Cost of early exit from life insurance may cost a little less, but will still hurt

The insurance industry is aware of the fact that high lapse rates coupled with very high surrender costs can cause a huge reputation risk to the industry.

The cost of ditching your bundled insurance plan—traditional policies that club investment with insurance—is high and, according to the new product regulations notified on 10 July 2019 , will continue to hurt.

Although, as signalled in the draft guideline released in October last year, the surrender costs—charge for leaving the policy before the term expires—have come down slightly, they are nowhere close to giving you the comfort of moving out of an insurance plan mid-way with little cost implications.

New cost structure

Currently, when you buy a traditional bundled plan with a term of over 10 years, you are eligible for a surrender value only after three years. The new rules have brought down the period to two years. This means if you have paid two annual premiums of, say, 100 each, on surrender , the policy will pay 30% of the premiums or 60 back; the draft had proposed a 35% pay back. If you surrender after paying three premiums (in the third year), the minimum guaranteed surrender value will increase to 35%. Surrender between the fourth and seventh years will have a minimum guaranteed surrender value of 50%. After the seventh year, the rules remain the same—insurers are allowed to fix surrender values, except that the new rules mandate that surrender values follow a smooth progression and converge to at least 90% of the premiums as the policy approaches maturity.

In order to give more in the hands of policyholders who decide to quit mid-way, the draft had suggested that the guaranteed surrender value would also give at least 30% of the value of accrued bonuses along with the minimum guaranteed surrender value. The final rules, though, don’t specify a minimum limit, but just state—as is the norm even now—that the guaranteed surrender value would comprise the surrender value of any accrued bonuses or benefits. According to a senior executive of a private life insurance company, who spoke on the condition of anonymity, the surrender value of bonuses was always way less than 30% and if the final rules had mandated at least 30% payback, it would have suppressed returns for existing policyholders as it would have increased the amount of “reserving” with the company.

Limited open market on annuity

The other big change is for pension plans offered by life insurance companies. As per the new rules, on maturity, now you can keep up to 60% of the corpus as lump sum—up from 33.33%—and annuitize a minimum of 40% of the corpus. The new rules on withdrawals make pension plans on par with the National Pension System (NPS).

Further, while the draft guidelines aimed to give full freedom to the policyholders to buy an annuity product that pays pension for life from any insurer, the new rules are a halfway house between the current practice and the draft. While the current rules mandate that you need to annuitize the maturity corpus through the same insurer you bought the pension plan from, the new rules mandate that only up to 50% of the corpus will have to be annuitized from the same insurer. The idea is to offer flexibility to the policyholder to shop for an annuity product in the market on the one hand and, on the other, encourage insurers to develop their annuity portfolios.

The insurance industry is aware of the fact that high lapse rates coupled with very high surrender costs can cause a huge reputation risk to the industry. However, the industry has not been able to slash surrender costs drastically like it did for unit-linked Insurance plans, and so the traditional insurance market continues to be a buyers-beware market.