Insurance must be unquestionably the most misunderstood financial instrument in India. People buy insurance for all sorts of reasons except for the ones that matter. Some treat it as a way to save taxes, some as an investment scheme, and some even take life insurance for their minor children. I have even seen people buying insurance from a particular agent because he offered them a percentage of his commission!
In this blog post, I will cover the points to be kept in mind while buying a life insurance product.
Why is life insurance needed?
The sole purpose of buying life insurance is to ensure that if something unfortunate were to happen to you, your family would not have to face any financial hardships due to the consequent loss of income. Nothing more, nothing less.
A life insurance policy pays your family a predetermined lump sum of money (known as Sum Assured) in the event of your demise at any time during the policy period, thereby shielding them from the financial consequences of such an event.
Who should take life insurance? Should my spouse and children be insured too?
Since the sole objective of life insurance is financial security, only the principal income earner(s) in the family need to be insured. There is no point in buying life insurance for any family members who do not contribute to the family’s income, because there is no financial loss arising from their demise.
With this in mind, let’s proceed to discuss the points to be kept in mind while choosing a life insurance product.
What are the types of life insurance products available?
Life insurance products can be classified into Traditional Insurance Plans and Unit Linked Insurance Plans (ULIPs).
Traditional plans can be further categorized into Term Plans, Money Back Plans, Endowment Plans, and so on.
Term plans are pure and simple insurance products. They pay a fixed amount of money to the next of kin in the event of the policy holder’s demise, and nothing at all if the policy holder survives for the duration of the policy.
But most other insurance plans (both traditional and ULIPs) operate as insurance-cum-investment schemes, offering not just a sum assured in the event of death, but also some “return on investment” on survival. The difference between these schemes lies in the rate of return of investment they offer.
Traditional plans invest your money in bonds and securities, and therefore offer a guaranteed rate of return on investment (usually in the range of 4-6% per annum). In such policies, it is known in advance how much money will be paid either on death or on survival.
On the other hand, ULIPs invest in the stock market and thus offer a market-linked rate of return. Depending on the performance of the stock market in the time between policy purchase and payout, the return may be equivalent or better or worse than that offered by traditional plans.
What type of insurance policy should I take?
It is strongly recommended to separate the twin objectives of insurance and investment, to have better control over both.
Term plans may not seem like an attractive option at first, given that they do not offer any survival benefits or return on investment. However, being purely insurance products, they charge much lower annual premiums for a given sum assured than other traditional plans or ULIPs. This actually allows you the flexibility of investing the money saved in an investment scheme of your choice and for a duration of your choice, rather than locking it in with your insurer.
Therefore, it is recommended to buy a pure term insurance policy with a suitable sum assured, and invest the difference in annual premium into a good long term savings scheme with a proven history of performance, and preferably one that invests in a mix of equity and debt.
Suppose I want to buy a life insurance policy with a Rs. 50 lakh cover. I can go for either a money back policy or a term plan. The following example indicates the annual premiums I would have to pay in each case, as well as the money received on death and maturity:
1. LIC Jeevan Surabhi Money Back Policy
Annual premium for a sum assured of Rs. 50 lakhs and policy period of 25 years: Rs. 4,19,468 (premium paying term is 18 years)
Total premium paid: Rs. 4,19,468 x 18 = Rs. 75.50 lakhs (approx.)
Amount payable on death: Sum assured of (Rs. 50 lakhs – Rs. 1.5 crores)* + bonus of (Rs. 1.4 lakhs – Rs. 35 lakhs)*
* Exact amount depends on time of death.
Amount payable on maturity: Sum assured of Rs. 50 lakhs + bonus of Rs. 46.5 lakhs = Rs. 96.5 lakhs
So over 25 years, you have paid Rs. 75.5 lakhs (over the first 18 years) and you will get Rs. 96.5 lakhs on maturity.
2. HDFC Life Click2Protect Term Plan
Annual premium for a sum assured of Rs. 50 lakhs and policy period of 25 years: Rs. 6,200 (premium paying term is 25 years)
Total premium paid: Rs. 6,200 x 25 = Rs. 1.55 lakhs
Amount payable on death: Sum assured of Rs. 50 lakhs
Amount payable on maturity: NIL
So over 25 years, you have paid Rs. 1.55 lakhs for a cover of Rs. 50 lakhs. This is a very small amount to pay for the same amount of insurance cover. And although term plans don’t offer survival benefits, the money saved on premium can be invested in other financial instruments to generate a healthy return, as we will see below.
Comparison of policies
As per this calculation, you would have to pay approx. Rs. 4.2 lakhs per year for a LIC Jeevan Surabhi policy with a cover of Rs. 50 lakhs, while you pay Rs. 6,200 for the same cover with a HDFC Click2Protect term plan. That’s a difference in premium of Rs. 4.14 lakhs a year.
Assuming you were to invest roughly this amount (say Rs. 4.2 lakhs annually, or Rs. 35,000 per month) for 18 years in a Recurring Deposit that offers a modest 7% annual interest rate, you would get Rs. 1.51 crores (approx.) at the end of 18 years.
If you were to transfer this amount after 18 years into a 7-year Fixed Deposit with a 7% annual interest rate, you would get Rs. 2.45 crores (approx.) at the end of 25 years!
By contrast, the LIC Jeevan Surabhi policy gives you a maturity amount of just Rs. 96.5 lakhs after 25 years!
As you can see from this example, it makes a huge difference to your final return on investment when you separate insurance from investment.
Then why are insurance-cum-investment policies popular?
Most people are inherently lazy or callous when it comes to insurance and financial planning. If a single policy offers an insurance cover plus “assured” returns on the money invested, people deem it a good investment without analyzing whether the insurance cover is adequate for them or whether the returns are really as good as they seem.
Not only that, by combining insurance and investment, your investments get locked in with your insurer and the rates offered by them. You cannot take advantage of better investment schemes or move money to a different scheme if the existing one isn’t doing well. You also cannot withdraw the money if you need it for some reason.
Moreover, such policies also have a higher percentage of “administration cost”, which means a larger part of your premium goes into the pockets of the insurer and does not contribute to your returns or the sum assured.
Which insurer should I take my life insurance policy from?
Before buying a policy from any insurance company, you must check their Claim Settlement Ratio and Solvency Ratio.
- Claim Settlement Ratio is the ratio of insurance claims accepted to the total number of claims made. A higher ratio is better, as it indicates the company approves most of the claims it receives. Typically, a settlement ratio of over 90% is good enough. Anything below that means the company should ideally be avoided.
- Solvency Ratio is the ratio of an insurance company’s assets to its liabilities. The purpose of solvency ratio is to ensure that an insurace company has adequate funds to service all claims and maturity benefits that it has to pay out. A solvency ratio of 150% is mandatory in India, as per IRDA norms.
As per IRDA statistics, the company with the best settlement ratio and solvency ratio is LIC. Unlike what they show in ads, LIC has an excellent track record of servicing claims and tends to approve around 99% of claims made. Beat that! And being a Govt. owned company, their ability to service claims is backed by a sovereign guarantee.
However, the problem with LIC is that its term plans are quite expensive compared to other insurers. For instance, for the same cover of Rs. 50 lakhs, LIC’s Amulya Jeevan term plan has an annual premium of Rs. 17,450. This is almost three times the annual premium of Rs. 6,200 for HDFC Life’s Click2Protect term plan!
In terms of solvency ratio and settlement ratio, the next best companies currently are HDFC Life and ICICI Prudential. This, of course, may change from time to time.
The term plans offered by these companies are HDFC Life Click2Protect and ICICI Prudential iCare Plan.
What should be my Sum Assured?
It is important to choose an insurance cover that is just adequate for your needs. If the cover is too low, it will not be enough to take care of your family’s needs after you. If it’s too high, you will be unnecessarily paying a higher policy premium that could have been invested elsewhere.
The following steps explain how to calculate a sum assured that is adequate for your needs:
1. Calculate your annual household expenditure
Calculate your monthly average household expenditure and multiply by 12 to arrive at the annual expenditure. To this, add any other recurring annual expenses like school fees, etc. to arrive at your annual household expenditure.
Say your monthly household expenditure is Rs. 20,000. So annual expenditure is 20,000 x 12 = Rs. 2.4 lakhs.
Assume other recurring annual costs add up to Rs. 1.6 lakhs. So total comes to Rs. 4 lakhs a year.
Now the question is, to generate Rs. 4 lakhs each year, what is the lump sum required? The answer is: a lumpsum of Rs. 60 lakhs can generate Rs. 3.6 – 4.2 lakhs at 6-7% interest, if invested in Fixed Deposits or Debt Mutual Funds.
Therefore, your sum assured should be Rs. 60 lakhs.
2. Add any liabilities you have
If you have any outstanding loans or other liabilities on your head, you must add that amount to the sum assured calculated above.
Assuming you have outstanding loans are worth Rs. 20 lakhs, add this to the sum assured.
Now the sum assured becomes Rs. 80 lakhs.
3. Subtract disposable assets
If you wish, you can subtract the value of any disposable assets or investments you have, such as jewellery, FDs/bonds, shares, etc. provided you are willing to sell them in case of emergency. Do not include immovable assets like real estate, etc. which cannot be disposed off in a hurry.
4. Add a margin to account for future inflation
You can add a margin of 20-25% to account for future inflation.
With a margin of 25%, the final sum assured becomes Rs. 80 lakhs + (25% of Rs. 80 lakhs) = Rs. 1 crore.
You can calculate your sum assured in a similar manner and take a term plan for that amount.