Pursuing Financial Freedom: Step 1 – Buy a Term Insurance

Insurance is Risk planning – to mitigate the impact of a risk. A Financial Plan, however well made, can hit a nasty roadblock if the inevitable things [like death] are not planned for. Insuring one’s life will support the dependents financially long after one is gone.

When it comes to Life Insurance in India there is no dearth for options to purchase from – Endowment Plans, Money Back Plans, Whole Life Plans, ULIPs, Term Plans etc.

Most of us who started our working careers in the 1990s and early 2000s invariably hold a money back plan/endowment plan where:

  • A Sum Assured is defined at the beginning of the plan. This is the death benefit.
  • You pay a fixed annual premium usually for a duration of 15, 20 or 25 years
  • At the discretion of the insurer a bonus amount is declared every year (usually between Rs. 40 and Rs. 50 per 1000 of Sum Assured) starting Year 6. Additional discretionary bonus may be declared from time to time (none of this is known when you take the policy!!)
  • In both these types of plans you get back the total premium paid at the end of the policy term.
  • If you outlive the term of the policy you get the sum assured + Accrued bonus + Discretionary bonus. In Money Back plans you get some percentage of the  Sum Assured usually every 5 years. In Endowment plans you get the entire premium paid lumpsum at the end of the policy.

Let do some numbers here. Annual Premium: 30,000 Sum Assured (SA): 6 Lacs, Premium Term: 20 Years. Assuming TOTAL Bonuses of 60 per 1000 of Sum Assured (an over estimate) ==> We accrue 36,000 for the 6 Lacs of SA every year. So at the end of Year 20 one gets: Sum Assured (6 lacs) + Bonuses (36000*15=5.4 Lacs) = 11.4 Lacs. Let’s calculate the Internal rate of return (IRR). In an Excel spreadsheet fill (30000) from cells A1 to A20. This is the Cash outflow. At the beginning of Year 21 (ie, end of year 20) the cash inflow is 11.4 Lacs. Enter this is Cell A21. In Cell A22 use the formula=IRR(A1:A21) and hit ENTER. Voila, your rate of return is 6%.

2 Major drawbacks here:  Primary one being Sum Assured for the duration is only 6 Lacs + Accrued bonus (Say ~ 10 lacs). The covered amount is way too low to offer any meaningful ‘Insurance’. The other one being the return on the money is just 6% obviously unacceptable in India as on date. Enter Term Plan and we may have a better solution here.

ULIPs:

ULIPs are heavily front loaded with so many charges and provide barely any real insurance like Endowment plans. Although they participate in Equity the returns they generate must way exceed that of a normal Mutual Fund to generate any final decent return. Given that only a handful of funds have ever beaten the market over any long term  globally and given that the Life coverage is usually lip service ULIP is definitely not a recommended product. Just like drinking and driving do not mix so do insurance and investment.

Term Plans:

  • A Sum Assured is defined at the beginning of the plan. This is the death benefit.
  • You pay a fixed annual premium for a duration you choose (Maximum of 35 years available now)
  • If you outlive the policy term the Insurer keeps all the premiums. If not the SA is paid to the nominee/legal heirs

Let do some more numbers here. Annual Premium: 10,000 Sum Assured (SA): 50 Lacs, Premium Term: 20 Years.  You take the remaining Rs. 20,000 (given we were ready to invest 30,000 in the Endowment Plan) and invest in Diversified Mutual Funds. Even assuming a very modest long term return of 10% [Just put =FV(10%,20,20000,0,1) in an excel cell] you will see you get an amount of 12.6 Lacs. The future value will increase exponentially for any increase in the expected return. In the case of this Term Plan the Sum Assured is reasonably large to support one’s dependents after their death.

Any calculation back and forth will establish beyond doubt that Term Insurance Plans are what really constitute LIFE INSURANCE and we see they are very cost effective. You may not find too many agents selling/pushing Term Insurance plans because historically the commissions are lower than selling an Endowment plan/Money Back plan.

Term Plan basics:

  • Rule of thumb: The coverage must be 8 to 10 times your annual income.
  • Take a Term Plan few years into your work life and for the longest possible duration. If you take one at 25 years of age for a period of 35 years then your cover ceases at 60. It is likely your dependents have all settled by then and you have a retirement corpus built for your spouse.
  • The earlier you take a Term plan the cheaper it is. Don’t wait to get married and have kids to take a term plan. Yes it is general knowledge that unless you have something to protect you don’t need insurance. However the insurance premium for a 25 year old and 30 year old vary (10% at least) and adds up to a decent sum over the life of the policy. So load up that policy sooner.
  • As you start earning more and more in life add additional cover
  • It is a no frills attached policy. You don’t like it/You don’t need it – just stop paying the premium and the policy will lapse.

Are Term Plans reliable:

IRDA regulates the insurers and there are several capital adequacy parameters that are monitored regularly. In the absolute worst case that an insurer falls sick IRDA can force it to be merged with another entity for sustainability. All policies issued will be honoured, as long as all information provided in the policy proposal document is true. There are several online term plans available as well today which are even cost effective as the agent sales commission on such policies is virtually zero. If you have decided to take insurance from company A it does not matter for claim processing in future whether it was a policy sold online or not – no worries there as well.

Takeaway: Reducing the rampant misspelling of financial products in the market by educating the readers is one of the major objectives of this blog. Choosing a Term Insurance is a step in that direction and is indeed the most important step in your overall Financial Planning. Let buying a Term Insurance Plan in 2011 be your first action item in your pursuit to Financial independence.

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One Response to Pursuing Financial Freedom: Step 1 – Buy a Term Insurance

  1. Pingback: Impact of Trail commission on your Mutual Fund Returns | justgrowmymoney

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