Free Press Journal

Life Insurance : The do-it-yourself guide


life insurance

What life insurance does is, it provides financial security to your dependents against the very real risk of your death, writes TENSING RODRIGUES.

It’s your life; and therefore you have got to decide about your life insurance. Life insurance does not protect your life; what it does is it protects those who depend financially on your life. In case you die, their livelihood will be under threat. What life insurance does is it provides financial security to your dependents against the very real risk of your death. Therefore I prefer to call it death insurance!

Before we get to the nitty-gritty of buying life insurance, two basic truths: one, there is no need to buy life insurance if you do not have any dependents; just as you need not buy car insurance if you do not have a car. Two, insurance is not an investment in the category of bank deposits, equity shares or mutual funds; it can neither grow your wealth not give you regular income; sometimes if you come across an insurance product that looks like investment, because an investment product has been bundled with it, do not buy it; keep it simple, buy an insurance product for insurance sake and buy an investment product for investment sake.

Basically you will find two types insurance policies in the market: without profit and with profit; the rest are all permutations and combinations and variations on these basic policies. The without profit policies are usually called the Term Plans (TP); with profit policies are usually called Endowment Plans (EP).

The TPs are pure and simple risk covers, like non-life policies (vehicle insurance, home insurance, etc.). You pay a premium – technically called the risk premium, and you get a risk cover. Sometimes you may be confronted with a Term Plan With Return of Premium. That is not a TP; it is an EP.

TP is a must if you have dependents – persons who will face a financial distress if you cease to live. How to buy a TP? There are two things about TP that you need to decide: one, what should be the term of the TP; and two, what should be the Sum Assured (SA). Term of a TP is the number of years for which you get the cover. If you die during the term, the insurer will pay your nominee a sum of money which should save the dependents from the financial distress. How long should the cover remain?

Simple, only as long as your dependents need it. Let us suppose your child is five years old. You expect that by twenty-five your child will be able to fend for herself. Then the term of the TP should be twenty years; not a year less, not a year more. Remember, in case of a TP you get nothing if you do not die. What happens to the premium that you have paid then? It gets used to pay SA to the nominees of those who have died. Just like in the case of the motor insurance, for instance.

Now the SA. Here again, the SA should be just sufficient (well, that is not a very unambiguous quantity) to meet the needs of your dependents; not a rupee more, not a rupee less. It works this way: Your dependents get the SA on your death. They invest it somewhere and live on it till they can fend for themselves. You need to work it backwards.

First decide how much your dependents will need every month for meeting their needs. Make sure you factor in the inflation and the changes in needs as time passes. Once you have decided on the monthly requirement, ask yourself: to give this amount every month, over the entire term (the balance term, actually), what is the corpus that will be required? That corpus has to be your SA.

There is a practical difficulty in this calculation: the balance term. The balance term is the period between the day of your death and the day on which your dependent will begin to fend for herself. The latter you can more or less approximate. But how do you decide on the former? (!) You cannot (forget those FB apps). So you take a practical (simple) way out. Either take the whole term as the balance term (this way you are playing absolutely safe; but it costs.) Or take half the term as the balance term (this way you are taking a little risk; but it saves money.)

See what you are comfortable with. Many experts use the Human Life Value as the basis of determining SA. I am not very comfortable with that concept because in life insurance we are trying protect against ‘financial distress’ not ‘financial loss’; I feel the concepts of ‘compensation’ or ‘restoring the asset to its condition before the adverse event’,  as they are used in non-life insurance are not very appropriate for life insurance.

Let us now turn to the other basic product in the life insurance market – the Endowment Plan. There may be many variations of EP. But it is very important to understand the basic architecture of EP, so that one does not get carried away by the marketing gimmicks.

The most common variations of EP that are likely to distract the customer are the Money Back Policy (MBP) and the ULIP (Unit Linked Insurance Plan). MBP is just an EP package that pays a sum of money periodically instead of at the end of the term. There is no basic difference between MBP and a ‘classic’ EP. So choose between the two based on just that : whether you want money periodically or at the end of the term.

ULIP is an EP, but with a significant difference. Let us come to that a little later after we have understood the basic architecture of EP and its rationale. An EP is a bundle of insurance and investment. Your EP premium will include two components: one, the risk premium (what gives you the risk cover; same as the risk premium of TP); two, the investment component. The risk premium goes towards providing the risk cover (paying SA to the nominees of the dead policy holders); once the year ends ideally all of it would get exhausted in paying the claims.

The investment component gets invested by the insurer on your behalf. At the end of the term the insurer pays it to you along with the interest/dividend that it has earned. The question is: why should you leave your investment to the insurer whose core competency is management of risk, not management of financial assets ? Ordinarily you should not; as I have said before, buy an insurance product (TP) for insurance sake and buy an investment product (bank deposits, equity shares, mutual funds) for investment sake.

However there is an exception to this rule: a special situation where EP needs to be bought for risk sake. But this is a special EP – an EP with a WOP (Waiver of Premium) rider. The special situation is when you need to protect a savings and investment plan you have begun to provide for a future need of your dependent. Let us suppose you are saving and investing to provide for the higher education of your child.

What happens if you die before you complete the plan? If you buy an EP with WOP, you pay the premium as long as you live (the investment component of the EP premium is your saving and investment plan); when you die the insurer pays the EP premium on your behalf.  So the saving and investment plan continues.

Now let me come to the ULIP. ULIP is a better version of EP. The conventional EP is not at all transparent – it does not tell you the breakdown of your EP premium between risk premium and investment, it does not tell you where your investment is going and what its current value is, and so on. An ULIP does.

Further it gives you the freedom to direct your investment to the assets of your choice. Very important, by not stone walling the investment from the risk premium, a conventional EP makes you share in its losses arising from bad underwriting.  So, when you need to buy an EP, as far as possible opt for an ULIP as against a conventional EP.