# Beware of the insurance terminology

The wording of insurance contracts is normally difficult for a lay person to understand. Insurers need to make contracts and communication easier for policyholders, Sanjay Matai explains

October 10, 2012 12:27 IST | India Infoline News Service
A few days back, one of my clients sent me the following e-mail seeking my opinion on a particular insurance policy:

"Hi Sanjay, Attached is the file sent by ****** Bank rep. who are selling this product. Pls advise if suitable. It gives 7.5% assured return, plus 6 to 10% additional, complete total amount is tax free. If ok, then i intend to invest about Rs. 2 lakhs p.a.
tks n regards."

I was surprised by this as it seemed too good to be true. When I studied the details of the Plan, I realised that the terms used by the insurance company were highly misleading. Now, this particular client of mine is a well-informed investor. I was wondering that if he could misunderstand the policy terms, then it would be too much to expect for an average investor to understand the policy and take an informed decision.

The policy required that my client should pay Rs. 2 lakh premium per annum for the first seven years i.e. a total payout of Rs. 14 lakh (sum assured is Rs. 8,32,051). He was promised a guaranteed amount of Rs. 62,404 from the seventh year to 21st year of the Plan and a guaranteed maturity payout of Rs. 8,94,455 in the 22nd year. Further, depending on the actual performance of the fund, a higher payout would be payable. In this regard, calculations at 6% and 10% returns were worked out.

Here’s what I discovered. The 7.5% assured return is NOT the return that we understand in the normal parlance. It is NOT the return on our investment of Rs. 14 lakh—which comes to Rs. 14 lakh x 7.5% = Rs. 1,05,000 per annum. The 7.5% return is calculated on the sum assured of Rs. 8,32,051. (That is Rs. 8,32,051 x 7.5% = Rs. 62,404). Thus, in actual terms Rs. 62,404 on Rs.14 lakh works out to just 4.46% (Rs. 62,404 / Rs. 14 lakh = 4.46%). But this is not the end of the story.

Now if you invest Rs. 2 lakh per annum in a safe fixed deposit instrument for seven years, at the end of the seven years you get Rs. 1,05,000 each year at 7.5% p.a. interest rate. However, the insurance Plan mentioned above provides only Rs. 62,404 each year after paying premium of Rs. 2 lakh p.a. Here there is a clear loss of Rs. 42,597 (Rs. 10,5000 minus Rs. 62,404).

According to the policy, the guaranteed amount of Rs. 62,404 is paid from the seventh year to 21st year. So at the end of the 22nd year, you get Rs. 8,73,656 (Rs. 62,404 x 14) instead of Rs. 14,70,000 (Rs. 10,5000 x 14). Therefore, there is a loss of Rs. 5,96,358 (Rs. 14,70,000 minus Rs. 8,73,656).

This payment of Rs. 62,404 starts only after seven years. Hence, there is no return for first seven years. Therefore, the effective guaranteed return over 22 years works out to be just around 2% and not 7.5% as people are being led to believe. My contention is why use the word ‘return’, which can be easily misunderstood as return on one’s entire investment over a period of time.

The policy brochure mentioned that if the fund generates 6% return, the guaranteed maturity payout would be Rs. 19,72,793 in the 22nd year. Thus, the effective guaranteed return is around 5% p.a. Similarly, the brochure further said, if the fund generates 10% gross return, the guaranteed maturity payout would be Rs. 37,91,299, while the effective guaranteed return is about 8% p.a.

I am sure we can get much better returns than the above mentioned returns by investing in pure investment products such as a bank FD offering 9.5%-10% and above interest rate.

There is another issue with guaranteed products. If insurance companies invest in equity and markets are down, they will have to shell out money from their pockets if they have to honour the guarantee. No insurance company would prefer to make loss, if the markets are down. Hence, they will surely invest money in debt instruments. So investors should forget earning higher returns on their plans.

A normal non-guaranteed product is comparatively a better choice as over long term one can expect good returns because the fund manager can afford to invest in equities. (Of course, the product may still find it difficult to give better returns than a normal equity mutual fund).

Insurance companies need to take efforts to simply the language of their policies so that there is no scope for such ambiguities.
The wording of insurance contracts is normally difficult for a lay person to understand. Insurers need to make contracts and communication easier for policyholders.

Investment Vs Returns
 Years Guaranteed Option At 6% returns assumption Outflow Inflow Netflow Outflow Inflow Netflow 1 200,000 - 200,000 200,000 - 200,000 2 200,000 - 200,000 200,000 -200,000 3 200,000 - 200,000 200,000 -200,000 4 200,000 -200,000 200,000 -200,000 5 200,000 -200,000 200,000 -200,000 6 200,000 -200,000 200,000 -200,000 7 200,000 -200,000 200,000 -200,000 8 62,404 62,404 62,404 62,404 9 62,404 62,404 62,404 62,404 10 62,404 62,404 62,404 62,404 11 62,404 62,404 62,404 62,404 12 62,404 62,404 62,404 62,404 13 62,404 62,404 62,404 62,404 14 62,404 62,404 62,404 62,404 15 62,404 62,404 62,404 62,404 16 62,404 62,404 62,404 62,404 17 62,404 62,404 62,404 62,404 18 62,404 62,404 62,404 62,404 19 62,404 62,404 62,404 62,404 20 62,404 62,404 62,404 62,404 21 62,404 62,404 62,404 62,404 22 956,859 956,859 2,035,197 2,035,197 IRR 1.90% IRR 4.86%
Note: Annual returns and maturity amounts are according to the benefit illustration given by the insurance company.

The writer is the promoter of The Wealth Architects.

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