Till private insurance companies started operating in India, endowment insurance plans were the most popular form of life insurance. After the onslaught of private insurance companies unit linked insurance plans (Ulips) seem to have taken over.

Last year, of the new insurance policies sold by private insurance companies Ulips accounted for around 90% of the policies. This though is not the case with the Life Insurance Corporation of India, endowment policies still form a major part of the insurance policies it sells. Given this, there are certain things that individuals should understand about endowment policies.

1. An endowment policy is a combination of insurance and investment: The life of the individual taking the policy is insured for a certain amount. This life cover is referred to as the sum assured.

A certain part of the premium gets allocated towards this sum assured. Some portion of the premium is allocated towards the administrative expenses of the insurance company selling the policy. The remaining portion of the premium gets invested.

2. An endowment policy may declare a bonus every year: The money that is invested generates a certain return every year. This return may be declared as a bonus. The bonus is typically generated as a certain proportion of sum assured or life cover as it is popularly known.

So if an individual taking the policy has a policy of sum assured Rs 10 lakh (Rs 1 million) and the company declares a bonus of Rs 50 per thousand of sum assured, then the bonus works out to be Rs 50,000.

3. The bonus declared is not payable immediately: Like is the case with a stock dividend or a mutual fund dividend which is payable immediately after it is declared, the bonus declared accumulates and is payable only when the policy matures or in case the policy holder dies.

4. The bonus declared does not compound it, only accumulates: Let us take the case of a 35 year old individual who takes a policy with a sum assured of Rs 10 lakh with a term of 20 years.

The premium for this would be around Rs 49,000 per year. At the end of the first year, the insurance company declares a bonus of Rs 50 per thousand of sum assured or 5% of sum assured. This amounts to Rs 50,000. This Rs 50,000 remains Rs 50,000 for the next nineteen years till the end of the policy. The same thing happens to the bonuses declared for the remaining period of the policy as well.

5. Since the bonus declared does not compound returns are low: Extending the example taken above, let us assume that the insurance company declares an average bonus of 5% every year. What this means is that every year on an average a bonus of Rs 50,000 is declared. So at the end of twenty years, the total accumulated bonus would amount to Rs 10 lakh (Rs 50,000 x 20).

Chances of an insurance company declaring an average bonus of more than 5% over a period of twenty years are very less. This is primarily because endowment policies largely invest in government securities and after taking into account the administrative expenses of the insurance companies, a greater bonus is highly unlikely.

So at the end of twenty years, the individual gets Rs 10 lakh of accumulated bonus and Rs 10 lakh of sum assured, making a total of Rs 20 lakh (Rs 2 million).

On this he has been paying a premium of Rs 49,000 every year. This amounts to a return of 6.39% per annum, which is not great. If the individual expires during the period the policy his nominee gets the Rs 10 lakh of sum assured as well the accumulated bonus till that point of time.

6. Take a term insurance policy and invest in the public provident fund: A better way out for an individual is to take a term insurance policy. A term insurance policy is a pure insurance policy.

If the policy holder dies during the period of the policy, his nominee gets the amount of the sum assured. If he survives the period of the policy, he does not get anything. Given this, the premiums on a term insurance policy tend to be the least among all insurance policies and they provide an adequate life cover.

A term insurance policy for a period of 20 years, for a 35 year old individual, would cost around Rs 4,600 per annum. So instead of taking an endowment policy it makes more sense to take a term policy of Rs 10 lakh.

The remaining money i.e. the difference between what needs to be paid on taking an endowment policy of similar sum assured and the premium on the term policy, can be invested in the public provident fund (PPF). The difference in the example taken here works out to Rs 44,400 every year.

If this is invested every year into the PPF, at the current interest rate of 8%, the individual is likely to accumulate Rs 21.94 lakh (Rs 2.194 million) at the end of 20 years, which is nearly Rs 2 lakh (Rs 200,000) more than Rs 20 lakh he is likely to accumulate in case of the endowment insurance policy. Also the bonus on the insurance policy is not guaranteed whereas PPF guarantees an interest of 8% every year.