How do life insurance products work

Friend 1: “Do you have a life insurance policy”?

Friend 2: “Yes”

Friend 1: “Which one?”

Friend 2: “I don’t know. I bought it because my financial advisor said it is a good policy!”

Friend 1: “Okay, but what benefits does it provide?”

Friend 2: “Not sure. But I pay Rs.25,000 as premium each year and get Rs.20,000 as bonus each year! It is a very good policy. You should buy it too!”

Conversations such as the one above, between two friends, are both – amusing and alarming at the same time! It is unfortunate that many a times, we blindly trust our financial advisor and simply buy a product ‘recommended’ by him / her without asking some basic questions and understanding the product ourselves.

To a certain extent, the life insurance industry is to be blamed for making the insurance products so complicated to understand. However, it is also us, as the policyholders, who have never put in the effort to try and understand the insurance products offered and whether or not they meet our specific needs.

This article aims at de-mystifying some of the commonly used jargon in the life insurance industry.

Various ways to define the features of a life insurance product

The main attributes of a life insurance product can be defined based on the following:

Benefit term of the product
Premium payment term of the product
Premium payment frequency
Ownership of the product
Number of people insured
Based on taxation aspects governing the product
Linked vs. non-linked (or traditional)
Type of benefits offered
Profit participation feature
Nature of profit participation

Let us understand these concepts in some detail.

Benefit term of the product

This is simply the number of years for which the product provides the various benefits. For example, you may have a product that is for 20 years, meaning that the various benefits are provided to you over 20 years only.

However, not all products have a term specified. For example, some products may provide the benefit for the whole of your life – as long as you live!

Premium payment term of the product

This is simply the number of years for which you need to pay premiums under the policy. The premium payment term may or may not be the same as the benefit term.

For example, for a product having benefit term of say 20 years, the premium payment may be for one year (referred to as ‘single premium’ plan) or for a limited period shorter than the benefit term (e.g. for 5/10/15 years) or for the entire benefit term of 20 years itself (referred to as ‘regular premium’ plan). Typically, the shorter the premium payment term, the higher would be the premium amount that you are required to pay. This is so simply because the insurance company may need to recover its costs of providing the benefits to you over a shorter period, resulting in a higher level of premium each year.

Premium payment frequency

The premium payment frequency is the number of times in a year that you are required to pay the premium of your policy. This could be monthly (12 times a year), quarterly (4 times a year), half-yearly (2 times a year) or annually (once a year).

Although more frequent premium payments result in each instalment to be of a smaller amount, overall, you would end up paying more premiums over the year than if you had opted for a less frequent premium payment.

For example, if the annual premium for a policy is Rs.12,000 and if you opt for a half-yearly premium payment, you may be required to pay Rs.6,120 every six months, resulting in a total premium outgo of Rs.12,240 over one year.

Ownership of the product

A life insurance product can be owned by either an individual or by a ‘group’.

The policies that we buy are ‘individual’ policies – owned by us as individuals.

However, in some cases, we get insurance benefits by virtue of being part of a group – e.g. because we may be employed in a company or because of us having borrowed a loan from a bank etc. In such circumstances, the employer or the bank is the owner of the policy even though you may be the person on whose life the insurance is obtained.

The premiums charged on a group policy are typically lower than those on an individual policy given that the insurance company also saves money on cost of administration.

Number of people insured

An ‘insured’ person may be different from the owner of the insurance policy. The ‘insured’ is the person, upon whose death, the benefits under the policy become payable, whereas the policy owner has the legal rights on the policy. Typically, the insured and policyowner are different in group policies.

However, they may also be different in individual policies – e.g. where a parent has bought a child policy to fund for the child’s future education.

Although in most individual insurance policies, there may be only one person insured, there are individual products that allow you to have two insureds (typically husband and wife) in the same policy.

These are called ‘joint life’ policies. The insurance benefits under such joint life policies become payable either upon death of the first insured person or upon death of both insured persons.

Of course, in certain health insurance products, the entire family can be insured in a single policy – such that the insurance company will reimburse the expenses upon hospitalisation of any member of the family insured.

It would be more cost effective for you to have multiple people insured in a single policy than to buy multiple policies on the life of each of the insured persons

Based on taxation aspects governing the product

In India, there are certain tax advantages enjoyed by insurance companies on products that are classified as ‘pension’. Essentially, any profits of the insurance company arising from ‘pension’ business are tax free under the current tax laws.On the contrary, any profits arising from life insurance business that are not classified as ‘pension’ (and which is referred to as ‘life’ business for taxation purpose) are taxable under the current tax laws.

Given this, the insurance products offered by companies may be classified as either ‘life’ or ‘pension’.

It may be noted that the maximum commission payable to the distributor is also lower in a ‘pension’ product than in a ‘life’ product. Also, the regulations governing investment of the funds underlying a ‘pension’ product are less restrictive than those in a ‘life’ product.

Given the differences between ‘life’ and ‘pension’ products, all other things being equal, a policyholder may get a higher investment return (before any tax he / she may be subjected to) on a ‘pension’ policy than on a ‘life’ policy.

Linked vs. non-linked (or traditional)

‘Linked’ products are those, where the benefits offered are directly linked to the performance of an external investment portfolio or index. For example, unit-linked insurance plans (ULIPs) are the products where the policyholder’s premiums are invested in a fund of his / her choice (e.g. 100% in an equity fund; or 50% in an equity fund and 50% in a debt fund etc.) and the future benefits to the policyholder are directly dependent on the performance of the selected fund(s).

Given that the benefits offered in these products provide a direct link to the performance of the underlying fund(s), these products are very transparent in nature.

On the other hand, ‘non-linked’ (also known as ‘traditional’) products are those where the insurance benefits are not directly linked to the performance of the funds in which the premiums are invested.

In India, the investment regulations applicable to linked products are different as compared to those applicable to the traditional products. For example, in a linked life insurance product, a policyholder may be able to invest 100% of his premiums in an equity fund. However, in a traditional product, the policyholder does not have the option to decide where his premiums are invested. Instead, the insurance company decides on the asset categories in which the policyholders’ premiums are invested based on the restrictions imposed by the regulations.

Given the investment restrictions applicable to traditional products, all other things being equal, the illustrative policyholder IRR at maturity of the policy may be lower in a traditional product than in a linked product that invests 100% of premiums in an equity fund.

Type of benefits offered

This is the most commonly used categorisation of life insurance products. The products are categories based on different types of benefits offered:

Pure term product

These products offer only a death benefit during the tenure of the policy and no other benefit are available. Thus, if the insured survives the policy tenure, he / she will not receive any survival benefit.
Given that these products offer only death benefits during the tenure of the policy, they are the cheapest form of insurance available – i.e. for a given level of premium, the death benefit will be highest in these products.

Term with return of premium product

Some of us (wrongly) think about pure term products as a ‘waste of premiums paid’ if one doesn’t die during the policy tenure as one doesn’t get anything back!
To appeal to such people, insurance companies offer a variant of pure term products that refund the premiums paid, if the insured survives until the end of the policy tenure.
Given that you get back some amount at the end of the policy tenure, these products are more expensive than the pure term products – i.e. for a given level of premium, the death benefit will be lower in these products than that in pure term insurance products.

Endowment product

These products offer an ‘insurance’ (i.e. death) benefit along with some ‘investment return’ on your premiums.
The policyholder gets a death benefit during the policy tenure. At the end of the policy tenure, there is also a lump-sum survival benefit (referred to as ‘maturity benefit’), which is typically higher than the premiums paid as it includes some investment return on the same.

Anticipated endowment (or ‘money back’ as known in India) product

These products are similar to endowment products. However, the maturity benefits are paid in various instalments during the policy tenure. For example, instead of paying 100% of sum assured at the end of the policy tenure, these products may pay 20% of sum assured every five years starting from year three, and the balance amount at the end of the policy tenure.
As the survival amounts are paid out earlier (in instalments), typically, these products have a lower IRR on the premiums paid by the policyholder. However, some policyholders may prefer to buy such products given that they provide an assured ‘money back’ at regular intervals.

Whole life product

These products are similar to pure term insurance products, with no fixed policy tenure – i.e. the death benefit is paid out whenever the insured dies.
Some whole life products have a fixed tenure – e.g. the policy may terminate when the insured becomes 100 year old. Although practically, this would still be a whole life plan, in a scenario that the insured does survive until that age, the policy would pay out a maturity benefit – similar to that in an endowment product.

Annuity product

Annuities are like pension receipts – the insurance company pays out regular (e.g. annual) amounts of money as long as the policyholder survives.
There may be different variation of the annuity payable. For example, some policies may offer level annuity payments, whereas others may offer amounts that increase each year. Similarly, there may be annuities that also offer a death benefit equal to the refund of premium paid. There may also be annuities that may be guaranteed for a certain period (e.g. 5 years / 10 years) irrespective of the survival status of the annuitant.

Riders

Riders are additional coverage attached to any one of the ‘basic’ policies purchased by the policyholder.
Riders offer a cheap and convenient way to increase the overall ‘pure protection’ benefit in your life insurance products. These benefits may be of different form – e.g. additional death benefit; accidental death benefit; disability benefit; critical illness benefit etc

The actual quantum and structure of benefits offered in the various products discussed above may also be different. For example, a variation of an endowment policy may pay out 2x or 3x the sum assured as death benefit; or another variation of an endowment policy may pay out the maturity benefits in the form of an annuity.

Given the variety of products and benefits offered, it would be important for one to look into the exact nature and quantum of the benefits offered for the given level of premium, to ascertain the suitability of the life insurance product offered to you by your financial advisor.

Profit participation feature

Some of the insurance products are classified as ‘participating’ (or ‘par’ as a short-form; also known as ‘with-profits’) whereas others are classified as ‘non-participating’ (or ‘non-par’ as a short-form). These terms specify whether or not the policyholder ‘participates’ in the profitability of the life insurance company.

In par products, the policy benefits (i.e. death and maturity benefits in an endowment type plan) consist of two components – one is guaranteed and the other is non-guaranteed. The guaranteed benefits are payable irrespective of the profitability of the life insurance company. The non-guaranteed benefits are discretionary in nature and depend on the profitability underlying the fund in which the participating policies reside. If the fund’s profitability is less than expected, the insure may declare a lower non-guaranteed benefit on your policy. In an extreme scenario, the non-guaranteed benefit may well be zero. Thus, a par product allows the policyholder to benefit from future profitability of the fund, whilst providing some ‘down-side’ protection (through the guaranteed benefit).

On the other hand, in non-participating products, the policy benefits (i.e. death and maturity benefits in an endowment type plan) are fully guaranteed and decided at outset. No matter what the insurance company’s profitability would be, the policyholder’s benefits are fixed. Thus, a non-par product does not provide the policyholder to benefit from the future profitability of the fund, although it provides complete guarantee (and peace of mind!) on the benefits payable.

Nature of profit participation

The insurer declares the ‘non-guaranteed’ benefits in a par product in the form of ‘bonus’, through two main mechanisms as described below:

Reversionary bonus (RB) and terminal bonus (TB)

An RB, once declared by the insurer, is added to the sum assured in your policy. Thus, your future death benefit and maturity benefit will increase with the amount of RB declared. For example, if the sum assured of a policy is Rs.1 lakh and the insurer declares an RB of 3%, the sum assured will increase to Rs.1.03 lakhs. Thus, a subsequent death or maturity benefit will become Rs.1.03 lakhs.
The RB may be ‘simple’ or ‘compound’. In simple RB structure, the declared amount will be based on the original sum assured only, whereas in compound RB structure, the declared amount will be based on the sum of original sum assured and any historically declared RBs. Thus, all other things being equal, a compound RB will result in a much higher amount over the longer term than a simple RB.
Given that the RB is not paid-out in cash immediately (i.e. it gets added to the sum assured only, and will become payable only in the future – upon death or maturity), it would not be appropriate to compare the premium paid against the RB declared – a common mistake everyone makes in ascertaining the attractiveness of these products!
The insurance companies may also declare a ‘final’ bonus, referred to as TB, typically upon maturity of the policy. Unlike RB, the TB, by definition, becomes payable immediately in cash.

Cash bonus (CB)

Some par products include a bonus that is payable in cash. Unlike RB, the CB is not added to your sum assured (and therefore becomes payable only in the future), but paid out immediately upon declaration.
However, instead of receiving the CB, the insurance companies may also provide you the ability to increase your sum assured by ‘purchasing’ additional sum assured from the amount of CB declared. In such an instance, the CB will work in a similar manner as the RB.

It is important to note that whichever mechanism is used to declare the bonus, ultimately, the ‘bonus’ to a policyholder is declared out of the profits generated from the premiums received from the policyholders themselves. There is no free lunch!

Some other commonly used terms in the life insurance industry

We have discussed a number of aspects covering various life insurance products already. Here are some additional terms that are commonly used in the industry and their meaning:

Surrender

When you want to terminate a policy before the end of its term, the policy can be ‘surrendered’ for some cash. Given that you are terminating the contract, there is usually some penalty involved and the amount you will be able to get back may be much lower than the amount you would have received had you continued paying the premiums until the end.
Typically, one should never surrender a policy as it would, almost invariably, result in some financial loss.
The policy can be ‘surrendered’ for cash only when the policy acquires a surrender value – typically from third policy year only.

Lapse

When you do not pay the premiums due and the policy does not have any surrender value payable, it is considered to be ‘lapsed’.

Revival

Insurance companies may allow policyholders who have lapsed their policies to re-start them, by payment of missed premiums and interest. This is referred to as ‘revival’ of a lapsed policy.

Paid-up / reduced paid-up (RPU)

When you have paid all the due premiums until the end of the premium payment term, the policy is considered to be fully ‘paid-up’.
However, when you have stopped premium payment in-between and if the policy has already acquired a surrender value, the policy will continue with reduced level of benefits and the policy will be referred to as in RPU status. For example, a 20-year regular premium non-participating endowment policy with a sum assured of Rs.1 lakh will have a reduced level of sum benefit of only Rs.50,000, if the policy is converted to RPU status after 10 years.

Reinstatement

Insurance companies may allow policyholders who have their policies in RPU status to reinstate them for full benefits, by payment of missed premiums and interest. This is referred to as ‘reinstatement’ of a RPU policy.

Hopefully, you may now be in a better position to analyse a life insurance product and decide if it meets the specific needs that you may have. Never buy a product before fully understanding it!

28 February 2022 | 20 minutes

Life insurance products - de-mystified!

Sanket Kawatkar