Policyholders seeking an early termination are required to pay a substantial fee.
Why do insurers impose substantial surrender charges on policyholders who wish to terminate their life insurance policy early? Both customers and insurers benefit when policies are maintained for the long term, ideally until the end of the policy term. However, there are practical economic reasons behind insurers setting high surrender charges in the event of early policy separation.
To begin with, life insurers face significant upfront costs during the initial year of the policy. Commissions, including bonus commissions, paid in the first year are considerably high. Moreover, agency managers and development officers receive substantial incentives based on the business brought in by agents. Additionally, administrative expenses remain elevated, even in the second and third years.
Recovering the significant administrative and marketing expenses incurred during the initial years of policies becomes challenging unless the policies are held for an extended period. Typically, it takes around five to seven years in a policy term of, for instance, 20 years or more, for the policies to begin contributing to a substantial valuation surplus. This holds true for most non-linked insurance products.
Policy duration plays a crucial role in this regard.
Towards the end of the policy term, if the policyholder chooses to surrender the policy, the surrender charges are minimal. As per IRDAI's guidance, all insurers now include charts in the policy documents that outline the surrender charges applicable at different policy durations. These surrender charges are determined by two key factors: the duration of the policy at the time of surrender and the overall policy term. For instance, if a policy has a term of ten years but has been in force for only five years, the surrender charge will not be high, as the policy has completed half of its term.
Furthermore, insurers predominantly invest their funds in long-duration debt instruments, aligning with the long-term nature of life insurance contracts, ensuring optimal asset-liability matching. When a significant number of early surrenders occur, it leads to a substantial asset-liability mismatch. Consequently, insurers are compelled to hold a considerable amount of funds solely to fulfill surrender payments, resulting in the loss of potential income. If these funds were invested, the returns generated could have facilitated future claim payments. To compensate for the lost income and safeguard the interests of existing policyholders, who will eventually receive claim payouts (such as maturity, survival benefits, or death benefits), insurers implement necessary surrender charges.
INSURANCE FOR THE LONG RUN
* Insurers can recoup administrative and marketing costs incurred in the initial years only when policies are held for an extended period.
* High surrender fees are implemented to recover lost income resulting from excessive early surrenders and to address asset-liability gaps.
