For a novice, understanding life insurance can be like navigating a maze. It is often confusing to choose from the plethora of life insurance options that are available. Some “experts”/ salesmen say that you should buy endowment plan or money-back plans. Some say, go with plain vanilla term life insurance.
How do you navigate this maze?
In this post, I’ll be sharing some thoughts on the purpose of life insurance, type of insurance you should choose and what should be the cover. As usual, I’ll refrain from sharing a number, since it depends upon your context, but try to help with how to approach the process to get a term cover.
What is the purpose of insurance?
The primary question a beginner has to answer is – Is insurance for managing risk or getting returns on investment?
Maybe, this is a rhetoric question!
The purpose of insurance is to manage risk. Specifically financial risks arising out of of events that may have financial implications. For example, death of breadwinner of the family. Or a 10-day hospitalization that can cost a large sum of money. Or car getting damaged in an accident and need for major repairs.
Insurance can help you deal with such major unexpected expense. In return, you pay a small amount to the insurer, who “buys” the risk and issues an insurance policy.
Life insurance is one of the most popular insurance. Here, you pay insurer a certain amount (premium) and in case of death of the policy holder, an amount (called – sum insured) is paid to the nominees.
(Related – Expenses that can set your financial plans back)
Why term life insurance?
Life insurance has several products that you can buy. Within risk management it is useful for managing financial risk that comes because of loss of income (one of the) breadwinner(s) of the family dies.
Some of the most popular ones are:
- Term insurance – This doesn’t offer any returns. It is just a risk cover. If the policyholder dies, the nominee gets the sum insured. If the policyholder survives till the end of the policy tenure, no money is paid back. That’s it.
- Money back plan – In this, the person insured gets a percentage of sum assured back periodically as survival benefit. And in case of death, it pays the sum assured to the nominee.
- ULIP – Unit Linked Insurance Plan – ULIP is is a combinations of insurance and investment (mutual fund) which can potentially give good returns in long run. In case of death, it pays the some assured to the nominee.
- Endowment plan – They typically pay the sum assured and bonus at the end of the policy term. In case of death, it pays the sum assured to the nominee.
There are few others also – like retirement plan, child plan, lifetime coverage etc. These are some variants of the above plans.
Why term insurance is the best for life insurance?
Most of the above, barring term plan, give very less insurance cover or charge high premium. In other words, for a coverage of an amount X, term insurance has the least premium – by a huge margin. (For investments, there are lot of avenues, probably better than what insurance provides!). There are lot of online calculators. Go and check them! (Example)
Another argument is that – What if I don’t die when the policy term ends?
Well, it’s a good problem to have. You lost some money, but would probably have earned a decent amount by then. But in case of death, the family will get a much better benefit in case you have term insurance. And that serves the purpose of risk management quite well.
However, many agents sell anything and everything barring term insurance, because of the huge commission they can get. What’s good for agent is not necessarily good for you! Do your own math and understand.
How term life insurance plans work?
Top put in simple words – You pay a certain money to the company (insurer) called premium. The insurer issues a policy for a certain duration. (you can choose this). If the policyholder dies during that period, the nominee gets the insurance amount which they can invest as they they want. If nothing happens till then, that policy lapses and you don’t get any money back. But, that’s a good problem to have, in case you view it as a problem!
In a term plan you can also add riders – typically pertaining to critical illness, accidental death/ disability etc. However, they are optional and you can judge for yourself if you need to take it (I would suggest to go without any riders, but n harm in evaluating them)
The insurance premium is dependent on probability of the insured person dying/ staying alive during policy tenure. So premiums increase with age. It also increases if you have certain habits like smoking or drinking. If you are working in relatively hazardous workplace, the premium may again increase. If you have some health condition (e.g. diabetes) your premium goes up.
However, once you have bought the policy, you need to pay the same premium throughout the policy tenure.
For a 30 year old, the premium for a Rs. 1 Crore term insurance is likely to be in the range of Rs. 8000-10000. (can be higher if there are some medical conditions or habits like smoking). In other insurances (money back etc.) the insurance cover you get for this amount will be very less.
How should I calculate insurance cover required?
Before answering this, let’s revisit – what is the purpose of life insurance?
I believe, for most (or all?) of us, it will be to secure family’s finances in the unfortunate event of death.
So, to begin with, you need to understand how much money would your family need to live a reasonably comfortable life (assuming the current status of living) and meet key financial goals (e.g. buying a house, kids’ education, kids’ marriage etc.). You also need to consider that some of these goals may be a bit far away, and hence money required will increase. So do consider the inflation.
Here are the factors you should consider while arriving at the sum assured (based upon the above objective)
- Your family’s current expenses. (day to day expenses and major life goals)
- Earning potential of the spouse (if spouse is earning well, then you may need a lesser cover vis a vis if he/ she is not working)
- Your current savings & assets
- Your current liabilities.
Suppose, there is a couple — Mr. & Mrs. A.
- Their post tax salary is Rs. 10 Lac per annum each. (Total – Rs. 20 Lac)
- They have one child who has just been born. They plan to have only one child.
- Current savings is Rs. 25 Lac. They don’t have any liabilities.
- Annual expenses are Rs. 15 Lac & rest Rs. 5 Lac is savings.
Further, I am assuming salaries, expenses & investment returns to grow at same rate – rate of inflation. Will not consider that as of now for simplicity.
In case any of them dies, in terms of finances there will be shortfall of Rs. 5 lac per annum (as the other spouse will continue to earn). In order to be able to manage day to day expenses, the insurance amount must be able to generate that Rs. 5 Lac per annum. If the sum insured is Rs. 1 Crore, then this amount can generate these cashflows (with prevailing rate of returns among debt instruments. With some investment in equities it may be a bit more). However, this may or may not leave enough buffer for major financial goals (higher education, marriage, buying a home etc.)
However if the spouse is not working (e.g. is housewife) and expenses is Rs. 10 Lac, then the insurance amount needed will be much more – To the tune of 1.5 Crore (Which will give returns of Rs. nearly 10 Lac per annum), if same standard of living has to be maintained. Add some more for one time major life expenses.
Typical tenure of the insurance should be till the end of your expected active earning life or when your child(ren) can start earning. This can be till around the age of 60 or 65. By that time, you are anyway expected to build certain assets which can be useful to your family, if need be.
Another factor yous should thing about is inflation. Value of Rs. 1 Crore today will not be same in a decade. IF inflation is 7%, it would probably have halved. However, you are also expected to have built some more savings/ investments during that period of time.
That being said, the calculation is not always this straightforward.
Real life can be a lot more complicated. There may be many other social cultural factors that may come into play (e.g. parents staying and helping, remarriage, etc.). However, that all is in realm of speculation and shouldn’t have bearing on deciding on term cover.
Just to reiterate – The purpose of this cover is to ensure that your family is able to maintain more or less the same standard of living after you. If you have lot of liabilities, you’l need a higher amount of insurance. If you have huge amount of savings and assets, which can take care of all your family’s needs after you, you may not need term insurance at all! Usually, this number (for insurance cover) is in the range of 10X – 25X of your annual expenses.
(In case of Endowment plans or ULIPs, you may be paying more premium and probably get a cover of 2 Rs. 2 Lac or 5 Lac or something ! Is this cover of any use?)
How do I buy term insurance?
In India, LIC has the highest market share. It was a monopoly since few years back. Post that there have been lot of private insurers in India.
You can either buy insurance through an agent or directly online. If you are relatively aware about insurance products, online may be a better route.
Some of the factors you should consider are:
- Premium you need to pay
- Claim settlement ratio
- What are the inclusions and exclusions
- This may be useful if you go for any riders like critical illness or accidental death.
- Size/ market share of the company may also be a factor. (Usually for having a certain comfort level in your decision than anything else)
At the same time, be aware that you’ll require to provide lot of details, especially about your health & health history. There may be medical tests too. Provide as accurate details as possible. Better to pay a slightly higher premium if asked for (based upon health condition) than your claim getting denied when need be, due to false information provided.
With this, I hope that I have been able to shed some light on the purpose of term life insurance and got you thinking about how much cover you should get (if you haven’t bought term life insurance)