Traditional Insurance

History

In the Indian context, traditional insurance refers to the popular plans by originally started by LIC that combined savings and insurance. These are typically sold by a freelancer agents who get a (pretty hefty - around 25%) commission for each plan they sell as well as a (small - 1-2%) commission each time the customer pays a renewal premium. Originally these were the only alternative to Post Office schemes (NSC and Kisan Vikas Patra) for a large number of Indians. This, together with the network of LIC agents is probably what accounts for their popularity.

Issues

I am highly suspicious of products that have a large commission because I find that the commissions are rarely justified for an informed investor. This is what makes me most skeptical of traditional insurance policies. At a minimum, these result in a lower yield for the investor.

The other major reason is that there is no good reason to club insurance and investment. Clubbing the two typically only results in opaqueness - it is not clear how much of the premium goes into insurance and how much into investment making it difficult to compare with other options. Often, this is used to mask the actual returns be-fooling the investor.

Analysis

A typical plan that was sold to me had an annual premium of 24,000. The insurance provided was Rs 5 Lakh. An online policy that would typically provide an insurance of 50 Lakh at an annual premium of around Rs 8,000. So we can assume that premium for Rs 5 Lakh would be Rs 800. This means that 23,200 goes into investment.

This plan gave 75,000 every 5 years and 5 Lakh on maturity. Other returns were unclear; there would be some bonus depending on the performance of the fund. I have seen a bonus of 8 Lakh at times for similar schemes. Thus the rate of return varies form 5-10%. It is here that opaqueness comes into play. We have no idea what the risk is; whether it is tied to markets (and which ones) so that the same can be hedged. We have no certainty regarding how much money we will get so it makes planning difficult.

The largest issue, however, is that these policies are VERY illiquid. Often if you stop paying the premium after 2-3 years, the policy lapses and you do not get any return. I know a large number of people who suddenly had increased financial commitments forcing them to stop paying premiums. Many of these people suffered losses to the tune of 50,000 to 1,00,000.

Alternatives

Fixed deposits would be very safe but would give a pre tax return of 8-9%. For people in the lower tax brackets, this would easily beat the traditional insurance policies. On the other hand, mutual fund investment over a 25 year period is likely to be as risky as the traditional insurance plans but would probably give 12-15% tax free.

Lastly, I would strongly recommend everyone to buy a term life plan to take care of the insurance needs.