Term Insurance Vs Endowment Policies
One of my friends Suresh had an argument with me last month that he would not take a Term insurance because he will not get any “returns” from this policy on maturity. It took me more than an hour to educate him that Term Insurance is the ideal option for Life Insurance.
For him, Endowment plans are attractive, because they give money both on maturity and on death. The likely returns from endowment policies will be around 5%, while even SB account offers 4% now.
What happens in a family on the death of the breadwinner?
If he is the sole earning member, all the expenses are met from the earnings of this member. Now consider this person dies in an accident or because of some illness. If they don’t have money to take care of themselves, either someone from family have to take up some job and start working. This may not be possible for them always, or they have to decrease their standard of living. Children education will take a hit due to lack of money. In short they are totally messed up, which should not have happened. I have seen several such situations, during my claim investigations with LIC of India.
How to avoid such situation?
Having enough insurance cover is the only way to avoid such situation.
You must have a backup plan which can give your family the same kind of income and they should not fall short of money in case the breadwinner is no more. If there are some debts like Home Loan, or any other tasks which need money apart from regular income, the cover must be good enough to take care that too. But what you mean by ‘enough insurance’? How to calculate it?
How much insurance he should go for?
The monthly household expense of Suresh is around 20,000/- and he is having an outstanding home loan of 15 Lakhs. He is 30 yrs old. His family includes his wife aged 30 and a daughter aged 2. He has investments worth 5 lacs in mutual funds and PF. In case he dies now, who will take care of Home loan? How the family will manage their monthly expenses? What about daughter’s education and marriage? The family is left with a house on loan and 5 Lakhs savings.
They need 20,000 * 12 = 2.4 lakhs per year for house hold expenses. Let Y be the amount of Insurance required for Suresh. If Suresh is having an Insurance cover of Y, on his death, the insurance company will settle this amount to his wife and she can invest this amount at 8% (safe and risk free investments) to take care of the household expenses.
Y x 8/100 = 2, 40,000 or Y= 2, 40,000×100/8 =30 Lakhs.
For daughter’s higher education he is planning to spend 10 lakhs in current cost after 15 years.
Add another 15 Lakhs for covering the outstanding housing loan liability. The total comes to 55 Lakhs (30+10+15 =55 Lakhs) and this is the minimum insurance requirement for Suresh. Since he is having liquid investments of 5 Lakhs, this can be reduced from this 55 Lakhs and so the insurance requirement for Suresh is 50 Lakhs. To make the calculation simple, I have ignored the effect of inflation. If we take 6% inflation also into account, the amount required to maintain the same standard of living for his family will be 71 Lakhs assuming a life expectancy of 75 for his wife. So the total insurance requirement will go upto 71+10+15 =96 Lakhs. Almost 1 Crore!
Imagine, the family is getting a lump sum payment of 1 Crore on his death from the insurance company. His wife can close the housing loan of 15 lakhs and invest 10 lakhs for the daughter education in a balanced mutual fund or in an MIP with less equity exposure. The balance 75 lakhs can be deposited in a bank/invested in safe investments which will offer atleast 8% return. From this, they can withdraw 20,000 per month for their household expenses. They can increase the withdrawals by 6% every year to offset the inflation. This shows that the adequate insurance cover for Suresh is 1 Crore.
So before starting any investments or spending on luxuries, he should have this cover. The first step is to give adequate cover to his life and that’s the most important responsibility.
How to plan for this insurance cover of 1 Crore?
The life insurance market is flooded with lots of insurance plans to select. Let us discuss the age old endowment policy for Suresh for 1 Crore. The annual premium quoted for a 30 year policy for Suresh is 3.13 Lakhs. I am sure, Suresh cannot manage this premium along with his housing loan EMI and other commitments. So what he will do? He will go for an insurance cover for 5 lacs or 10 lakhs! And guess who suffers in case of his death, HIS OWN FAMILY.
Why Term Insurance?
In term insurance, you will not get anything on maturity. It is like the Car insurance, where you will not get anything if there is no claim. Let us discuss the features of the term insurance policy in connection with the above example. The premium is very low for Term insurance Policies. For Suresh, the yearly premium for 1 Crore cover for 30 yrs is around Rs 8000/- for an online term insurance policy. Just Rs.22/- per day! This is affordable for Suresh.
Insurance is not an investment product, it is a Protection instrument. There are other products for your investments. Don’t mix insurance and investments because there are lots of charges in these policies. They complicate things and confuse people. ULIPs offer some flexibility, but still they are not worth it. The charges are very high.
Go for a Term policy of decent value and invest the balance in good mutual funds/PPF etc. for long term wealth creation as per your risk profile. We will suggest some cost effective Term insurance policies in our next article.