bonus from one company might not be the same as a 5% guarantee from another. Why is that so?

Guaranteed bonuses are either simple bonuses or compound bonuses. Simple reversionary bonus is declared for each year as a percentage of the sum assured. This bonus is not calculated on earlier years’ bonuses declared. Compound bonus is declared as a percentage of sum assured plus earlier bonuses declared.

Although the rate of bonus declared by two companies maybe the same a compounded bonus will give higher yield than simple bonus. As an example, a compound bonus of 5% every year for 5 years will equate roughly around 12% of simple bonus.

Guaranteed bonuses are either a percentage of the premium paid or the sum assured

Bonus on the premium paid is the actual return on investment since the premium is the amount invested. Bonus on the sum assured is something that is notional and will accumulate till the end of the policy term.

Although the rate of bonus, whether as a percentage of sum assured or premium, maybe the same, the amount of bonus would be higher when it is a percentage of the sum assured.

There are no free lunches

If you are looking at a traditional endowment kind of policy, you will end up paying a substantially high premium if there is a guarantee attached to it.

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Met Life Insurance offers a money-back policy with a guaranteed return of 10% of the sum assured every year. Now that’s a bonanza, one would think. But read on to find out how that bonanza could dig a hole into your pocket.

We took a look at money-back policies across companies. This is a comparative chart of premiums for a 30 year old who buys a money-back policy with a sum assured of Rs 5 lakh and a term of 20 years.

If you were to look at the range of the premium, for most companies it is between Rs 30,000 to Rs 35,000 every year. Only in the case of Met Life Insurance’s money-back policy, the premium is a high of Rs 48,000. That’s at least 50% more premium every year when compared to the lowest priced product in the same category.

Why this pricing? A guaranteed return comes at a price. In order to generate guaranteed returns, the company must maintain a higher solvency margin.

Solvency margin is a regulatory requirement that all insurance companies must maintain and it measures the ability of the company to honor its liabilities.

A higher margin means keeping aside higher reserves and thus bringing in more capital. This increases the costs.

So if you look at the yields, you would see that Met Life with a guarantee of 10% of sum assured ever year gives an yield equal to LIC’s policy which promises no guarantee. Of course, it is assumed that LIC returns 3 per cent of the premium per annum compounded.

If it’s a unit-linked policy, your expenses will work out higher if the company is giving you a guarantee. Experts say this could work up to 1% higher than a policy without a bonus.

The reason for higher expenses is the same as in the case of traditional policies. A guaranteed return comes at a price.

Is a guarantee necessary?

Guarantees are provided by companies to attract business. This is true especially for private sector companies, which are new and must compete with LIC, which provides sovereign guarantee.

Experts in the field of actuarial sciences believe that inclusion of guarantees is not by itself a risky venture for insurance companies. The risk lies in not understanding the impact of the guarantees provided and not managing the same.

Very high guarantee may result in low overall profitability of the insurance company, thus impacting returns on non-guaranteed products.