Importance of life insurance

Importance of life insurance

A lot of people go through their entire lives before understanding what life insurance is all about. There are several reasons for this - the most common is that no one really informed them about it. Another equally common reason is that those who did inform them (read insurance agents) gave them half-baked information so that they could sell them what they wanted (based on the insurance commissions) rather than what was best for clients.

Anyone who has been reading the Money Simplified regularly (we are in the fifth year now and there are plenty of regular readers) has no excuse. For the benefit of the first-timers; life insurance is all about providing for the future in a way that your absence does not hurt your family members financially. For this you must first, as accurately as possible, estimate the value of your life. This is called the 'Human Life Value'. One of the methods of calculating your human life value is to sum up all expenses along with your future liabilities that your family members will have to pay off in the unfortunate event of your death. Once you have done that you must take a life insurance policy to give you an insurance cover equaling your human life value.
Let's understand how the Human Life Value (HLV) is calculated with the help of an illustration. Vivek is a 32-Yr old software professional. He is married; at present he does not have any children. He has some liabilities mainly in the form of loans as also regular household expenses. This is how his HLV is calculated:

It is important to note that calculating the HLV is not a one-time process. It must be reviewed regularly. For instance, in Vivek's case, if things were to change over the years - for instance, more loans, higher expenses, children, then he would have to revisit his HLV calculation.

As we explained before, life insurance is all about providing for your HLV so that your family members are not left to fend for themselves in your absence. Life insurance allows individuals to opt for a life cover broadly through two plans, viz. term plans and endowment plans.

A point to note is that the way life insurance premiums are structured, opting for life insurance policy at an earlier stage of your life works out cheaper.

Term Plans

Term plans simply provide a life cover, nothing more, nothing less. To understand this better, consider the two likely scenarios while opting for a life insurance plan; the individual either survives the tenure or does not survive it. Term plans and endowment plans (explained later in the article) differ in the way they tackle both these scenarios.

Term plans are relatively straightforward; they pay-out the sum assured only if the individual does not survive the term. If he survives the term, he gets nothing. To draw a parallel between term plans and other forms of life insurance, consider the premiums paid out on medical insurance or a vehicle. The premiums are paid out regularly with the explicit intention of being compensated in the event of any loss (to health or vehicle). If there is no loss to health/vehicle in a particular year, then there is no compensation. However, you must keep on paying the annual premium because you don't know when your health/vehicle will deteriorate.

If you have understood how medical insurance or vehicle insurance works, you will appreciate how term plans work. When you opt for a term plan you are required to pay an annual premium over a pre-determined tenure, till you encounter an eventuality (put bluntly, till you pass away). On death, your survivors will receive the sum assured that has been promised to them. On survival, you will receive nothing.

However, term plans differ from medical/vehicle insurance in one important aspect. While medical/vehicle insurance are annual contracts and must be renewed every year, a typical term plan tenure is usually much longer (the number of years varies across life insurance companies).

Endowment Plans

If you have understood how term plans work, you have already got a fairly good idea of how endowment plans work. Endowment plans differ from term plans in one very critical aspect i.e. maturity benefit. Term plans do not pay out the sum assured if you survive the term; you receive the sum assured only if you meet with an eventuality over the tenure. Endowment plans, on the other hand, pay out the sum assured under both scenarios - death and survival, so long as you have paid the premiums regularly.

Instinctively endowment plans appear more worthwhile because they pay out the sum assured regardless of whether you survive the term. You get a sense that paying those premiums worked out for you.

Before endowment plans get your thumbs up, it's important to consider a few points. Endowment plans do pay out the sum assured (along with profits) but this comes at a cost to you. Since endowment plans have to pay out the sum assured regardless of whether you survive the tenure or not, the insurance company builds this into the cost of your insurance plan i.e. the premiums you pay. So a part of your endowment plan premium is apportioned towards this. What the insurance company provides you (either on death or on maturity of the tenure) is not just the sum assured, rather it also provides you a return/profit on the sum assured. It does this by investing the premiums in assets (stock and debt) and paying out the return to you on death/maturity.

Like we mentioned, endowment plans do give you the sum assured with accumulated profits under both scenarios - death and maturity, but this comes at a cost. The cost is deducted from your premium. So everything else being the same, for the same life cover, the premium on your endowment plan will be higher than the premium on your term plan. To quantify the difference in premiums let's take Vivek's illustration to ascertain how much premium he needs to pay for a term plan and an endowment plan for the same cover (rounded off to Rs 11 m for ease of calculation).

Unit-linked Insurance Plans (ULIPs)

The ULIP, a variant of the endowment plan, is another insurance product that is much misunderstood. Unlike term plans and traditional endowment plans, ULIPs invest in stock/debt markets (you have the option to choose the allocation). Since equity/debt markets fluctuate on a daily basis, the performance of your ULIP gets linked to the markets. The value is captured by the NAV (net asset value) of the ULIP. If you find that ULIPs are similar to mutual funds, then you are right, at least to the extent that both are market-linked.

ULIPs have been a victim of much mis-selling largely due to two reasons. First, they have been sold as life insurance while at best they are a combination of investment and insurance in that order. This is because if getting a life cover is really critical then subjecting your insurance monies to the fluctuations of stock markets is not a very prudent thing. For instance, imagine how Vivek's family will be placed if the value of his ULIP falls sharply to coincide with his death. However, the insurance agent is unlikely to inform you about this because the commissions he makes on ULIPs is sizeable compared to say term plans.

Another reason for the mis-selling is rooted in the expense structure of the ULIP. Most ULIPs have a complicated expense structure, which is rarely understood by the individual. Not just complicated, in some cases ULIP expenses are forbidding. Again, don't expect too many inputs from your insurance agent on how expenses work out over the long-term. Having said that, the expense structure of certain ULIPs could make their expenses comparable to mutual funds over the long-term.

While ULIPs can add value to the individual's portfolio, in our view it would be a mistake to opt for ULIPs as your frontline life insurance policy. Rather, that is a role most suited for a term plan. The reason for this is that ULIPs, like endowment plans discussed earlier, can be very expensive. Consider Vivek's HLV (Rs 11 m). For a term plan of Rs 11 m over a 30-Yr tenure, Vivek will have to pay a premium of Rs 36,230. For a ULIP of the same cover and tenure, he will have to pay Rs 733,334, i.e. over 20 times the term plan premium!

We have compared term plans to endowment plans and ULIPs. Term plans work out the cheapest and it is something that all individuals must consider taking, especially at a younger age. A ULIP can play the role of enhancing your investment portfolio and bridging the shortfall, if any, in your life cover.