A term insurance policy is one of the most misunderstood products in India…well, it is another matter that 'insurance' itself is not understood or appreciated enough in India.
But let's restrict ourselves to term insurance for the moment. For a typical investor buying an insurance policy primarily because there is a tax benefit attached, the basic characteristic of a term policy, which is that you pay premiums in return for a benefit to your family in case you die and nothing for you if you survive is an anathema. The most common question is why should I pay annually for a product if I am not going to get anything back?
Very few understand that a term policy is insurance at its purest and simplest. You pay premiums because there is a guarantee that if something happens to you, your family will be paid out the pre-decided amount, hence you have the peace of mind that even if you are not there, those loved ones you leave behind will not have to bear a financial loss as well. Term insurance is protection against risk to life.
Since there is no value of your financial investment or a savings element involved, the premium accounts only for the risk cover costs (mortality costs) and hence is very low compared to other insurance products. No other insurance policy will offer you as much value for money as this.
Let's say you bought a pure term insurance plan for 20 lakhs for 20 years. If you die within that period, your family receives the 20 lakhs sum assured, which will help meet their needs and goals. However, if you outlive the 20 year period, you get nothing on maturity of the term. Pure term plans do not accumulate cash value, and hence do not have any maturity benefits.
If the question then is "why should I take this plan?" The answer - it provides a safety net for your family and is the cheapest form of insurance available. The premium depends on the mortality charges, which are lower at a younger age. Hence, the earlier in life you take insurance, the longer the term and cheaper the cost.
Term insurance policies cover you for a specific amount of money and for a specific period of time. How do you then decide what is the right amount and right term for you?
The amount depends on a number of factors like the age of your children, the important goals that you have, the number of years left to your retirement and so on. Likewise the term of the policy is mostly linked to how long you are going to be working. Basically term policy is a replacement of income, hence as long as you are going to generate this income, the term of the policy should be that long - unless you build up enough assets that your family doesn't need to depend on insurance or all your major commitments are fulfilled and t would not matter if you stopped work.
The amount of the policy or the risk cover as it referred to can be calculated by using two methods - the human life value approach and expense protection approach.
The Human Life Value approach determines what your economic contribution would be over your expected working life. It is the expected life time earnings of an individual expressed in present rupee terms. A rupee today is worth more than a rupee tomorrow and therefore it has to be discounted by an assumed rate to arrive at its present value. This calculates your economic worth today and the amount for which you should be insured.
Say you're 30 years old, earning an income of Rs. 12 lakhs per annum currently and expected to retire at the age of 60. Assuming an average growth of 2% per annum on your income and a return of 8% on your investments, your economic value today is Rs.1.8 crores.
On the other hand, expense protection approach addresses the issues pertaining to liabilities, protection of future goals and family expenses. If you are an earning member of your family and there are others dependent on your income, you need to protect them and their interests even if you're not around. Income is supplemented by the returns expected to be earned from an invested corpus. The shortfall in this corpus is the Expense protection that needs to be taken care of.
There are different kinds of Term Insurance Plans available in the market today such as Single Premium Term Assurance, Loan Cover Term Assurance and Term Insurance With Return of Premium. In the single premium variant the premium for the life cover for the full term of the plan is collected in the first year itself, whilst in the Loan Cover Term variant the Sum Assured reduces in sync with the reducing loan amount, annually, clubbed with a limited level premium paying mode. Most home loans are covered by this variant.
The 'Term Insurance With Return of Premium (ROP) Plan' works the same way as a pure insurance policy. The only difference is that on maturity, the insurance company returns to the customer all the premiums that he has paid to secure his cover.
The death benefit from a term plan is tax free under Section 10(10D) of the Income Tax Act, 1961. Premiums paid towards the plan(Upto Rs.1 lakh) can be claimed as a deduction under Section 80C of the IT Act.
It is unfortunate that most Indians buy insurance, some even the term plan mainly to avoid tax rather than to seek cover against risk. Hope after reading this, you at least will be wiser and look at term insurance as a cheap and sound investment offering tremendous peace of mind and security to your loved ones.
Lovaii Navlakhi, CFM, is the Managing Director and Chief Financial Planner of International Money Matters Pvt Ltd.