Life Insurance : An Important Risk Transfer Mechanism - Part II

In India the principle of life insurance was reflected in the institution of joint-family system. Sorrows and losses were shared by various family members in the event of unfortunate demise of a member, as a result of which each member of the family continued to feel secure. However, the break-up of joint family system and emergence of the nuclear family in the modern era, coupled with the stress of daily life has made it necessary to evolve alternative systems for security. This highlights the importance of life insurance to an individual or family. 

Life insurance policy covers the risk of untimely death of the insured person. It is a contract between an insurance policy holder and insurance company (insurer or assurer), where the insurer promises to pay the nominee a sum of money (the benefit) in exchange for a premium, upon the death of insured person. The payment of the policy amount can be made in one shot (lump sum) or periodical instalments, i.e. annuity.

Why is Life Insurance Important?

Any living person has three major concerns regarding life –

1. 1. Dying too early – In case of unfortunate untimely death of sole earning member, all dependent family members face multiple hardships – emotionally, physically and financially. During these difficult times, proper life insurance helps the family by considerably reducing financial burden even though it cannot reduce the emotional and physical pain of the family. Thus having life insurance is a must – as it somewhat handles the financial risk of dying too soon.
   2. Living too long – In modern times, with better living standards and good medical care overall life expectancy has increased. It is not uncommon to be living into your 80 and 90. However, as one ages their ability to earn reduces and they require some sort of pension to meet their day-to-day expenses. Life insurance companies provide pension plans which give a fixed amount on a monthly basis to meet day-to-day expenses. Thus handling the concern of living too long.
   3. Living with disability – Accidents keep happening which at times cause serious injuries and disabilities. Some of these disabilities impact ones earning abilities. Thus having a disability insurance or rider helps in replacing a portion of lost income. Thus handling the financial risk associated with disability.

Thus, proper life insurance planning and execution can help an individual or family considerably reduce their risk of financial pain and suffering at all stages of life.

What are the different types of life insurances?

Life insurance can be divided into two broad categories –

1. 1. Traditional life insurance. These are further subdivided into three different groups –
      • • Term insurance plans – Term life insurance fulfils the main and basic idea behind life insurance, that is, if the life insured dies prematurely there will be a sum of money available to take care of his/her family. Term insurance is valid only for the time period specified in the contract. Protection may extend up to age 65 or 70. All premiums paid as part of term insurance are towards the cost of mortality risk covered by insurance company. There is no savings or cash value associated with the policy. Term insurance is the cheapest insurance cover.
        • Whole Life insurance plans – Whole life insurance does not have a fixed term of cover rather the insurer offers to pay an agreed upon amount whenever the insured dies. Whole life premiums are much higher than term premiums since a whole life policy is designed to always pay the death benefit. The premiums can be paid throughout one’s life or for a limited time period. The prime motive of purchasing whole life insurance is creating wealth to be passed on to the next generation.
        • Endowment plans – Endowment plan is primarily a savings programme with insurance against premature death. Its lends certainty to one’s personal financial plans by offering a safe and compulsory method of savings accumulation. Popular variants of endowment plans are – money back plans, participating in profits and non-participating in profit plans.
   2. Non-traditional Life Insurance or Market linked Insurance plan. Market linked insurance plans are more focussed towards investments than towards insurance. These are further subdivided into two groups –
      • • Variable Insurance plan – Variable insurance plans are characterised by flexible premiums after first year, flexible face amount and flexible death benefit amounts. Variable life policies is for those who wanted to invest in an assortment of funds of their choice to directly benefit from favourable investment performance of their portfolio provided they are able to bear the investment risk on the policy. These policies should only be bought by people with knowledge of equity / debt investments and market volatility.
        • Unit Linked Insurance plan (ULIP) – Unit linked policies provide means for directly and immediately cashing on the benefits of a life insurers investment performance. It allows policy holder to choosing between debt, balanced and equity investment funds maintained by life insurance company. Each investment fund has a different portfolio mix of assets. The life insurer while managing these funds does not give any guarantee about unit values. Entire investment risk is borne by the policy holder.

One should be very careful while buying market linked insurance plans as mis-selling is quite prevalent with them.

How to calculate the amount of life insurance needed? 

The amount of life insurance needed by an individual or family is calculated using the principle of human life value(HLV). In most simple terms human life value for an individual is calculated by dividing the total annual income the individual or family would like to have, even if the bread earner was no longer alive, with the rate of interest that can be earned.

Let us take example of Mohit whose average income is INR 40,000 per month. Assuming inflation to be 6% per annum so the minimum life insurance to be purchased by him will be INR 80 Lacs calculated as shown below –

Some other factors that impact the life insurance amount are –

1. 1. One’s future earning capabilities
   2. Age of the person, and
   3. Their financial goals and associated time-frame.

Based on these factors the amount of life insurance and the type insurance to be purchased may vary. Thus it is very important to do insurance planning as part of overall financial planning.

Which insurance to Buy?

For an individual or family, buying proper insurance cover can be quite confusing an time taking. Since there are multiple life insurance providers with each provider offering a different range of plans and charging different premiums. Thus it’s important to compare several providers and plans at the same time to ensure that you’re getting the best value.

Most important considerations for an individual or family while buying life insurance should be –

1. 1. Insurance amount – One’s life insurance needs change with each life changing event like getting married, buying a home, starting a family, starting new business and approaching retirement. Thus as a rule of thumb your life insurance amount should be calculated using human life value plus taking all other factors like existing loan etc into consideration. This will ensure your family does not face any financial uncertainty due to untimely death of key earning member.
   2. Policy Type – First policy for any individual should be a pure term insurance policy with large cover bought within the first few years of their professional life to benefit from low insurance premiums for the policy duration.
   3. Policy Duration- Life insurance policy duration for your first policy should be equal to the time left in your actual retirement from job. For example Suresh is working in a MNC with retirement age specified as 60 year. His current age is 25 years. Thus, he should buy term life insurance policy for 35 years.
   4. Additional riders – Any person buying life insurance must include disability rider and accidental insurance riders into their first policy. This will ensure they have additional financial cover for unfortunate events like accidents and illnesses which may lead to disabilities.
   5. Saving philosophy of individual and family –  One should generally not mix insurance with investments as this leads to large premium pay-outs containing unwanted large agent commissions and  administrative charges of insurance company. However if one does not have habit of doing regular savings then purchasing additional endowment plans or Unit Linked insurance plans to meet future family goals is a must even though it has large premiums.
   6. Claim Settlement Ratio – Claim settlement ratio is number of claims that the insurer has paid to their policyholders. Thus, if a life insurer has a claims settlement ratio of 80 percent, it means that the insurer pays (“settles”) 80 out of every 100 claims filed. It means that a company with a high claim settlement ratio is always the better choice because the probability that this company will settle your future claims is much higher.

Because your needs and life goals are unique so your “best” life insurance plan will depend on you and your family needs. Some people require coverage for a few years whereas others need lifetime coverage. Thus it is best to consult a financial planner to do proper goal based insurance planning for yourself and family.

Where to buy insurance from?

An individual or family, can buy insurance from any of the three channels – Online directly from Insurance provider, Insurance agent,  or Corporate agent or Broker.  However your purchase should take into consideration the channels ability to handle your queries, their commissions and after sales support during claim handling.

Conclusion

In this article, we from financial planning perspective have introduced you to life insurance, various types of life insurance and its importance. And, we have detailed out the steps to calculate amount of life insurance needed and various aspects to consider while buying it. This information should help you in having a more detailed conversation with your financial planner or investment advisor. For more information please feel free to reach out to us via email at – enquiry@taptoprosperity.com or by phone – 91-9515475381.

Next Article – Health Insurance : An Important Risk Transfer Mechanism – Part III

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any entity prior to publication.