Once Your Time's Up, Then What?
India is a country which predominantly has a very traditional mindset when it comes to investing. The investment patterns followed by one generation in a family is copied and carried forward by the next. One of the best examples of this can be seen in the case of life insurance. The moment an individual starts earning and more importantly gets married, the first piece of advice they get from elders and family is to get their lives insured.
While it is a good idea to invest in life insurance, there are certain aspects of life insurance that must be clearly understood. How does life insurance work? For whom is life insurance suitable? How are life insurance premiums calculated? How much life cover does one need? Which are life insurance products available? And which one is the best among them? The answers in today's blog post. Life insurance is a arrangement between an individual (known as the insured) and an insurance company (known as the insurer). The insurance company agrees to pay an assured amount to the family of the insured individual in the event of the death of the insured individual. In exchange for this compensation, the insured individual pays the insurance company a fixed amount periodically. This is known as the premium. Look at the diagrammatic representation below for a better understanding.
Life insurance compensates for the loss of income suffered by the family as a result of the death of an individual. Therefore it is advisable only for earning members in the family to get life insurance cover for themselves. Every insurance company has their own procedure to calculate premiums for a life insurance policy. But the calculations are based on a certain set of factors such as age, medical history, lifestyle risks and so on. Pre existing health conditions such as heart conditions, diabetes and so on and lifestyle risks such as smoking or drinking for instance, contribute to a higher premium.
There are three major modes in which premiums may be paid. Regular Pay is a payment mode where a fixed premium is paid at regular intervals over the entire term of the policy. Limited Pay is a mode of payment where premiums are paid for a certain number of years over the term of the policy after which payment of premium is stopped. The policy however remains active for its entire term. For instance lets say a 25 year old takes a 35 year policy with a limited pay clause for 25 years. In such a case, the individual pays premiums until the age 50, but the policy remains active until the individual turns 60. Single Pay is a mode of payment which involves payment of one single premium for the entire term of the policy.
Having understood how premiums are calculated and paid it is now time to understand how much life cover one needs. The general rule of thumb is to have life cover worth 8-10 times one's take home annual income. More exact requirements can be calculated using various methods. The Human Life Value method calculates the amount required based on the present earning capacity of the individual and how earning capacity is expected to grow in the future. The Expense method calculates the amount required based on how much would be needed for the individual and his or her family to meet current and future expenses and liabilities. The financial goals of the individual can also be incorporated into the calculations to give a clearer picture. It is also important to include any existing life cover or liquid assets that the individual already while estimating the amount required. The amount of life cover required must be reviewed whenever there is a significant change in the individual's financial situation. For instance when the individual gets married, becomes a parent, takes on a loan and so on. Once the amount required is estimated, the next step is to choose a suitable life insurance product.
There are various types of life insurance products available. Term insurance plans are the cheapest life insurance plans available. The premiums of these plans are the lowest among all life insurance plans. A Rs 1 crore term plan usually costs an annual premium of Rs 15,000 - 20,000. The amount paid as premium under a term plan can be claimed as a deduction under Section 80C of the Income Tax Act of 1961. But, a term plan is a pure insurance product that only covers risk and does not include any return component.
An Endowment Plan combines risk coverage with a return component. They typically provide coverage that is roughly around ten times the annual premium. So an endowment plan providing a coverage of Rs 5,00,000 for example would cost an annual premium of roughly around Rs 50,000. The amount invested in an endowment plan is paid out at the time of maturity and is completely tax free. But rates of return under these plans are actually quite low. Take two examples. Take case 1, where lets say you invest Rs 50,000 a year for five years and you get back Rs 5,00,000 after 15 years. Or take case 2, where lets say you invest Rs 50,000 a year for 15 years and you get back Rs 10,00,000. The absolute numbers may make these plans look attractive, but the actual rate of return in case 1 is just 4.15% per annum. Its even worse for case 2 where the rate stands at 3.98% per annum. Most bank FDs would give better returns than this.
Unit Linked Plans or ULIPs are even worse. On the face of it, they combine insurance with investment by investing a portion of the premium in the financial markets. But the actual picture is a lot worse. First there are multiple charges which the insured individual is required to pay. These include charges such as premium allocation charges, fund management charges, policy administration fees and so on. On top of that, amounts invested in ULIPs are locked in for 5 years. If payment of premium is stopped, the amount invested is transferred to a Discontinued Policy Fund. Any amount transferred here earns meagre returns of 3% per annum. And all charges would still be applicable and the amount would be paid out only at the end of the lock in period. Look at the table below which compares unit linked plans and term insurance plans for a better understanding.
After analysing all the major life insurance products given above it is quite clear that term insurance is the best option for an individual with regard to life insurance. Though there is no maturity benefit, it still has the advantages of being cost effective while also providing tax benefits. It is advisable to draw out a term policy as early as possible and hold it until retirement. Investments and creating a retirement corpus can be satisfied through other avenues. This ensures that insurance is kept independent of investments at all times.Each of them can then play the role that they are ideally meant to. Purchase of life insurance products online may also be considered. Doing so usually results in premiums being 5-6% cheaper. Life insurance coverage may be stopped when the individual's networth is significantly higher than the amount of life cover required.
So to sum up, every individual who earns an income for the family must make it a priority to get their lives insured. They may work with a financial planner to draw up the most reliable estimate of the amount of life cover required. Once that is done they must focus on picking the most cost effective life insurance products available which meets their life cover requirements. A term insurance plan is most suited to fit this bill. Buying a term plan also ensures that insurance and investments are kept independent of each other. There is the option to buy insurance products online which results in premiums being 5-6% lower than regular plans. Life coverage may be stopped at the discretion of the individual when networth is significantly higher than the amount of life cover required. The emotional blow on the death of a loved one is undoubtedly harsh and painful. Investing in life insurance may at least prevent the situation being even worse by helping you deal with the financial blow caused by the same.