ABC of Life Insurance and Why Term Policy ?

Recently, one of my friends died due to accident. Arun was just 35 and was working for a software company in Bangalore. He is survived by his home maker wife Aarthy aged 30 and 2 kids aged 7 and 5.

He used to contribute 1 Lakh per month for the family. His monthly cash flow was as follows.

• EMI for the Home Loan – 45,000
• House hold expenses – 28,000
• Parents’ Support – 10,000
• Life Insurance premium – 5000
• Mutual Funds Investments – 12,000

He was staying in own house purchased on loan and were leading a quality life. Kids are studying in good school. Since there was an insurance cover for the home loan, the home is now debt free and family is staying in the same house.

He was paying an insurance premium of 5000 per month for a life insurance policy of 12 Lakhs. The insurance company settled the claim of 12 Lakhs. His employer paid another 10 Lakhs from a group insurance policy covering all employees of that company. Aarthy has deposited this amount of 22 Lakhs in a bank. She is getting around 14,000 per month as interest on it.  Now the family is living on this. But she finds it difficult to manage the schooling of both kids with this income. She is planning to shift both kids to another school from next academic year.

If they want to maintain the same standard of living, there should be an inflow of 28,000 per month. Instead of 22 Lakhs, if there were 44 Lakhs in bank, she wll be getting 28,000 as monthly interest.

In simple words, Arun should have insured his life for 44 Lakhs.

Is it sufficient? In the above calculation, I have not considered the effect of inflation, possibility of reduction in interest rates etc. Assuming these 2 factors into consideration, the amount required to ensure an inflation adjusted withdrawal of 28,000 per month for the next 50 years (till she is 80) is around 1.3 Crore. Here I have assumed that the amount of 1.3 Crore will generate a return of 1% above the inflation.

So, this is the amount Arun would have looked at instead of 44 Lakhs.  He was planning to provide for 10 Lakhs in today’s cost for the higher education of both kids when they are aged 17. For that he was investing in mutual funds. If you consider this goal also into account Arun would have insured his life for 1.5 Crores.

Had he insured his life for 1.5 Crore, now his family will be getting 1.5 Crore as death claim. Aarthy can invest 20 Lakhs for the children higher education needs and use the balance 1.3 Crore to ensure same standard of living till she is 80.

Now, let us check the premium for a 1.5 Crore policy. He was paying a premium of 5000 for a 12 Lakhs policy. Going by that rate, the premium for a 1.5 Crore policy will be around 62500 per month, which is not affordable to him.

Is there any alternate to insure life at a lesser premium? Yes. He could have opted for a term insurance policy.

What is Term Insurance?

In this policy, there are no maturity benefits. In simple words, you will not get anything at the end of the policy. But if you die during the term of the policy, your nominee will get the policy amount immediately.

If you are 35, the annual premium for a 1.5 Crore policy will be around 18,000. If you pay this premium every year from 35 to age 60, your family is sure about the payment of 1.5 Crore in case of your death. But if you live upto age 60, nothing is payable from this policy. You will be losing the premium of 4.5 Lakhs paid during these 25 years.

This is the only way to ensure adequate life insurance for a person. The amount of 18,000 per year (1500 per month) is to be considered as the price you are paying for the peace of mind you are getting in ensuring a decent living for your spouse and kids in your absence. After all, this 1500 per month is just the cost of a weekly outing.

The premium quoted above is for an online term policy, which you have to purchase online. If you purchase it through agents the premium will be higher.

Precautions while purchasing term policy

Insurance is based on the concept of ‘Utmost Good faith’. You are supposed to disclose your health/habits etc correctly while applying for an insurance policy. For example, if you are diabetic, or having hypertension don’t forget to mention these in the proposal form. Similarly if you are a smoker or consume alcohol, mention these in the proposal. The insurance company may charge a higher premium depending on your health/habits. It is called loading. This prompt disclosure is important to avoid confusion later. If you are hiding these details at the proposal stage, there is a possibility of claim rejection in future. Be 100% honest while purchasing the policy.

Claim Settlement Ratio

This is the ratio of clams settled out of claims reported. The higher the ratio, the better it is.

Some companies are claiming that their claim settlement ratio is highest in the industry.  Suppose the clam settlement ratio of company A is 98% and for company B it is 90%.  As a heart patient, if you purchase a policy from company A without mentioning this issue and die after 2 years the claim will be rejected. So, you will be within that 2% rejection of company A.

But if you are purchasing the policy from company B with prompt disclosure, your clam will be settled. This is because you will fall under the 90% of company B.

More than claim settlement ratio, prompt disclosure from your side is more important in insurance.  You may purchase the policy from the company of your choice with prompt disclosure.

If the claim is rejected, there are many options for the claimants to represent the case. They can approach the grievance cell of the insurance company, insurance ombudsman or consumer forum with appeal. Normally all genuine claims will be settled.

Ensure Prompt Nomination

While purchasing the policy, ensure that you are nominating your legal heir as the nominee. If you are purchasing the policy before marriage and nominate parents as nominee, it is better to change the nomination in favour of your spouse after marriage. Remember, you can change nomination anytime and the nominee has a role to play only in case of your death.

Inform the nominee the following

1. I have purchased a policy for Rs. X from company ABC and as a nominee you are eligible to get Rs. X after my death.
2. The policy number, premium amount and the due dates of premium.
3. Where you are keeping the policy document
4. The contact details of company ABC to be contacted in case of your death.

Why term policies are not popular in India?

We feel that we are losing the premium in term policy because there is no maturity benefit. But see the large benefit in case of death of the bread winner! This is the only way to ensure a decent life insurance cover for a person at an affordable premium. If you really love your family, purchase a term policy of decent value when you are alive and healthy. The main reasons for the low popularity of term policies are

1. Agents are not interested in selling this policy because of the low premium and the small commission involved.
2. Low awareness about the real benefit of term policy
3. Feeling that you are not getting anything on maturity and losing the premium paid
4. Emotional issues like wife saying – I don’t want any amount because of the death of my husband.

If every wife knows what a widow feels, no husband will remain uninsured. It is high time that you should purchase a term policy and ensure all earning members in the extended family and friends circle are insured for a decent amount. Infact government can think of making it mandatory as a social security measure so that no family will suffer in case of death of the breadwinner.

Savings linked life insurance policies

The aversion to term policies by Indians motivated life insurance companies to innovate and come out with policies with maturity benefits along with death benefit.

Let’s understand this with an example:

If you are aged 35 and purchasing a 20 year endowment policy of 10 Lakhs, the annual premium will be around 50,000 per year. You have to pay 50,000 for the next 20 years and you will be getting the following at age 55.

1. Sum assured – 10 Lakhs
2. Bonus – 8.4 Lakhs

Total – 18.4 Lakhs

Bonus is declared by the insurance company every year based on its profitability and claim experience. In the above calculation, I have assumed a bonus rate of Rs. 42 per thousand sum assured. Since it is a 10 Lakhs policy, the bonus for a year will be 42,000. If you are getting the same bonus for the next 20 years, you will get 42,000 x 20 = 8, 40,000 as bonus.

Let’s calculate the rate of return on this policy. It is around 5.5%. This is a pathetic return for a long term investment.

Please note that the bonus is not guaranteed and it can change every year. Since the interest rates are coming down in India, there is all possibility of a reduction in bonus rates in the near future.

Now, let us understand the benefits from this policy in case of your death. Your nominee will get the sum assured of 10 Lakhs and bonus accrued till date of death. Suppose the death happens at age 40, your nominee will get the following

1. Sum assured – 10 Lakhs
2. Bonus for 5 years – 2.10 Lakhs (42,000 x 5 = 2.10 Lakhs)

Total – 12.10 Lakhs

Will this 12 Lakhs is sufficient for the family in your absence? No.

This policy is not good as investments due to poor returns and not good for risk cover due to the low insurance cover it offers.

Who benefit from this policy?

When you are paying 50,000 as the first year, premium, your agent is getting around 25-30% of it. 12,500-15,000/- is going to his pocket. From second year, the commission is around 5%. The agent is getting 2500/- every year as long as you pay the premium. In the 20 year policy, the agent is getting 65,000/- in total!

This is the reason why agents and banks are trying to sell insurance policies.

What you can do?

Instead of paying 50,000 premiums under such policy, you can purchase a 1.5 Crore term policy by paying 18,000 per year. The balance amount of 32,000 can be invested in a mix of equity & debt as per your risk taking capacity. If you are investing 32,000 per year in an equity mutual fund, you can expect around 23 Lakhs assuming 12% returns. Please note that many good mutual funds have given 20% returns in the past 20 years.

In case of unfortunate death, your family will get 1.5 Crore immediately. This amount can really help your family in maintaining the standard of living in your absence.

This combination of term policy & mutual fund is beneficial both in case of death and maturity.

Different types of savings linked policies

To make it attractive, insurance companies are offering many types under this category. The most popular ones are the following:

Endowment Policy

In this policy, the sum assured and the bonus is payable at the end of the policy term. In a 20 year policy, you will get this at the end of 20 years as explained above.

Money back policy

In this policy, you will be getting certain percentage of the sum assured at different intervals.  A typical 20 year money back policy will give you 20% after 5 years, 20% after 10 years, 20% after 15 years and 40% along with bonus at the end of 20 years. In case of death in between, the nominee will get the full sum assured irrespective of the payments made already. The premium under money back policy is high compared to endowment policy.

Children policies

This is sold in bulk on emotional appeal. The benefits under this policy are paid in instalments during the higher education of the child. In some cases, there is an option to waive the premium in case of unfortunate death of the parent proposer.

Pension policies

In this policy, the benefits are paid out as pension during your retired life.

Unit Linked Policies (ULIP)

In this policy, the insurance company is investing your premium in a mix of equity & debt instruments as per your mandate. ULIP policy can give better returns compared to other types of policies discussed above.

But there are many charges which are deducted from your policy, which will reduce your effective return.

Draw backs of savings linked policies

The main draw backs of savings linked policies are:

Lack of flexibility

Once you join for a 20 year policy and later, if you are not happy with the policy, exit options are limited. If you stop paying the premium in the first 3 years, you will not get anything back under most of the traditional policies. If you surrender the policy after paying premium for 3 years, then you will get only 30% of the premiums paid. After paying 50,000 for 3 years (1.5 Lakhs), you can exit the policy with just 45,000 as surrender value.

In ULIPs, you will not lose the premium paid, if you stop paying the premium within 3 years. The fund value will be moved to discontinuance fund and it will be payable to you on completion of 5 years from the start of the policy. During this period, you will get around 4% returns on the fund value.

If you want to surrender the policy after 5 years, you will get the fund value immediately.

If your fund is not performing the only option for you is to surrender and take the money out.

In both these cases, you can understand that there is no flexibility. But if you opt for a combination of term policy & mutual funds, you have 100% control on your money. If a new insurance company is offering a term policy with lesser premium, you can opt for that and just drop the existing policy (subject to your good health at that time). If your mutual fund is not performing, you can just sell it and reinvest in better funds without any difficulty.

Lower returns

In traditional policies, the returns will be in the range of 4-5% only. This is because the investment is happening mainly in debt products and a good amount is going towards commission and other expenses of the insurance company.

In ULIPs, there are many charges. When you pay Rs. 100/-, full amount is not invested in your account. The company deduct premium allocation charges from your premium and only the balance is invested. If the allocation charge is 10% only Rs. 90/- is invested in your account. There are other charges like policy administration charge, fund management charge and mortality charge etc. These charges are deducted by way of cancellation of units from your account. You will not understand it unless you verify the fund value statement carefully.

If you just check the percentage return on your Net Asset Value, it will not reflect the reduction in number of units due to various charges. Even if the fund is performing well, your actual return will be much less due to the cancellation of units.

Conclusion

The only policy you require from a life insurance company is a term policy. Buy it online to get the advantage of lower premium. All other policies are not beneficial to you. It will help only the insurance company and the agent.