This article has been written by Dwaipayan Bose, Co-Founder of Advisorkhoj.
Last year, a life insurance adviser informed me that while more clients are opting for term plans, there are many who prefer non-term plans for their “Survival Benefits”.
I can understand the psychology. If we have a term plan and do not die during the life of the policy, it may seem that the premiums paid are a waste of money. In a non-term traditional insurance policy you get the sum assured plus guaranteed additions. Therefore, since untimely death is unlikely, non-term traditional plans are better than term plans.
Let me explain why this thinking is flawed both conceptually and financially.
Its purpose is protection.
If the electrical wiring in your house has been done securely and all your electrical appliances are in excellent condition, you should not expect a short circuit to take place. Yet, chances are you would install a circuit breaker, because a short circuit, however unlikely, can cause a severe hazard. It provides protection from the risk of electrical hazards.
We need protection from both likely and unlikely risks. In fact, unlikely risks are much more dangerous than likely risks because we are less prepared for it. An untimely death, however unlikely, is the most dangerous risk that our families face. Life insurance provides protection against this risk.
Now, do you expect the circuit breaker to serve any other purpose, such as doubling up as a door bell? It sounds ridiculous, but hopefully it reinforces the point that, the purpose of a protective device should be to provide protection against specific risks, nothing more. Similarly, the purpose of life insurance is to provide financial security to your family in the event of your untimely death. It is nothing more and nothing less.
Non-term traditional plans may cause you to be underinsured.
Let us now understand with the help of an example, why non-term traditional life insurance plans, like endowment plans, money back plans, pension plans etc are detrimental to your life insurance objective.
Let’s assume you are 30 years old and your annual income is Rs 20 lakhs. How much life insurance is adequate for you? To get a proper estimate of your required life insurance cover, you should factor in your debt, monthly income your family needs to meet their expenses, and future expenses such as a child’s education or marriage. For the sake of simplicity let us go with a rule of thumb which suggests that your life cover should be at least 10–12 times of your annual income. Based on your annual income of Rs 20 lakh, your life cover or sum assured should be Rs 2 crores.
Let us come to affordability now. Assuming your annual income is Rs 20 lakhs, your estimated net monthly income after mandatory deductions like provident fund and income tax will be around Rs 1.2 lakhs. Let us assume that after paying for all expenses such as rent, servicing of home loans, food, transportation, utility bills, schools fees etc, you are able to save 30% of your net monthly income. This means your monthly savings will be Rs 36,000.
Let us now assume you want to buy a non-term traditional life insurance policy. As discussed earlier, your ideal life cover or sum assured should be Rs 2 crores. Based on premium rates of one of the largest life insurance companies in India, your annual premium for an endowment policy of a 20-year term and Rs 2 crores sum assured, will be Rs 10-11 lakhs. Since your monthly savings is Rs 36,000, you cannot afford a Rs 2 crores sum assured policy. So how much can you afford? Let us assume that you are ready to pay a premium of Rs 25,000 per month or Rs 300,000 per annum. With an annual premium of Rs 300,000 per annum, based on premium rates discussed above, you can buy a 20-year endowment policy of Rs 60 lakhs sum assured. In the event of an unfortunate death, your family will get the death benefit of Rs 60 lakhs.
Let us assume that your family invests the money in a risk free assured return fixed income product yielding 8%, the annual income will be Rs 4.8 lakhs or Rs 40,000 on a monthly basis. Under normal circumstances, you spend Rs 80,000 – 85,000 on a monthly basis for your expenses. But in the event of an untimely death, your family has to survive on less than half of that amount! If you have a loan, the financial distress gets much worse.
There is no doubt in this example, that your decision to buy a non-term traditional insurance cum savings plan has left you underinsured.
What if you survive the policy term?
Based on historical data, the internal rate of returns, or IRR, of life insurance endowment plans is around 6%. The IRR of money back plans are even lower. Some insurers may have given slightly higher returns, but let us go with 6% in our example. If the IRR of your non-term traditional plan is 6% and you pay an annual premium of Rs 300,000 (as in our case study), your policy maturity amount will be Rs 1.1 crores. Many life insurance agents position the maturity amount of your policy as part of your retirement corpus. As discussed earlier, your normal monthly expenses are Rs 80,000–85,000. Applying a 4% long-term inflation rate, assuming you are 30 years old, by the time you retire, your monthly expenses will be Rs 2.6–2.8 lakhs.
Let us see how much your policy maturity amount will earn you, if invested in an annuity product yielding 8%. Your annual income will be Rs 8.8 lakhs. On a post-tax monthly basis, you will earn little more than Rs 65,000. This does not even meet 25% of your income needs during retirement; 75% of your income will have to come from some other investment. So is this a good investment? I am sure you will agree that it is not.
Non-term traditional life insurance plans, like endowment plans, money back plans and pension plans are detrimental to both your life insurance and investment objectives.
What about the tax benefit under Section 80C of the Income Tax Act?
Consider term life insurance plans.
The premiums are much lower than non-term life insurance plans and leave the investor with substantially higher surplus savings to invest towards their long-term financial goals.
Buying a term plan and investing in mutual funds is better than buying non-term life insurance.
Continuing with our previous case study, you need a life cover or sum assured of Rs 2 crores for your life insurance needs. If you choose a term insurance plan, based on premium rates of the same life insurer discussed above, your annual premium for a 20-year term insurance policy for a sum assured of Rs 2 crores will be around Rs 31,000.
As discussed in our case study, your monthly savings is Rs 36,000 or Rs 4.32 lakhs per annum. Very affordable.
The premium is eligible for the 80C benefit.
You can ensure sufficient cover to provide protection to your family in the event of an unfortunate death.
The balance money can be invested in an equity linked savings scheme, which will get you a much better return and tax saving under Section 80C.
Conclusion
Going back to the circuit breaker example, the purpose of a protection device is to provide protection against risks; nothing more and nothing less.
Just like you cannot expect a plumber to do an electrician’s job and vice versa, you should separate your insurance and investment plans.
This post was initially published on Advisorkhoj.com.
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