Careful mistakes you make!!

MISTAKES can be expensive. Ask the guy who looked at a beautiful girl crossing the road instead of looking at the car in front of him. His glance cost him over 1 lakh (Rs 100,000) in damages. But you could argue that this was a careless mistake. But what about the mistakes we make carefully?

Careful mistakes are the ones we make after long deliberation, wrong calculation leading to the wrong choice. And naturally these cost you more. Lets look at Insurance for instance.

Firstly, we need to be a clear about one point — Insurance is a cost. Whether one would want to incur this cost or not, and to what amount, is a matter of personal choice. And since it is a cost, the obvious thing to do is minimize the cost without sacrificing the basic life cover.

The big mistake
This is where the big mistake comes in: Pure-protection policies, where one doesn’t get anything back if one survives the policy term, are the ideal choice for the above objective. But psychologically, it is difficult for people to pay-up hard cash for an intangible product, ie security. So they go in for insurance products with returns.

Hence, moneyback and endowment (and of late Unit Linked Insurance Plans or ULIPs) type of policies are taken. But this is what they forget:

• The same amount that they would otherwise pay in a term policy also gets deducted from these so-called protection and investment policies. And only the net amount gets invested.
• The administrative costs are high
• Corpus is invested in very safe instruments
• Therefore, the returns from such policies are usually very low — usually in the range of 5-7% pa.

Naturally, a person would be better off taking a term policy to get the life cover and investing the balance premium amount say in PPF where he can earn 8% pa returns (assuming he wants no risk of investing in equity, where the returns can be much higher).

The mass exodus
As more people realise their mistake, they want to exit from such insurance policies. Unfortunately, early exit from insurance policies results in a huge loss. So does it make sense to surrender one’s policies despite this loss? There could be three broad scenarios possible, depending on how many premiums you have already paid, out of the total premiums payable.

• Early stage: A policy can be surrendered only if it has been in force for three years and premiums have been paid for these years. If you have paid just one or two annual premiums, then you will get back nothing when you exit from the policy. Even thereafter, you will get back say only 25-35% of the premiums paid + bonus accrued, if any. This is for a typical 20-year term policy. The % varies depending on the term and premiums paid.

Now, if you invest this amount + the future premiums in other investment options, you will need to generate around 9-11% p.a. returns to recover the lost premiums and break-even with the insurance policy if you had continued with it.

If you’re confident take a hit and move on!

• Middle stage: If you are somewhere around the middle of the policy, you can either surrender the policy by taking around 50% of the premiums paid + bonus; and invest this and the future premiums somewhere else. But remember that the absolute loss is higher here as more premiums have been paid and time for recovery is less. So, you need to generate maybe around 14-17% pa returns to break-even.

Optionally, you can make the policy fully-paid. Your sum assured will be suitably lowered. And you will back the premiums paid + bonus earned — but only at the end of the original term. Also no fresh bonus will accrue during this period. The net return for this amount works out about 4%. Invest the future premiums in the other options. Here you may have to generate somewhat lower returns of around 12-15% p.a. to break-even on overall basis.

• Late stage: If your policy is just about to mature in three to five years, then it may well be prudent to let it run its course. You can’t do much by saving 3-5 years’ of premium payments.

These are only broad numbers purely for indicative purposes. It’s important that you do a detailed working for each of your policies, before taking any further action.

But, with a GDP growth expectation of 7-10% over the next decade or so, the returns outlined are pretty reasonable especially if you choose equity. If you have the capacity for a little risk, go ahead. After all, there’s no gain without pain right?

Author: Sanjay Matai
Source: Wealth, MoneyControl