LIFE INSURANCE DEMYSTIFIED

Most people I meet or interact with, consider Life Insurance Policies as investment. It is the biggest myth for an investor.  Almost everyday, I get a query on Life Insurance or ULIP or some other insurance plan and invariably the question is, “Should I take this plan? There is an assured return of xyz amount.” Some of those myths need to be debunked. Insurance agents usually will not tell you what I am going to tell because somewhere hidden is an agenda of fat commissions from that policy.

 Your agent gets a nice commission  on the total premium collected for the duration of policy. In other words higher the premium paid by you, higher is the commission earned by him or her for 30 to 40 years (which is usually the duration of the policy).  I do not rue the agent his or her commission because the agent is only 50% to blame. The balance 50% blame rests with us, the consumer or customer. Our behavioural desire to get something back from the insurance premium paid is the culprit here.  And therein hangs the insurance agent’s tale.

Let us take the case of Ram Subramanian, an officer in BSF. Why does he need to insure his life?  Till yesterday, he was just a trainee in the training academy, and before that a student. At that time he was not insured, then why suddenly when he becomes an officer, is there a need to insure him?

The purpose of any insurance is to receive a monetary compensation which can partly or completely make up for my loss. If I insure my house and it burns in a fire, the memories of my wife’s bridal gown which turned to ashes as a result of the fire cannot be recouped with insurance but insurance will give me some money to buy another saree for her. Similarly, life if insured, will give the dependents some money or sum assured to keep the home fires burning. Though it can never be a substitute for the lost individual, the money will help.

Ask yourself a very simple question before insuring anyone. If the candidate for insurance were to suddenly die due to some calamity or mishap before time, will it affect the running of his or her household monetarily? If the answer is an emphatic YES, go ahead and insure the person.

It implies that insurance of life is meant only for an earning member on whom there are financially dependent individuals. The more the dependence, the proportionate should be the sum assured.

So, first thumb rule—Insure only the earning member. If he dies, the dependents should be able to lead their lives in the same fashion as they were leading earlier. DO NOT Insure your children, dependent father, mother or spouse. All the advertisements of insurance play on the emotional pitch of a grandfather buying a saving product morphed into an insurance plan for the child, etc. The spouse should take some insurance only if she has a regular working career. Otherwise it is not required.

Having established Why to insure and  Who to insure? I will try and elucidate on When to insure and How much to insure?

Coming back to  Ram Subramanian, Subbu needs to insure himself only if his parents or family depend on his income to run their lives. Otherwise he could even remain uninsured and his death would not materially affect anyone. Emotionally, Subbu’s kith will get affected but finance and emotions should always be divorced. Because that’s the only way to take correct financial decisions.

When should Subbu buy insurance? The correct time to insure is ideally when an individual starts supporting dependents. Subbu should buy an insurance policy when he gets married to a girl who is not working. In case she is earning a handsome amount herself, insurance could again be delayed. But in India, the general pattern is that a young woman or man after college starts earning and then plans a marriage and children. Subbu is also likely to follow the same pattern. Therefore, my advice to Subbu will be to buy insurance, the day he starts earning his first salary. Why? Because insurance premium amounts are linked to age.

So, here comes my second thumb rule— buy insurance when you are younger and have more earning years left. The younger you start, the lesser you pay for similar sum assured. To take an example, if I had bought a pure Term Cover of 60 Lakhs, for a cover upto 61 yrs of age, with accidental death benefit rider at age 21, I would have paid an annual premium of Rs 5295. Whereas, if I buy the same policy at 45 years of age, for a similar cover, the premium would be Rs 14,400.  My premium rises by almost 3 times.

My third thumb rule — amount of sum insured should be 100 times your monthly salary. The amount of sum assured or what the insurance company should pay is approximately 100 months of your earnings. If Subbu earns Rs 40000 per month, he should get insurance worth Rs 40 lakhs. In case of Subbu there is already a mandatory insurer in the form of Group Insurance.  Subbu pays them an annual premium of Rs 48000 and is insured for Rs 40 lakhs. Is there a requirement for Subbu to  further insure? If Subbu’s salary were to remain frozen at this level till his retirement, he does not require additional insurance. But his salary and emoluments will increase and assuming that by middle age he earns Rs 100,000 per month, I would advise him to take up a policy of additional Rs 60 Lakhs. Bringing his total insurance cover to Rs 1 Crore.

Ram Subramanian who  has become an officer at the age of 21yrs on 16 June 2012, should immediately buy additional insurance cover. He must buy an Aegeon Religare online I-Term plan. The sum assured should be Rs 1crore. The policy should be valid till age 75 years.The accidental death benefit rider (it will give Subbu’s dependents an additional Rs 42 lakhs over and above Rs 1 Crore sum assured) and waiver of premium in case of critical illness should also be taken. The total premium for this would be Rs 8355 annually.

Only caveat, like a car insurance, Subbu will not receive anything back as a saving if he lives till the age of 75 years.

But being human as Subbu is, he does a mental calculation and says I pay Rs 8000 a year for 54 years, I pay about 4 lakh and get nothing, this is not fair. So, he asks his insurance agent to tell him some other policy.  And therein comes the twist in the tale. Our expectations from insurance is like that from a savings product. If that be so, we will always get sub optimal products like endowment plans or money back plans or ULIPs or plans linked to assured NAV or some such shitty product. Insurance companies are ingenuous at structuring and innovating new products. They have enough high IQ, MBAs in their stables.

If you want savings from insurance, the insurance company will increase your premiums, put the additional money received in some market instrument and give you a 3-4% return on your money. They simply make a Charlie out of you.

The insurance company will give you some money when your retire but it will charge you a premium of 48000 per year instead of 8355. Give you a cover of 40 lakhs instead of 100 lakhs. And cover you upto 54 years of age instead of 75 years of age. Take your pick. And the money they return to you would no where be close to what it could be, if invested in a good mutual fund for 30 years or even in PPF/DSOPF for 30 years.

So my fourth thumb rule— buy insurance for insuring and not saving. Every salaried individual must only buy term cover. The money saved on premiums should be put in an ETF or some other mutual good mutual  fund with the same periodicity and duration of your insurance scheme premiums. It will be a huge sum, mark my words. Do the math yourself, by going to any calculator site.