Your "Money-Back"or " Your-Money" Back Policy?
There is a great joy in receiving money and if it comes on its own, we feel elated! Whether what we received was already rightfully our own, becomes secondary to the pleasure of the receipt. Insurance companies and dividend- distributing mutual funds make use of this feeling of joy to innovate products that appeal psychologically rather than financially to the consumer. Let us take the case of money back insurance policies today.
A friend of mine called me to celebrate the first birthday of his kid and proudly told me that he has become a good father for this kid, at least financially. Further probing revealed that he had purchased a children‘s endowment policy with a money back option. He was happy that his son would get Rs. 50 lakh at the age of 24, which will finance his higher education.
"And do you know what the best thing is", he continued, "I will start getting back money from the insurance company! The starting premium is Rs. 126,321 (Rs. 123,150 as investment and Rs. 3,171 as payor rider premium) which reduces from 4th year onwards such that I get back Rs. 39,500 in the last year of the policy!"
Is it really good?
IRDA guidelines require that all illustrations shown by insurance companies show returns of 6% and 10% p.a. on a non-volatile basis. We will look at the "guaranteed" and the 10% returns only. Note, however, that the 10% return is highly unlikely given that the company will invest -by the design and the bye-laws of the policy - in government and secure securities.
The company is guaranteeing my friend an annual return of 4% p.a. To calculate this number, you need to calculate the IRR of the series of 24 payments of Rs. 123,150 (without payor rider premium) every year for a guaranteed value of Rs. 50 lakhs.
Now let us look at the money back part of the policy: The company says that if it makes profits on the policies it sells or on the investment it makes, it will share it with the policy holder. Assuming the 10% return, the company expects a schedule as shown in the exhibit. The company declares a bonus, which is netted off against the premium payable by the investor. Hence, in the year 3, when the bonus of Rs. 23,050 is announced, the premium for the next year is reduced by that amount. Given that we do not know how much bonus the company will declare, the premium every year will be a fluctuating number.
Now note IRR or the implied internal rate of return when the insurance company is "earning 10%". The IRR in this case works out to 7.19%, which is lower than 10% due to adjustment of "payor rider premium" , company administration charges, agent‘s commission, etc. Note that this is lower than the return from PPF, which has an implied IRR of 8%.
The interesting part of the policy is the payor rider which waives the premium in case some unfortunate event happens to my friend. Note that there is no separate life cover in this policy. However, if my friend were to take a term life cover for himself, then even if something were to happen to him, his son would get the sum assured right upfront, which he can invest such that the amount grows till the time he reaches 24.
Let us evaluate the policy:
Life cover: There is no life cover in case anything happens to my friend during the tenure of the policy. However, since he has taken a "payor rider", the premiums on this policy will be waived if something were to happen to him, such that his son will still get the money at the specified years.
Inflation: Let us look at what the amount of Rs. 50 lakh will mean to his son when he reaches the age of 24. Note that education costs rise far more quickly than the general inflation: we see that anecdotally as well as there is documented literature to show that education costs can rise by almost 1.5 times the normal inflation. Assuming a 6% normal inflation, education costs will possibly rise by 9% year on year. Hence, 23 years from now, the Rs. 50 lakh will be valued at only Rs. 6.9 lakhs (i.e. Rs. 50 lakhs/(1.09^23)) in today‘s terms. I asked my friend to think about what degrees his son can possibly acquire with this type of money today.
Returns: "There is a guaranteed return" - something that mutual funds don‘ t promise me" , said my friend. "I understand that the returns guaranteed are only 4%, but still I know for sure that I will make that return." At such low rates of return, you are actually eroding your capital!
Tax benefits: whether you invest in an insurance policy or invest in a PPF / ELSS scheme, the tax benefits are similar and the amounts are received tax free in the hands of the individual.
What is a better option?
Consider getting a term insurance (for a 30 year male, a Rs. 50 lakh cover should cost around Rs. 15,000 a year). Ideally my friend should invest the remaining amount of Rs 111,321 per year into PPF, but current regulations do not allow an individual to invest more than Rs 70,000 per annum into a single PPF account. What can be done is that my friend can invest another Rs 30,000 per annum into a PPF account opened in his wife‘s name. Doing this will allow him to claim the maximum benefit of Rs 1 lakh under Section 80 C. After 23 years, this investment of Rs 1 lakh per annum will amount to Rs. 6576476 which is higher than what the insurance company promises - and yes, all of this is tax free! So we see that by investing an amount of Rs 115,000 per annum (Rs 100,000 towards PPF + Rs 15,000 towards term insurance), which is around Rs 11,000 lesser than the premium being paid in case of the money back policy, he can build a greater corpus. Also, if something unfortunate were to happen to my friend in the meanwhile, then his son still gets the Rs. 50 lakh life cover, which can be invested on his behalf for a bigger corpus.
Un-bundle insurance and investments: This should be your guiding mantra in almost every financial decision involving insurance and investment. Else you will end up with a policy where your own money is returned to you as "money back"!