Non-linked insurance plan: Surrender or stay? Do the math before deciding

The new norms contained in IRDAI's exposure draft, if implemented, will make surrendering less painful

The Insurance and Regulatory Development Authority of India (Irdai) has issued an exposure draft on the surrender value of non-linked insurance policies. These rules, if implemented, will make it less painful for customers to 

surrender a policy they don’t wish to continue with.

Issue with current norms

Currently, if a customer surrenders a non-linked, regular premium plan before having paid two premiums, he doesn’t get any money back. He gets 30 per cent of the total premium back if he surrenders after paying two premiums, 35 per cent after paying three premiums, and so on.

“If by mistake you have bought a plan which you don’t wish to continue with, you lose a large portion of the premiums paid if you surrender in the initial years,” says Deepesh Raghaw, a Securities and Exchange Board of India (Sebi) registered investment advisor (RIA). The key reason for high surrender charges is the commission structure. Says Abhishek Kumar, Sebi RIA and founder, SahajMoney: “The commission paid to intermediaries is front-loaded and can go as high as 40 per cent of the annual premium in these policies.” The large hit makes customers reluctant to surrender a policy. 

“Policyholders experience sunk cost fallacy — the inability to abandon a strategy because they are invested heavily in it, even though abandoning it would be more beneficial,” says Kumar.

Proposed changes

The exposure draft introduces the concept of threshold premium: any amount above it will not be subject to a surrender charge.

 Here’s an example from the exposure draft to illustrate how guaranteed surrender value (GSV) will be calculated. Suppose that a customer pays an annual premium of Rs 1 lakh and the threshold premium is Rs 25,000.

Earlier, the policy acquired a surrender value after the payment of two premiums. “The proposal has decreased this to just one,” says M. Pattabiraman, associate professor, IIT Madras and founder, Freefincal.com.

If the customer surrenders after paying one premium, the threshold premium will be deducted and he will get the balance back — Rs 75,000 in this case.

If the customer has paid three premiums (Rs 3 lakh), the total threshold premium will be Rs 75,000 (25,000 x 3). The customer will definitely get Rs 2.25 lakh (Rs 3 lakh minus Rs 75,000) back. Surrender charges will only apply to Rs 75,000. If a customer gets 35 per cent back, he will receive Rs 26,250 (75,000*35 per cent). The GSV he receives will come to Rs 2,51,250 (2,25,000+26,250).

According to Pattabiraman: “With the new changes, the loss, even if the policy is surrendered close to maturity, is expected to be significantly less.”

Mayank Gupta, co-founder and chief operating officer, Zopper, remarks that the exposure draft marks a movement towards a more consumer-friendly regulatory regime.

Strategy for surrendering

Experts say an unsuitable policy should be surrendered immediately under the current regime. Says Pattabiraman: “Many buyers are hesitant because of the incurred loss. However, paying more premiums or making the policy paid up will usually result in a higher loss. Therefore, it is better to cut one’s losses and invest the premium with a plan suited to one’s future goals.”

Customers tend to be willing to stomach the loss if they have only paid one premium (assuming the amount is not very large). A bigger issue arises if they have paid three or four premiums. In such cases, Raghaw suggests doing (or getting done by an expert) the following calculation. Assess the cash flows that the product will generate over its tenure.

Subsequently, estimate the Internal Rate of Return (IRR) you would need to earn to replicate similar cashflows by investing the surrender value and the remaining premiums in an alternative product with a similar risk profile. Adjust for the cost of life insurance if needed.  
 

“If the post-tax return you need to earn to recreate policy cash flows seems too high, continue with the current plan, provided you can pay the premiums,” says Raghaw.
 

Finally, do rigorous research before investing in a non-linked plan so that the need to surrender does not arise.

Non-linked policies
 

Prevailing surrender value norms

In the case of non-single premium policies, the policy acquires a guaranteed surrender value (GSV) if premiums have been paid for at least two consecutive years

The GSV is at least 30 per cent of the total premium paid if the policy is surrendered during the second year (after payment of two premiums)

It is 35 per cent if surrendered during the third policy year; 50 per cent if surrendered between fourth and seventh policy year; and 90 per cent if surrendered during last two policy years

From the amount payable, any survival benefits already paid is deducted

To the GSV is added the surrender value for any subsisting bonus and any guaranteed additions already accrued to the policy