- LIC’s annual bonuses come out of the valuation surpluses in policyholders’ funds. They are not guaranteed
- They are simple additions to your account and don’t compound.
- They are not comparable to other kinds of returns because they are calculated on your Sum Assured and not Premiums paid
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Strongly refuting social media rumours that it was in financial trouble, the LIC (Life Insurance Corporation of India) has recently pointed out that it has just declared a record bonus of over Rs 50,000 crore to its policyholders for 2018-19. Many investors flocking to traditional insurance plans are also attracted by their annual bonus declarations. The latest set of bonuses declared by LIC on its various schemes are available in this link.
The simple reversionary bonus
The word ‘bonus’ conjures up visions of a freebie in the minds of most of us. If a company whose shares you own declares a 1:1 bonus, you get a free share for every share you already own. If the company you work for suddenly decides to give you a hefty ex-gratia payment for Diwali, that’s a bonus you look forward to.
But bonuses declared by life insurance companies are not really freebies, but come out of the valuation surpluses on their policyholders’ funds.
To explain, LIC’s main business is to provide life insurance covers to policyholders who pay it an annual premium. Of all the policyholders who may sign up for life insurance, only a few will likely pass away within the policy term, allowing their nominees file a claim.
Now, the premiums collected from all policyholders is invested in a Life Insurance Fund that is managed by the LIC. This Fund is meant to pay out death claims to the beneficiaries who claim it each year. But how does LIC know if the sums sitting in its Life Fund are enough to meet the claims of all its policyholders’ who may die in future?
To gauge this, it appoints a specialist known as an “actuary” to do a comprehensive valuation exercise of all its insurance liabilities at the end of each year, based on assumed mortality rates. Once this valuation exercise is complete, LIC may find that the Life Fund that it is sitting on is in excess of the liabilities forecast by the actuary.
It is this sum, known as valuation surplus, which is distributed to policyholders in the form of annual bonuses. In LIC’s case, 5 percent of the valuation surpluses that are discovered each year go to the Central Government, which provides a sovereign guarantee on LIC’s life policies. The remaining 95 per cent is distributed as bonus to policyholders. At the end of FY19, LIC had Rs 28.31 lakh crore in its Life Insurance Fund and the actuary estimated its net liabilities at Rs 27.78 lakh crore. The difference of Rs 53,211 crore was the distributable surplus. Of this, the Government bagged Rs 2660 crore, allowing Rs 50,551 crore to be paid out as bonus to policyholders in LIC’s traditional plans.
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The bonus paid out of the valuation surplus is called a Simple Reversionary Bonus. Though LIC policies have paid out steady Simple Reversionary Bonuses each year, you as an investor need to note that these are not guaranteed. Should the LIC’s Life Fund fall short of its actuarial valuations in any year, it has every right to skip the Reversionary Bonus.
Do note that the Reversionary Bonuses declared by LIC are calculated as a proportion of the Sum Assured in your policy and NOT the accumulated premiums paid by you. For instance, if your insurer has declared a bonus of Rs 45 per Rs 1000 on your endowment plan with an annual premium of Rs 25000 and a Sum Assured that is 20 times of Annual Premium, your bonus will amount to Rs 22500 (Rs 500,000 x 45/1000).
The other bonuses
Apart from the Simple Reversionary Bonus, many LIC policies also offer two other kinds of bonuses. One is Guaranteed Additions, often for the first few years of the policy. As the name implies, this is a fixed sum added to your policy and is generally calculated as a percentage of Sum Assured. It will be paid irrespective of the valuation surpluses made (or not made) by LIC in any given year. In the above example, a Guaranteed Addition of 3 per cent for the first five years will mean an annual addition of Rs 15,000 to your account (3 percent of Rs 5 lakh).
A second form of bonus is the Final Maturity Bonus or Loyalty Addition. This is usually one-time sum promised to you at maturity of the policy, provided you stay with the policy (paying regular premiums) for a minimum number of years. Final Maturity Bonuses or Loyalty Additions are usually not quantified at the beginning. They are paid out of LIC’s surpluses after reversionary bonus payouts.
What you need to know
Now that you know how bonuses are decided and paid by traditional insurance policies, tempted to buy one? Well, there are three caveats to bear in mind.
One, bonuses in life policies work on simple interest basis. Unlike the returns on bonds or cumulative fixed deposits, the bonuses declared by insurers are simple and not compound additions to your Sum Assured. This means that, while declaring a bonus for any particular year, the insurer does not factor in all the past bonuses you have earned to calculate the payout.
Two, you do not receive any of the bonuses in your hand and stand to receive them only at maturity. Though insurers may declare a simple reversionary bonus or guaranteed additions every year, these sums will add to your Sum Assured and will be eventually paid to you only at maturity. If you surrender the policy midway, you may not receive them.
Three, given that they are calculated on the Sum Assured under your policy and not on the premiums you pay, they cannot be compared to the returns on your other investments, which are calculated on your principal.
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