Surrender of life insurance policy and Its Impact

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LIFE insurance, like marriage, is a long-term relationship. You have an exit option, but it can be messy and expensive.

The scrutiny of the game is similar to the way financial experts' advice on exiting an insurance policy. Some flatly recommend immediate termination, some suggest to wait for five years, and some also go that far to suggest the policy attains the paid-up status. In reality, the mumbo-jumbo does not state the fact that one looses if they exit a policy before its stated tenure.

Policyholders should be aware that unlike other savings instruments, life insurance policies are long-term tools and it is difficult to get out of them without taking a financial blow.

Compared with other financial instruments such as mutual funds or even a bank deposit, insurance is for the long term and, hence, has a substantial loss if one exits early. Short term needs vary and are flexible, however, long-term needs are rigid. For instance, there is no compromise in the year you will need money for your child's education or marriage, compared with a vacation or buying a car, two years from now. It is for this very reason that we always advocate that life insurance should be bought for the right reasons and the needs to be matched to the policy benefits.

Therefore, while making a long-term financial decision, one should be aware and create the necessary cash flow to continue the plan. However, despite such provisions, one may buy the policy wrongly, in which case insurers provide a 15-day free-look period for the policyholder to exit the policy with minimal loss. Such an exit feature is available only with life insurance plans and no other financial instrument. At every instance, policyholders should be aware that exiting an insurance policy should be done without compromising on their insurance needs.

In most circumstances, exiting a life insurance policy is a bad idea. The three factors to consider when exiting a life insurance policy are – the policy type, the number of years the policy has been in force for, and the reason one wishes to exit the plan. If one wishes to exit a plan because they can no more afford to pay future premiums, depending on the type of the plan, they can seek assistance from insurers who can rework on the policy tenure or the insurance cover or a combination of the two.

If the policy is pure risk protection, exiting is simple. Just stop paying the premium. But, do remember if you were to buy a term plan again in the future, the cost will only go up.

In case of hybrid plans that mix protection and investment, the policyholder does incur losses in the form of charges on account of premature exit. The tenure of the policy comes into play in such instances because when a life insurance policy is in force for at least five years, it acquires a surrender value.

Policyholders who wait for the policy to build surrender value before exiting, miss out on the opportunity gain that the cash value can build up to maturity of the policy.

Policyholders who terminate plans before the paid up value, completely lose out on the premiums paid.

This move can work favourable for very long-term plans because instead of staying invested for very long, the policyholder can cut their losses and instead look for better opportunities.

The same analogy should be applied if one is considering exiting such policies before they attain the paid-up value.

One should analyse the benefits of cutting costs on future payments before exiting and the prospects of benefiting from alternate investments. In extreme instances when one does surrender a policy by lapsing it, there is room to revive the policy ones things get better within limited time frames.

This is again an option which needs to be resorted to only in dire straits.

The exit complexity also takes tax treatment into account. It is akin to a rain-hit match where the 'Duckworth Lewis' method comes into play to decide the course of the match. The surrender value is tax free, provided the insurance component of the policy is five times the premium. On surrendering a policy after claiming tax deductions under Section 80C, the rules of the game change. According to the income tax rules, tax savings are reversed if the policyholder does not keep a single premium policy in force for two years after the date of commencement of the policy or regular premium policy premiums are not paid for two years.

Unlike a regular cricket match where the chance of a team winning is equal, surrendering an insurance plan before its complete term has a higher probability of actual loss to the policyholder. 

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