Monday, May 9, 2011

Endowment Policies - Are they really good products?

Endowment policies are a very popular asset class in India and are promoted by most insurance companies and insurance agents. Life Insurance Corporation of India (LIC) has a lot of products which are endowment insurance products and these are one of the most popular products in its kitty. This is another product which tries to combine insurance and investment. I have seen a lot of people buy this product without properly understanding what an endowment policy is and simply buy it because it is being sold by a ‘known’ agent from LIC. In this article, I shall explore the merits and demerit of an endowment plan and shall let the reader decide for himself/herself if it makes sense for them to take an endowment plan.

Firstly, an endowment policy is like I have mentioned before, tries to combine insurance and investment. The life of the individual is insured for a certain amount (referred to as sum assured in an endowment policy), So the amount you pay every year or quarter (known as ‘premiums’ in insurance parlance), is allocated towards the sum assured, administrative charges and what remains is then invested.

An endowment policy rewards its investors by means of a ‘bonus’ every year. The amount of bonus declared every year, differs from company to company and on fund performance. The bonus declared is declared in the form of a proportion of the sum assured. For example if the sum assured is Rs 5 lakhs (Rs 500,000), and the company declares a bonus of Rs 50 per Rs 1000 of the sum assured, then the bonus works out to be Rs 25,000. However, unlike stock dividends or mutual funds, the company does not pay out the bonus immediately. It is paid only when the policy matures or the policy owner passes away. The bonus does not compound but only accumulates (unlike your Bank Fixed Deposits where your interest compounds). To explain how this works, I shall illustrate using an example: Take the case of a 35 year old person who takes a policy with an assured sum of Rs 5 lakhs with a term of 20 years. The premium for this would be roughly around Rs 25,000. If at the end of the first year, the insurance company declares a dividend of Rs 50 per thousand or 5% of the sum assured which works out to be Rs 25,000. Since this bonus does not compound, this amount stays the same till the end of the remaining 19 years and this is the same for all the further bonuses being declared. However I must point out that it is not very likely that an insurance company would declare a 5% bonus every year. There could be years where the bonus payments could be lower.

Why is compounding important?

To answer this question, let us continue with our above example. If the insurance company continues to pay you 5% bonus every year, you would have accumulated Rs 5 lakhs of bonus by the end of the 20 year period. Hence you get Rs 5 lakh of assured sum and Rs 5 lakh of your bonus at the end of 20 years. You have achieved this by paying Rs 25,000 per year for 20 years. This is NOT an impressive return at all! This actually amounts to a return of just 6.39% per annum!
Had an individual taken a term insurance which covered the person for Rs 5 lakhs and invested in Provident Fund his returns would have been much higher. For example, a term insurance covering a person for Rs 5 lakhs for a period of 20 years would amount to an annual premium of about Rs 2,500. Subtract this amount from the Rs 25,000 premium you are paying for the endowment policy and it comes to Rs 22,500. Invest this amount in a provident fund for 20 years (at the rate of 8.5%). At the end of 20 years you receive 10.88 lakhs viz. Rs 88,000 more! The other point to be noted is that the return from a Provident fund is non-taxable and guaranteed while you can never be sure of the amount of bonus being paid out by an insurance company!

Conclusion: I would advise risk averse investors who do not want to invest in mutual funds or equity products to take a term insurance and invest in Provident Fund Account instead of buying an endowment plan. Once again I would like to re-iterate that insurance and investment are two important albeit different goals. Do not try to mix up both and be very careful about products which try to mix both!


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