By Nirjhar Majumdar
WHY DO INSURERS impose high surrender charges if a policyholder wants to surrender his life insurance policy early in the policy term? Well, while both customers and insurers gain if the policies are kept in force for a long term if not the entire term, there are real economic reasons why insurers have to keep the surrender charges high in case policyholders look for an early separation.
Upfront cost
First, life insurers incur a heavy upfront cost in the first year of the policy. First year’s commissions along with bonus commissions are very high. The incentives that agency managers or development officers earn on the basis of business brought by agents are also quite high. Then there are high administrative expenses. Even in the second and third year, the expenses remain on the higher side.
Unless policies run for a sufficiently long period, it is difficult to recover high administrative and marketing expenses incurred by them in their initial years. Policies usually start contributing to any meaningful valuation surplus only after five to seven years in a policy term of, say, 20 years or more. This is true for most of the non-linked insurance products.
Duration of a policy
If the policyholder has to surrender the policies towards the end of the term, surrender charges are very low. As advised by IRDAI, the policy documents of all insurers now contain the charts showing surrender charges applicable at various durations of the policies. Surrender charges depend on two factors. One is the duration of policy on the date of surrender. The second is the policy term. If the duration is only five years but the policy term is ten years, then the policy has already been in force for half the term and the surrender charge will not be high.
Second, insurers keep most of the investable funds in long duration debt instruments. Since policy terms are also long, there is perfect asset-liability matching in life insurance contracts. In cases of too many early surrenders, there arises serious asset-liability mismatch and therefore, insurers are left with no option but to keep a lot of money with them only to make surrender payments. This causes loss of incomes of the insurers because had this money been kept invested, then the returns earned could have facilitated making future claim payments. In order to recover the lost incomes, the insurers impose the necessary surrender charges. This is also to protect the interests of the existing policyholders who have to be paid claim amounts (maturity or survival benefits or death) when they fall due.
Insurance policies are not meant for surrender. Unless you are in dire need of money, do not surrender your policy.
INSURANCE FOR THE LONG HAUL
* Only if policies run for a long time can insurers recover administrative & marketing costs incurred in the initial years
*Surrender fees are kept high to recover the lost incomes from too many early surrenders & thereby asset-liability gaps
The writer is an insurance industry analyst