Insurance Policy Surrender: Pros, Cons, and Key Considerations

When you buy an insurance policy, you expect it to help you reach your financial goals or to protect you and your loved ones. However, sometimes you might feel that the policy you have no longer fits your needs or is not working the way you hoped. In such cases, you might consider ending, or “surrendering,” your policy. Surrendering an insurance policy means that you ask the insurance company to cancel it and give you back a portion of what you paid.

Before you take this step, it is very important to understand all the details, costs, and consequences involved. In this blogpost, we will see in simple terms what you need to check and consider before surrendering your insurance policy, using a practical example as well.

Understanding Policy Surrender

Insurance policies are designed to work over a long period of time. Most policies are not very flexible in terms of accessing your money because they are meant to be a long-term financial tool. One major challenge that policyholders face is the lack of liquidity – meaning that the money you put into the policy is often not easy to get back quickly, and when you do, it might come with a high cost.

Even though the rules allow you to cancel or “surrender” your policy at any time, the penalties can be so steep that many people choose to keep the policy, even if it no longer meets their goals. This is a common issue because many young people are persuaded by family members or agents to take policies that promise high returns or guaranteed outcomes. Over time, however, you might realize that the product is not as beneficial as you thought.

When you surrender a policy, the insurance company pays you a sum of money called the “Surrender Value” (SV). This amount is usually a fraction of what you have paid so far, and the percentage often increases as you continue the policy for a longer time. Typically, most policies have a minimum period, usually around two to three years, before you become eligible to get any surrender value. This waiting period is designed to protect both the policyholder and the insurer, ensuring that the surrender amount is not extremely low.

Review of Surrender Terms

Every insurance policy comes with its own set of rules, and these rules include what happens if you decide to surrender. It is very important to review these terms before making any decisions. Different types of policies have different surrender conditions.

For example, endowment policies, which are life insurance plans that combine protection with savings, often require you to have paid premiums for at least two years before you can surrender the policy. Even then, the amount you get back might be very small compared to what you have paid. This is because the policy is designed to mature over a long period, and early cancellation leads to significant penalties.

On the other hand, if you have a Unit-Linked Insurance Plan (ULIP), the surrender rules might vary. ULIPs are different because they mix investment with insurance protection. The rules for surrendering a ULIP can change depending on when you bought the policy, as there have been several updates to the regulations over the years.

In many cases, if you cancel a ULIP before a certain period (often five years), your money is transferred into a different fund called a discontinued policy fund. You might then have to wait until the end of the five-year period to receive your money. Because these rules can change, it is very important to read your policy document carefully at the time of purchase and review it if you are thinking about surrendering.

In short, before deciding to surrender your policy, check the following:

• Minimum Lock-In Period: Verify how long you need to maintain the policy before you are eligible for any surrender value.
• Specific Conditions for your Policy Type: Understand that endowment policies and ULIPs have different rules, and the exact conditions depend on your policy’s terms.
• Updates in Terms: Remember that rules may change over time, so always refer to the most recent version of your policy document.

Evaluating the Surrender Value

One of the most crucial aspects to consider is the surrender value itself. The surrender value is the amount that the insurance company will give you if you decide to cancel your policy early. There are generally two types of surrender values that you might encounter:

1. Guaranteed Surrender Value (GSV): This is a fixed percentage of the total premiums you have paid (usually excluding taxes and extra charges for riders). It is a baseline amount that is known at the time you purchase the policy.
2. Special Surrender Value (SSV): This is usually higher than the guaranteed amount because it takes into account any bonuses or additional benefits that have built up over time. Initially, in the early years of the policy, the difference between GSV and SSV is very small. However, as the policy matures and more bonuses accumulate, the SSV can become significantly larger.

Let’s go through an example to make this clearer. Imagine you have an insurance policy with the following details:

• Sum Assured: Rs. 5 lakh
• Annual Premium: Rs. 20,000
• Policy Term: 25 years

Now, consider two scenarios for surrender:

• Scenario 1: Surrendering the policy after 5 years.
• Scenario 2: Surrendering the policy after 10 years.

The insurance company calculates the surrender value using a formula:

  Surrender Value = Paid-Up Value × SV Factor

Here, the “Paid-Up Value” is the total amount of premiums you have paid so far, and the “SV Factor” is a percentage determined by the insurer based on how long you have been paying premiums. For example, if the SV factor is 20% after 5 years and 40% after 10 years, then:

• After 5 years: Paid-Up Value = 5 years × Rs. 20,000 = Rs. 1,00,000

Surrender Value = 1,00,000 × 20% = Rs. 20,000

• After 10 years: Paid-Up Value = 10 years × Rs. 20,000 = Rs. 2,00,000

Surrender Value = 2,00,000 × 40% = Rs. 80,000

Notice that even though more money has been paid in the second scenario, the penalty or the cost of surrender can still be significant. In the first scenario, if you surrender after 5 years, your loss is high compared to what you paid, and the loss might become even larger over time. This example shows that the longer you stay with the policy, the higher the surrender value may be, but only up to a point, and often with a penalty that cuts deeply into your invested money.

Comparing Investment Returns

Another important factor to weigh when thinking about surrendering your policy is the return on investment. Many traditional endowment policies provide returns in the range of 5-6 percent per year. However, these returns are not always clearly mentioned in the policy documents, which makes it harder to understand how much you are really earning from your investment.

To get a true picture of your returns, you need to look at all the money coming in and going out of your policy over time. One useful method for this is calculating the Extended Internal Rate of Return (XIRR). XIRR is a way to measure the annualized return on an investment when the cash flows (both incoming and outgoing) happen at irregular intervals. This method uses the exact dates of your premium payments and any returns you receive, making it a more accurate reflection of your investment performance.

For many policyholders, it can be beneficial to compare:

• The Returns from Continuing the Policy: Consider the benefits of staying with the policy and receiving a potentially higher surrender value later on.
• The Returns from Investing Elsewhere: Think about what you might earn if you stopped the policy and put your money into another investment vehicle.

A professional financial advisor can help you work through the numbers and run an XIRR calculation. This will let you see whether surrendering the policy now makes financial sense or if it is better to stick with the policy despite the high surrender charges.

Other Considerations: Beyond the Numbers

It is important to remember that the decision to surrender an insurance policy is not only about the immediate costs or the surrender value. There are several other factors to consider before you decide to cancel your policy:

1. Purpose of the Policy: Ask yourself why you bought the policy in the first place. Was it mainly for protection, for savings, or a mix of both? If the main goal was to secure protection for your family in case something happens to you, the benefits of that security might still outweigh the cost of a lower surrender value.
2. Existing Coverage: Check if you have another policy or protection plan that can cover your needs if you cancel this one. If you do not have an alternative plan, surrendering the policy might leave you without important coverage at a time when you need it most.
3. Long-Term Financial Goals: Consider your broader financial plan. If you are planning for long-term savings or retirement, the benefits of the policy might still play a key role even if the surrender value seems low. Sometimes, the security and discipline of regular premium payments are worth more than the immediate cash return.
4. Policy Mis-Selling Issues: Many times, insurance policies are sold with promises that sound very attractive but do not match the reality of the product. If you suspect that the policy was mis-sold—perhaps pushed on you by family or an agent with promises of high returns—surrendering might be tempting. However, a higher surrender value does not fix the issue of mis-selling. Instead, the solution lies in making sure you have clear and honest information about what you are buying, including all the benefits and limitations. Regulators have urged insurance companies to be more transparent about policy details, especially concerning surrender rules and the actual returns you can expect.
5. Future Prospects: Look ahead and consider if there might be any changes in your life or in the market that could affect your decision. For example, if your financial situation is likely to change soon or if new policies with better terms are expected to come into the market, it might be wise to wait or reassess your current policy rather than surrender it immediately.

A Step-by-Step Checklist before Surrendering

Before you decide to surrender your insurance policy, go through this checklist to help you make an informed decision:

• Read the Fine Print: Review your policy document carefully to understand all the surrender terms and conditions. Look for details such as the minimum lock-in period and how the surrender value is calculated.
• Calculate the Surrender Value: Use the formula provided by your insurer to calculate the surrender value. Consider how the SV factor changes over time and compare the expected cash amount with the total premiums you have paid.
• Assess Your Financial Needs: Think about whether you need the money right away or if you can afford to stay with the policy. Sometimes, surrendering a policy to get quick cash can lead to larger losses in the long term.
• Consult a Financial Advisor: If the calculations or the policy terms seem confusing, seek advice from a trusted financial advisor. They can help you run numbers, such as the XIRR, and guide you on whether surrendering is a wise financial move.
• Review Alternative Options: Compare the surrender value with potential returns from other investments. Ask yourself if you could get better returns by using the money elsewhere, or if the security provided by the insurance policy is more valuable.
• Think About Coverage Needs: Consider the protection the policy provides. If surrendering means you lose a vital safety net, make sure you have another plan in place to cover that gap.
• Reflect on Your Original Goals: Revisit the reasons why you bought the policy initially. Even if the surrender value seems low, the protection and long-term benefits might still be important for your overall financial strategy.

Making the Final Decision

The choice to surrender an insurance policy should never be taken lightly. Although the surrender value might seem like a quick way to access your money, it often comes at a high cost. When you surrender, you may incur significant penalties, and you might end up with far less money than you expect. It is very important to weigh both the immediate financial loss and the long-term impact on your financial goals.

If the policy was purchased without a clear understanding of its features or was sold with misleading promises, you might feel that surrendering is the only option. However, rather than relying solely on the surrender value, think about all the factors involved:

• The protection it offers against unforeseen events.
• The discipline of regular premium payments that contribute to long-term savings.
• The overall return on investment compared to other financial products.

In many cases, if you find that your policy no longer aligns with your financial goals, you might be tempted to surrender it. Yet, before taking this step, it is crucial to do a full review. Ensure that you have compared the surrender value, calculated the potential returns using methods like XIRR, and considered your current and future coverage needs.

Ultimately, the decision rests with you. If you are confident that another investment or insurance product will better meet your needs, then surrendering the policy might be the right choice. However, if you are unsure, it might be wise to hold on and consult an expert who can help you assess all the benefits and drawbacks.

Conclusion

Surrendering an insurance policy is a major decision with long-term financial consequences. It is not just about the immediate cash you receive but also about how that decision fits into your broader financial plan. Taking a step back and reviewing your policy in detail, while seeking professional advice if needed, can help you avoid costly mistakes.

In summary, before you surrender your insurance policy, be sure to check the surrender terms outlined in your policy document, understand how the surrender value is calculated, and compare your potential returns with other investment opportunities. Look beyond the immediate cost and consider your overall coverage needs, long-term financial goals, and the clarity of the information provided by the insurer. By doing so, you will be better prepared to decide whether keeping the policy or surrendering it is the right move for your financial future.

Check out my other article on how and why mis-selling of insurance products takes place.

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