Understanding Life Insurance
“Life insurance or life assurance is a contract between the policy owner and the insurer, where the insurer agrees to pay a designated beneficiary a sum of money upon the occurrence of the insured individual’s or individuals’ death or other event, such as terminal illness or critical illness. In return, the policy owner agrees to pay a stipulated amount called a premium at regular intervals or in lump sums” – life insurance as defined by Wikipedia.
Thus life insurance is an arrangement between the policy holder and the insurance company to pay the beneficiaries of the policy holder the sum assured (under the policy) in the policy holder dies. Let’s understand an apparently logical reason for life insurance. Mr. XYZ (in his mid 30’s) wants to secure his family’s (wife and two children – one in his early teens and the other in the primary school) financial interests for a sum of Rs. 5 crores today (there are scientific methods available to help determine the exact coverage needed, the same are not covered in this article). He believes that if this amount is made available to his family on his untimely death today, they would be financially well-off to meet their needs as well as luxuries in the coming time. Now, although XYZ earns a handsome salary of Rs. 20 lakhs p.a., he doesn’t have 5 crores in his kitty ready for the disaster management. Taking into account his investments and bank balances, he is worth approximately 50 lakhs. That means his family now is only at 10% of the ‘Safety Net’ set up by him.
At a savings rate of approximately 7.5 lakhs p.a. (with an average investment growth rate of approximately 10% p.a.), XYZ would do well to cover up this gap over the next 20 years for his family. But can he afford to wait for so long?
Obviously not – death doesn’t come with a fore-warning! So, how does he fill the gap of the rest 90%? Well, that’s what the insurance companies are looking for? These companies are willing to fill the vacuum of ‘90%’ in return for a small yearly premium payable for an equal number of years for which he wants to protect his family. So, the solution is to buy a life insurance cover worth Rs. 5 crores (availability of the cover subject to the underwriting requirements) for the next 20 years or even a higher term. This story seems true for most of the cases till here, but what about the subsequent years?
Decreasing pattern to follow with a higher initial cover
Increment in salary, tax-savings or a new addition in the family are just some of the excuses for XYZ to increase his life cover anytime during the next 20 years. One aspect ignored by people adopting the same approach as XYZ is the increase in the investment base over the following years. Accordingly, with an increase in the same, the gap between the safety level set and the current net worth of XYZ keeps moving down. This should trigger a decrease in the life cover in the subsequent years, practically however the reverse holds true in most of the cases. Keeping this in account, there certainly comes a stage in one’s financial life, where no or at least lesser insurance is actually required. But a decrease in life coverage is no where covered in one’s risk management plan.
The exact stage when a person touches his safety net (while he is alive) may vary between individuals depending upon their career advancement and the growth in their investments. So before opting for a life insurance cover, it is imperative for every individual to carefully evaluate their position in relation to their Safety Net. The need for life insurance is inversely proportional to one’s proximity to the ‘Safety Net’. In other words, the lower your achievement level of the ‘Safety Net’, the higher is the need for life insurance.
Other Factors for consideration
The’Safety Net’approach is just one of the factors for evaluating the need for life insurance or otherwise. Some other equally important factors that are to be weighed for avoiding life insurance are:
i.Incompetent policies available
It may not be always possible to match a perfect insurance policy for every risk that an individual may be exposed to. The need for life insurance too has many root factors – dependent family, loan liability, estate planning and so on. Not all insurance companies are equipped to provide consumers with the life
insurance policies they actually require. The recent surge in the number of insurance companies can be attributed to the vast market potential and the low insurance penetration ratio in Indian markets. Consequently, every company that enters the market tries to introduce similar products in the market that have precedents of being easily accepted and sold in the market. Factors adding to the need for insurance are dynamic and continuously evolving but the available products are not.
ii.Looking forward to a convenient investment option
Yes, convenience in paying premiums has often been observed as a common reason for people buying insurance policies while building their investment corpus.
However, they forget that there is a plethora of other investment options available, which also offer convenience. It would make prudent sense for an investor to look forward to investments that offer life insurance in addition to the investment value rather than hunting for policies that offer an investment option in addition to providing life cover.
iii.At the early stages of your career
If you are one of those fortunate ones, whose parents have been prudent in their financial planning, thereby not adding the burden of their responsibility on your shoulders…then it makes sense to stay away from life insurance at this stage. Enough research results are available to demonstrate that even the simplest of investments have the potential to deliver higher average returns over a long-term than life insurance policies.
The early start or the low-age benefit lost by delaying the life coverage to a higher age can be more than compensated for by some prudent investments made during the same period.
Some disadvantages of buying life insurance
At this stage, it also makes sense to peek at some of the perceived disadvantages in buying life insurance:
a.Inadequate coverage for disability
No doubt, policies payout lump-sum amounts on the death of the life assured, but these policies are not the perfect hedge for disabilities during your life-time. Even if the disability riders are added to life covers, they always come with a cap on the maximum that can be paid out in case of disabilities.
b.Withdrawal options
Some life insurance policies with a cash value component let you withdraw your money after a certain period of time, but come with loads of clauses to be noted by the policyholder. So, only if you are prepared for a long lock-in and are ready to wait for the entire term to reap the benefits of the policy, look forward to a life insurance policy.
c.Refusal to pay the death benefit
Life insurance contracts thrive on the fiduciary responsibility of the life insured. On the same grounds, the much coveted ‘Safety Net’ may be deprived for the family by the insurance company on the grounds of omission of an important piece of information in the insurance application form. Unfortunately, very little can be done at this stage, against the company by the family. This only acts as an added factor to the family’s woes.
There are no two opinions that the advantages of life insurance outnumber the disadvantages, thereby making this aspect of risk financing inevitable for the masses. But let your need determine whether you need to fall for this financial wonder!