Friday, January 15, 2010

Life Vs Money Vs Death

Just a note before you begin - the information completely pertains to Life Insurance in India. It may or may not be similar to the system in other countries.

DISCLAIMER: I am not an expert and neither am I an exceptionally good investor. I just do what I can and I have jotted down what I know in terms I am familiar with. So, take it with a pinch of salt. And any suggestions/corrections/criticism welcome :)

Who needs Life Insurance and why?
Anyone with a regular income needs Life Insurance. Here is why:
- To make up for liabilities (could be anything from a housing loan to taking care of dependents)
- To get a tax rebate
- To have a form of investment for the future.
However it should be kept in mind that the primary purpose of Life Insurance is to make up for the financial deficit that could be caused by one's sudden demise and it is not intended to purely be an investment.

What terms are often used?
SA - Sum assured: This is the sum paid by the Insurance Provider on the demise of the policy holder.
PA or PLA - Principal Life Assured: The policy holder or the person whose life is insured
SLA - Spouse Life Assured: Spouse of the policy holder or the person whose life is insured
Guaranteed Return: The SA is usually guaranteed (usually known as Guaranteed Death Benefit). Some schemes may also offer a percentage of the SA as a guaranteed return i.e. irrespective of how your premium is invested, you will get this amount (usually known as Guaranteed Survival Benefit).

You can also see this in the picture (there are pseudo numbers generated for the sake of clarity). Green indicates the Guaranteed Return while the red indicates the non-guaranteed return for two cases (6% and 10% ROI) based on how the investments perform. This policy starts when the PLA is 28 years old and shows that the premiums are to be paid for 16 years. The death benefit is valid until the age of 85.

What are the two common forms of Life Insurance (LI)?
1. Term Life Insurance
2. Permanent Life Insurance

What is Term Insurance (TI)?
Term Insurance or Term Life Insurance is purely a death benefit scheme i.e the policy pays out if and only it the policy holder expires during the coverage period. The payments are at fixed rate and coverage period is limited. The major difference between this and Permanent Life Insurance is that the latter pays out a sum (with accrued bonus, as applicable) after a period of time, even if the policy holder is alive i.e besides the SA there is also a return on Investment(ROI). For this reason, the premiums in case of Permanent Life Insurance are considerably higher than in case of the Term Insurance.

Insurance agents generally will not recommend TI because the commission they get out of it is negligible.

What is Permanent Life Insurance (PLI)?
As explained before, the policy accrues cash value and there is a payout at the end of the policy term besides the SA.

When is a good time to get Life Insurance?
As soon as one starts paying taxes (aka having a regular income). Exception: If one is a student and one takes a bank loan of 10 Lakhs for one’s studies, then one should have a Life Insurance to cover this liability. This means one should have a policy with a SA of a minimum of 10 lakhs (ideally, 12-15 lakhs to account for interest accrued on one’s educational loan during the period of one’s studies). In this case, since the insurance is purely to cover liability, one opts for what is known as term insurance. There are no returns but the premium for such a high SA is very less (roughly Rs.1000 per annum assuming the policy holder is 21 years old). This is necessary because in case of an unfortunate accident, the family, already going through a trauma due to the loss, need not have to deal with the repayment of the educational loan as well.

What is the minimum amount of Life Insurance needed?
There are 4 basic rules of thumb (from what I have seen/heard/learnt):
1. Income plus expenses rule: This rule suggests that an individual needs insurance equal to five times your gross annual income, plus the total of basic expenses like housing or car loans, personal debt, child's education, etc. This is only in the case of the person being the sole bread winner with no other form of income or property. Ideally, the amount should be sufficient to cover one’s financial responsibilities (care of dependents) and should be at least twice the annual income

2. Premiums as percentage of income: By this rule, payment of insurance premium depends on disposable income. Remember, only a portion of your savings can go towards this since you should have other forms of investment. At the same time, commit an appropriate percentage of your income for paying the life insurance premium. Care should be taken here because non-payment of even one of the premiums can result in the policy becoming invalid.

3. Capital fund rule: This rule suggests that if you need 2 lakhs p.a. for your family needs, and assuming you do not have any other income-generating assets, you may like to create a capital fund of 25 lakhs which can yield 2 lakhs annual income @ 8% p.a. Therefore a life insurance policy of 25 lakhs.

4. Liability rule: The SA should be at least equal to an individual’s liability. For example, If you have a housing loan of 20 Lakhs and if you are the only borrower then the SA should be at least 20 lakhs.

Is medical check-up needed for Life Insurance?
This depends obviously on the amount insured, the age of the person and the type of insurance. A medical check-up is mandatory for TI (Exceptions being children or youngsters). In case of PLI, normally SA of less than 10 Lakhs will not required a medical check-up.

Is Life Insurance an investment?
Yes and No

No because it is principally intended to reduce financial pressure on the dependents on the person’s demise i.e to counter liability, as explained before.
Yes because by choosing a good scheme, there can be a ROI of 10-15%

What kind of risk-return ratio is advisable?
Since LI is more of a protection than an investment, high risk is not preferable. However, one should keep in mind that these policies run for 15-20 years and over this period, the risk-return ratio will stabilize (irrespective of momentary fluctuations)

What other features are included or should be taken care of?

- Check if the Insurance is International, i.e. if benefits change depending on the location of the PLA’s demise
- Check if there are premium waiver benefits in case of dismemberment and/or accident. For example, if the PLA meets with an accident and cannot take on employment, is there an option for premium waiver? This is generally not offered to NRIs and is restricted to the accidents taking place in India but when the PLA moves back to India he/she can add this option.
- Check if the premium allocation and fund management charges (a fee is charge for processing your policy as well for premiums paid) are reasonable
- Check your eligibility for tax rebate
- Check if partial withdrawal option is available – A portion of the amount + accrued bonus will be paid to the PLA (This will be inevitably mean some loss in the ROI but can help in case of emergencies).

Are Life Insurance and Pension Plan the same?
Not necessarily

In case of LI, depending on the scheme and its life period, one can get a lumpsum amount when one retires but this is not the intention behind a LI. In case of a pension plan, one can either opt for a 'lumpsum amount' (I think this term is of desi origin :D) or a monthly pension and these schemes will usually also have death and dismemberment benefits.

Are nominations enough to claim money?
No, Nominations just indicate a person who is responsible for receiving the policy sum (or benefits) and is not necessarily the owner of it, according to the Insurance act of 1938 (I went crazy trying to read this document !) i.e. if a father's policy lists one of the sons as a nominee, he does not necessarily have claim to the policy sum on his father's demise. The other son can contest this in court unless there is a will that clearly explains that the nominee's claim. So if you have enough investments and want to avoid a family feud, make a will !

Other tips?
- Do some homework about the company– look at the history and reliability of the company, their financial record, where they invest in, stability of investments (you would be amazed at how much information google can generate on this topic !)
- Do some homework about the scheme – Many schemes are withdrawn from time to time even by companies long standing in the Insurance industry. So check what financial experts have to say about a scheme.
- Do not look at the ROI alone – Just because the policy ‘predicts’ that the amount in your account along with the bonus accrued will result in 20 lakhs at the end of 15 years is not enough to choose the scheme. Remember the inflation! Assuming an inflation rate of 4%, this would probably be worth only 10 lakhs (or even less) at the end of policy period !!
- Diversify your portfolio – When thinking about ROI, consider multiple options (Fixed deposits, Mutual Funds, Shares, Real Estate etc.). Do not use just insurance. Even too much Insurance can be fatal (pun unintended) !
- Above all, inform the nominee about your policy and make them aware of the benefits. There is no point in doing anything when no one can use the policy or is even aware that one exists. Also review the policies from time to time. For example, Marriage may call for a change of nominee - from parents to spouse or your liabilities may increase.

So, Be smart and let your spouse/parents/dependents know that you are :)


  1. Most of the best-selling books on investments, or be it the shows on television mostly make investing (and the monetary world in general sound like rocket science) .. it's funny how this stock-ticker channels go on and on about intergallactical 'market fundamentals'. What we can really do with now.. even like you're article points out.. is Money 101 for an average person like me!

    Nice job here!

  2. @Arjun

    oh..yeah, these channels are like GRE verbal books, no sane person will actually use those words in real life !


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