What is Life Insurance?

Insurance involves the transfer of risk from one party to another. The party that transfers the risk is called insured and the party that bears the risk on behalf of the insured is called as insurer.

Let’s take the example of Mr. Smart.

He is 30 started working 3 years back but didn’t quite start investing. He got married last month and is thinking of buying a home in the next year or so.

Now it has come to his realization that in the past 1 year and in a further couple of years his liability seems to increase in foreseeable future.

He has given a thought of putting his finances to track but is also concerned about liabilities increasing. He read somewhere that life insurance would help in doing the same and in covering the risk.

In this case, when he chose to opt for insurance what actually he is doing is transferring the risk of his life (i.e. death) in case of any bad event to the insurance company which will pay a certain sum (sum assured) in case of any eventuality the company insuring the life of Mr. smart (the insurer) will pay the amount to survivors.

So to understand things insurance is basically a contract between an insurer and individual where the insurer guarantees to pay a certain sum of money (sum assured ) in case the insured person dies or/and when the policy/contract ends.

The terms and conditions of the insurance policy differ depending on the policy type for example in a term plan the amount invested (in the form of premium) will not be returned back in case no eventuality happens.

Whereas a policy like a ULIP or some other policies will give certain returns (market or non-market linked) apart from covering life to a certain extent.

Basic concepts used in Life insurance –

Term

Every policy comes with a fixed duration till when the policy is considered to be in force which is referred to as the “term” of the policy.

Premium

Is the amount that the insurance company (insurer) charges to the individual who is paying for the insurance cover (proposer or insured). The premium depends on factors such as the cover, risk of the insured, etc. the policy is in force after the premium is realized.

Sum assured

Is the amount that Is paid to the insured in case he/she is no more. When an individual buys a term plan, for example, all he receives in case of eventuality is the sum assured in lieu of the premium paid.

In the case of ULIP in case of an eventuality, the higher of sum assured or the fund value is paid to the nominee or legal heirs.

Premium paying term

As we have seen “term” refers to the total time the insurance policy is in force and against the policy the individual has to pay a premium. Premium paying term refers to the total duration the investor has to or is supposed to pay the premium.

So for example, if the policy is for a total duration of 20 years and the individual is supposed to pay for 5 years in this case 5 years is the policy paying term and 20 years is the term of the policy.

Principle of life insurance –

Utmost good faith

It signifies that the insured person knows more about himself/herself than the insurer and hence the onus to declare any relevant fact that might impact the policy cost or benefits lies on the insured himself.

If in case it is later noticed that certain facts are hidden by the insured in such a scenario the insurer has the right to deny the claim.

Insurable interest

This principle means that the insured should have an insurable interest in purchasing an insurance policy and must suffer a financial loss in case of any such damage. For example, a person cannot buy insurance for his friend as he does not have an insurable interest but he can buy a policy for his wife or daughter.

Indemnity

The principle implies that the insured will not receive any compensation exceeding the amount of loss. The insured should be able to or intended to generate any profit of the insurance policy. The idea here is to put the insured in the same position as he or she was before the event of loss not to gain out of the loss.

Subrogation

In case of subrogation, it prevents the insured to make a profit from the event in the case when insurance needs to be claimed.

For example, if A meets a road accident and is hit by B, what A can do is sue B as well as claim insurance from the insurance provider but with the subrogation principle what actually happens is the insurance company pays A the amount of damage and in turn will sue B to recover the loss.

Types of Insurance –

Endowment policy

In the case of an endowment policy, the insured receives a certain sum (based on estimated return) if the policyholder survives the term.  

Money-back

This is also similar to what an endowment policy offers but apart from the survival benefits it also pays periodically certain sums as cash backs.

Whole life

Usually, a policy has a definite time duration of maturity which is called the term of the policy. But in case of whole life extends for the entire life of the policyholder. This policy also has survival benefits as an endowment policy has.

Term plan

Is a type of policy wherein the term of the policy is fixed and there is no return derived out of the policy as the premium used is only used to cover the life risk hence the premium of such policy is very low. The objective of a term plan is to cover the risk of life without looking for any return.

For example for an individual of 30 years and a term of 40 years (i.e. up to 70 years of life) for a 1cr sum assured the cost would be approx 12000 (ranging from 8000 to 13000).

 

Premium for a Term plan
Cost of Term Plan

 

ULIP

Unit Linked Insurance Plan is one of the most marketed products in the market due to the high commission associated with such policies.

They are a combination of investment and insurance as a certain portion of the investment is towards covering the life risk and the rest is invested into different funds ranging from equity and debt and depending upon the market conditions returns are derived from them.

Why is ULIP such a heavily marketed product in the Indian market be it advisors or banks?

Just look at any ULIP plan and look at the wordings used or the pictures being used in the brochure.

 

ULIP Plan Brochure MaxLIfe Insurance
Insurance Product Brochure

 

ICICI Prudential Life Insurance ULIP Plan Elite Wealth Super
ULIP Plan Brochure

 

SBI Life Insurance Smart Privilege Brochure
ULIP Plan Brochure

You will find a picture of a model looking like a successful entrepreneur or a family man showing concern for his family etc or words like “successful”, “great”, “ambitious”, “family man” etc to enhance the emotion of personal gratification or fear.

Here the insurance company is trying to enhance the emotions so that one feels important and often to get carried away. Especially this kind of marketing gives this sense of gratification to the NRI Diaspora.

Why do you need insurance?

Let’s take two scenarios.

Scenario 1 – an individual is under his late 20’s started working a few years back and is planning to buy a new car. He is unmarried. His father is a retired IAS officer and draws a pension of 75,000 monthly.

Scenario 2 – this individual is in his early 30’s and is married with a son. His parents stay with him and are dependent on him. His wife is a homemaker and he has recently bought a car and is paying EMI of the car along with EMI of flat as well which is approximately 60,000 per month.

Now in scenario 1 it’s quite evident that the person doesn’t have any significant liability and in case of his sudden demise the family will be affected emotionally but there won’t be any financial repercussions.

Whereas in scenario 2 the individual had lots of liability and he was to die tomorrow the family will be exposed to loss of his income as well as exposed to the debts as well (car and home loan EMI) in such case apart from emotional there will be a significant financial loss as well.

So in order to assess whether an individual needs any insurance or not there is one basic question one needs to ask – will there be any financial liability in case the primary earning member of the family dies tomorrow?

If the answer is yes then it’s advisable and almost necessary to have insurance as it covers the risk of life on the contrary in case of no such liability one can choose not to take insurance.

But for a young earning person like that in scenario 1 in the future, the individual would be having various life events such as marriage, kids and will acquire a house and car as well.

In that scenario, it’s better to go for insurance at the start of one’s career and the amount will be lower at such a stage, and in the long term, he will save substantial cost.

Insurance forms one of the very important aspects of one’s financial planning as it covers the risk associated with one’s life and substitutes the future cash flows in case of an eventuality.

Though no money can replace the loss of an individual but it empires a household as there is no financial stress on the family and any liability is also taken care of.

How much insurance do you need?

There are multiple ways to calculate how much insurance is required by a person but one has to understand the whole concept here is to calculate in monetary terms the value of one’s life in simple terms the present value of all the earnings the primary earner can generate if he is was alive.

 

Asset Liability mismatch
Pictorial representation of asset-liability mismatch

The picture above is just a graphical representation broadly depicting the asset and liability of an individual over a period of time during various stages of life.

Till one’s early 40’s the individual is mostly in the accumulation phase and the assets keep on gradually increasing but during the same time the liabilities (loan EMI, education and marriage provisions for child) also keep on increasing.

After this phase till 60, most of the liabilities are taken care of and tend to decline and monetary assets (which earlier was a liability for which loan was being paid) and maximum assets accumulation has happened by this age.

After retirement, most of the liabilities are taken care of and assets are being utilized to lead a post-retirement life.

Insurance and Investments (why you should not mix) –

It’s a very basic concept but most of the investors fail to understand.

Let’s understand this with an example. Suppose you need car insurance and you buy it with the premium which aims toward protecting you from the risk of an accident.

When one needs health insurance to protect them from a disease or accident the premium paid is directed towards securing oneself from the risk but somehow when the same person is looking to purchase (or invest) life insurance he is looking for a return from the same product though here the intention is to cover the risk.

The reason is unlike health or car insurance where the sum assured is low (usually in the range of 3 lakh to 15-20 lakh fro a normal household and hence a lower [premium in case of life insurance since the sum assured (value of life) is higher which might range from 50-70 lakh to even 5-10cr and hence the premium amount Is also higher.

Now since the investor has to pay a higher premium (a higher cash outflow) they look to generate some returns out of it as well if that is a possibility and that exactly is the trap.

Just going by the earlier example of car and health insurance since the aim was only to cover the risk of life then one should look for a product just covering that risk and a product offering that in the market is term plan but the irony is not most investors are aware of it and since it has lesser commission is not even marketed by distributors.

So, for example, for an investor of 35 years of age with no smoking and critical disease a premium for 1cr of cover would be approx 9,000 to 12,000  which is a fair price but since the money does not come to investors many perceive it as a loss (remember you are better off if you lose this premium).

 

Due to this approach of an investor, they end up in buying/investing in products which do not meet their requirement.

People end up investing in a 5lakh annual premium ULIP plans because some agent/advisor has pushed the same to them giving a rosy picture of good double-digit returns and making them believe that within a short span of time their money will double and they will get a very good corpus.

What this does is actually shifts the need of the customer who was earlier looking to protect himself from the risk to now start thinking about the investment aspect of the product to an extent that the insurance becomes secondary and his main focus is shifted to investment now.

 

 

As we have seen in the picture above for a 1cr plan for a 30-year-old individual a term plan costs somewhere around 8000 to 9000 which is a very moderate amount.

Now if for the same cover we look for a ULIP plan for a 1cr cover to be obtained through a ULIP a premium of 10lakh annual for a minimum premium paying term of 5 years will be required which is very high for almost most of the clients.

This implies that 10kah for 5 years is a total outflow of 50lakh which is quite high.

With a 10 lakh premium for a 15-year term, the total amount after 15 years will be about 1.3cr.

Now let’s say the investor takes a term plan of 1cr with a 9000 INR per annum the total outflow in 15 years will be 1.35lakh (9000 * 15) and in case of any eventuality, the investor’s family will receive 1cr.

And if the investor has to aim at 1.3cr corpus after 15 years (the amount he will have received in case he had opted for ULIP) a SIP 37,000.00 will be sufficient at 8% growth.

Now, there is two catch in these two scenarios.

  1. Since ULIP come with high cost (very high cost) generating an 8% return would mean a return of more than 13-14% annualized for 15 year which is very tough to achieve.
  2. In the second scenario, the return assumes is 8% in SIP which is very moderate considering the fact that SENSEX has given about 16% return which means the investment will grow more than 1.3cr (way too high than 1.3cr)

Returns on an insurance policy

ULIP – Unit Linked Insurance Plan, probably one of the most popular (if not the most popular) products in the insurance space. There is already much being said about ULIP as a product both in favor of and against.

We will start with presenting facts and figures of the ULIP products and how they fare as compared to various investment or insurance products (we have to compare both as it’s a combination of both investment and insurance).

ULIP is a product – is funny, to say the least. It’s a trap.

So it’s just like a cocktail with many flavors but none in particular that soothe your taste.

ULIP products are mostly aimed at generating revenue for the organization.

Since most of the investors feel that in the case of a term plan the amount paid towards the insurance is just the wastage of money and hence are looking for something that offers some returns as well.

This is the thing that incites insurance companies to create such products which are a cocktail of insurance and investments hence the investor gets the return and the life is insured as well.

But the catch with such products is that they are neither here nor there. For covering the amount of risk on one’s life let’s say 1cr an annual premium of 10lakh would be required to cover the risk worth 1cr.

On the other hand, if you look at the investment standalone point since the product covers the risk there is a premium allocation charge and mortality charge which is deducted from the investment amount and hence the net invested amount is quite less.

To put things in simple terms these costs increase the expense ratio of the investment amount and hence it would be very hard for investments to generate a return with such high cost.

Charges on ULIP –

Fund management charge

Is charged as a certain percentage out of the NAV of the fund in lieu of managing the fund invested. It is charged on the current fund value. As per IRDA, the FMC cannot be more than 1.5%.

Policy administration charge

Is charged on a monthly basis for managing the policy.

Mortality charge

Is being levied to cover the risk of life to provide for the risk against the untimely death of the proposer.

Mortality charge depends on multiple factors such as amount at risk, the sum assured, age, etc. these are deducted on a monthly basis from the funds that the investor has invested into.

Premium allocation charge

Is a front-load which means it is straightaway charged from the premium paid.  This charge is a fixed percentage charge from each year of the policy premium received. PAC is not similar throughout the policy and usually tends to decrease gradually as the policy term increases.

PAC is not charged for the entire term rather for the premium paying term of the policy which is 5 years for most of the ULIPS.

Switch charges

Switching means changing from one fund to another. For example, if one has chosen to invest 50% in equity and 50% in a debt fund but after a few years decides to switch some amount to equity more and increase it up to 75% in such cases he can switch from debt to equity.

Usually in most policies allow few switches without any charges within a year but after that, a flat fee in the range of 100-500 is charged.

 

Premium Allocation charge in ULIP Plan
Premium Allocation charge for insurance

 

Policy administration and mortality charges in ULIP
Policy administration and Mortality charge

 

 

Fund Management Charge ind SBI LIfe Insurance ULIP
Fund Management Charge in ULIP

 

ULIP Plan Details for SBI LIfe
Policy Details

 

Premium Paying options in a ULIP
Premium Paying options in ULIP Plan

 

Some facts on ULIP –

Discontinuance – is the scenario when the proposer either could not or does not wish to pay the premium during the premium paying term of the policy (usually 5 years in case of ULIP).

When the premium is not being received by the insurance companies by the cutoff date usually a 30days grace period is given and the insurance company sends multiple intimations via SMS or email and even then if the insurance is not paid the policy is assumed to be in discontinuance.

The benefits cease to exist once the policy is discontinued and the insurance companies pay the total amount after deducting charges after the minimum lock-in period (5 years in case of ULIP).

High charges –due to ULIPS being an amalgamation of insurance and investments the charges tend to be on the higher side.

Not ideal for getting insurance cover – as simple as that.

If one is looking to cover for the risk of a life term plan is the best option. We cannot stress this point more. ULIPS are just the waste of one’s money and time and effort put to no good use.

How to calculate one’s insurance needs –

There are many methods some thumb rules some very basic estimation of the insurance need but in this article, we will not be cover in any detailed mathematical calculations to estimate the amount of insurance required instead focus more on the qualitative aspect of it.

The idea while calculating the insurance amount is to make sure that once the primary earner of the family is no more in his absence the family is financially taken care of and his liabilities are taken care of.

The very basic method is the thumb rule of calculation which usually is about 10-15 times one’s annual income which is assumed to be a significant amount in case of any eventuality.

So for an individual with a 10lakh annual income, a cover of anything between 1cr to 1.5cr is supposed to be sufficient.

Income replacement method –

For a basic understanding, this method aims to calculate the amount of money the individual would be able to generate till his retirement so as to if something has to happen to him today the same amount is available to a family which would help as the source of income to the family.

So for example, if an individual earns 10 lakh a year and is 40 years old and is looking to retire at 60 ( 20 more years)  then an approx amount of 2 crores (10lakh * 20 ).

Usually while doing an actual calculation lot of factors like the amount of money spend on one’s own need is deducted from the required amount.

An annual rise of income is also taken into account while calculating the need. Inflation is also one factor that one should keep in mind.

Need-Based Method –

This method focuses on the needs of the household and calculates the future value of all the needs and calculates the assets available to provide for that need.

Basically in this approach, the value of all the goals such as home loan, education for children, education for marriage, and all other such goals are accounted for and then it is looked as to how much assets and liabilities are available to the household and balances them and finally, an amount is derived to cover those goals.

Term Plan

Mr. Smart is a 35-year young single-earning member of the family working for an IT company. He is looking o cover the risk of him so in case of any eventuality, his family has a sufficient amount to survive.

One product that suits this need of his is a “term” plan which covers the risk of life as it’s a pure life cover providing insurance policy and has a definite term associated with it.

For example, if he buys a policy worth 1cr for 20 years paying an annual amount of 15000(premium) then for the term of 20 years his life is covered worth 1cr and in case of any eventuality, the insurance company pays 1cr to the nominee or legal heirs assuming he pays the premium regularly.

Since term plans essentially are plain vanilla term plan covering just the risks and no other frills attached hence the entire premium is directed towards covering just the risk and hence the cost of a term plan is very less.

In case the same Mr. Smart wanted to cover the risk using a ULIP plan for example then he would have to pay a 10lakh premium every year with a payment of 5 years hence a total outflow of 50lakh (that Is too much commitment for most of the investors).

Types of term plan –

1. Increasing term

In this type of policy, the sum assured increases with a [period of time. It helps with encountering inflation. For example, if one needs 1cr life cover as of today for a 20 year but maybe after 20 year the 1cr amount might not be sufficient enough to account for family expenses which will be higher due to increasing inflation. In such a situation an increasing term plan will help in covering the family with an adequate amount.

2. Decreasing term

The opposite of an increasing term is a decreasing term plan wherein the sum assured of the policy decreases over a period of time. The investor with each year accumulates sum amount and the assets keep on increasing which also could be used in case of any eventuality hence the requirement of sum assured should decrease and hence a decreasing term plan covers that need of an investor.

3. Level term

Is the most popular where both the sum assured and the premium remains the same throughout the term of the policy.

4. Return of premium

Since most investors are bothered by the fact that the premium paid of the insurance policy will not come back (which is the good thing if it happens so!) hence see it as a loss and to use this psyche of the investor’s many insurance companies have come up with a return of premium option wherein a certain sum is returned to the policyholder.

How to choose a term plan –

  1. Look for good companies – it is always advisable to look for companies will long-term track records and decent brand value. Basically, the companies who have been in business for a longer time and wide network are easier to get the money once the claim is made.
  2. Buy online – online term plans are cheaper as they do not have any distributor/mediator involved and hence no commission is being paid to any intermediary hence the lower cost. It’s just like buying a direct mutual fund wherein one eliminated the cost of distribution.
  3. Diversify – as an investor one can diversify their term plan as well. For instance, if one needs 1cr of life cover you can buy from two different companies worth 50lakh of insurance each and cover the risk of just buying through one company.
  4. Claim settlement – it is defined as (total no of claim settled/ total number of the claim made) * 100.

Though claim settlement alone is not the criteria for deciding on the company wherein you should invest in a term plan but it is one of the important criteria.

Hence one should invest in those term plan of companies who have a high claim settlement ratio meaning thereby that when a claim Is actually made the chances of it being cleared is high. Anything above 95% is a good claim settlement ratio.

 

Claim Settlement Ratio by IRDA for insurance policies
Claim Settlement Ratios for Insurance policy

This can be viewed from the annual reports of IRDA and referring to “statement 6” and “statement 7”, a screenshot is attached.

One flaw of this report is it does not distinguish between the type of policy if it’s a ULIP or term plan or any other kind of policy.

The real deal behind advisors pushing insurance policies –

Money, that’s the crux of it.

What is the reason behind any product being shoved to a buyer? The answer is the heavy commission that is being paid to the distributors by the product makers.

All the ULIP products across various banks are heavily marketed and aggressively sold to the investors to generate more revenue for the banks.

If you look at the costs of a ULIP it is composed of premium allocation, policy administration and another host of charges.

 

MaxLIfe Fund management and Premium allocation charge for ULIP
Fund Management and Premium Allocation Charge

The following picture depicts the charges over a period of 15 years which Is approx 10% of the annual premium and for a policy to even recover the cost forget to generate a return of the policy.

Policy Administration, Mortality and Discontinuance charge for ULIP plan of MaxLIfe
Policy Administration, Mortality and Discontinuance charge

It’s funny how most of the investors fall under the trap without understanding their needs, the product, the good and bad aspects of it, the implications of purchasing such a product, etc.

 Do’s and Don’ts while buying life insurance policies-

Do’s

  1. NOT INVEST IN ULIP – anything beyond that is just a justification to the point of not buying the product.
  2. Keep long-term commitment – if you have already bought one have a long-term horizon and let all the onuses and loyalty additions kick in till the term of the policy.
  3. Switches – make the use of the switches available to maximize the returns
  4. Sell – one the policy term is near and if you have had a decent return (note we are saying decent) and you do not intend to keep your money blocked for the long term keep an eye on the value and sell at an appropriate time.
  5. Understand it’s for the long term and hence the commitment of paying or holding the investment is for long term meaning thereby that keeping a short term will not only result in loss of money but also one cannot derive the full benefit of it.

Don’t

  1. INVEST in ULIP – just do not invest
  2. Take money after 5 year  – as the policy premium paying term is 5 years most investors take money out after this time, it is advisable not to sell as you have already born the charges and this is the real-time when some return might be evident hence do not sell at this time.
  3. Search for liquidity – ULIP as a product is not meant for liquidity. One cannot withdraw before 5 years (i.e. premium paying term) and even after 5 years is when some benefits like loyalty and bonuses start kicking in is when the policy should be kept on for. So ideally one should remain invested in the term of the policy hence liquidity is a constraint in the policy.
  4. Look for better ULIP than you have already invested in – you already have invested in the best ULIP plan (remember that was what was told to you by the agent/manager while selling the policy) and probably that is true as most of the policies in the market are similar in terms of features, charges and returns (at least what they promise) so there is no point searching for a better one, in all probability you might end up investing in multiple such useless products.