A family typically has various needs. A regular income & a house to live in alone is not enough. There are other needs like providing for good education & future needs to children, going for vacations and finally leading a financially secured retired life. The risk to the family arises when there are uncertainties in meeting any of the needs.
Inflation, high cost of education, increase in longevity & consequent long retired life and high medicare expenses have added to the financial burden of the family. But how many ponder over what would happen to their family in case they pass away? Will the family be able to maintain the same standard of living which they are accustomed to right now? What happens to the EMI payments on your home loan? With the bread earner of the family gone, can the children aspire to pursue a career of their choice? Can the family afford to keep making payments for monthly expenses? Is there a way out for the family? Or they have to reconcile to the reality by scaling down their standard of living and compromising on the future of the children or in the worst case, become homeless? The solution lies in a Life insurance cover by which a pre-agreed amount called sum assured is provided by the insurance company to the surviving beneficiary.
How much Insurance is adequate?
But how much life cover is adequate to cover all the needs of the family? There are two ways to calculate the required amount. They are HLV (Human Life Value) method and need based approach. In HLV method, the effort is to estimate the future earnings of an individual in the remaining working life and find the lump sum discounted present value. This present value of the total future earnings is thus the total economic surplus available to the dependent family. The surplus amount, however, does not include the individual’s personal expenses, income tax and existing life insurance premium since these expenses are no more required. In the need based approach, the first step is to estimate the present value of total economic resources the family needs to maintain their standard of living in the remaining period of the surviving spouse. It covers the immediate needs at death and present value of ongoing regular family expenses.
The amounts so arrived under both HLV and need based approach are reduced by the current investments and the present insurance cover available to arrive at the required additional amount of insurance. Financial Planners and knowledgeable insurance agents can help in arriving at the required insurance amount by the above two methods. There is also simpler method to arrive at the required insurance amount. The amount is arrived at by dividing the annual income by the risk free rate of return. For example say the annual income is `10 lakhs and risk free return is 8%, then required insurance is ` 10,00,000/.08=`12500000. If current investments value are ` 40 lakhs and current insurance cover is ` 25 lakhs, then required additional insurance is ` 60 lakhs.
Price of under insurance
If the insurance cover is less than the required amount arrived at as above, then there is bound to be a gap between the financial needs of the family and the available resources. It will create difficulties for the family to liquidate outstanding loans and maintaining the quality of their living.
There are broadly two categories of life insurance i.e. term insurance and cash value insurance. The former covers only the mortality risk while the latter category includes savings and investments components also. The latter category has many varieties like endowment policy, Money back policy, Annuity & Pension policy and ULIP policy. The insurance agents selling these products try to pitch the savings/investment returns aspects of these policies to the potential customers. Term insurance policies, which are also called pure insurance provides protection for a specific period of time or term. If an individual dies during the coverage period, the beneficiary named in the policy receives the policy death benefit. If he does not die during the term, the beneficiary or survivor receives nothing. Term insurance products are the cheapest form of insurance.
Cost benefit analysis
In case of term insurance the premium paid goes towards mortality risk charge. In case of endowment and ULIP products, the cost is a combination of price of mortality risk and the opportunity costs of funds mobilized with an explicit/implicit promise on savings/investment returns. The price of mortality risk is a very small component in the cost of endowment and ULIP products. These products are at a disadvantage vis-a vis other competing investment products when they are sold for a short term horizon due to front loading of allocation charges. This is notwithstanding the fact that IRDA has taken recent measures to overcome these shortcomings. If the basic objective of getting the insurance policy is to cover the risk of the family arising out of the mortality risk of the earning member of the family and income replacement, the term products score over endowment and ULIP.
Types of Term life Insurance
In level term insurance, the sum assured and premium remains the same throughout the term of the policy. In decreasing term insurance, the premium is constant throughout the term, but benefit decreases over time. This is suitable for mortgage insurance. In case of increasing term insurance, the premium and benefit increases over time. This is suitable for increasing needs as one starts the career and moves on the life stage . In renewable term insurance, the policy holder has a right to renew the policy after the fixed term. In convertible term insurance, the policy holder has an option to convert his term insurance plan to a permanent plan. In case of term insurance with return of premium, the premium and sum assured remains constant throughout the term and the policyholder gets back the full premium paid.
Online buying of term insurance
Term insurance products are available through internet now. This is not only convenient but also cheaper than regular term products of the insurance companies. The first internet product iterm was brought out by Aegon Religare Life Insurance, which was followed by iprotect of ICICI prudential Life Insurance. Now other companies like Kotak Life and Met life have followed suit.
In sum, if protection is the need, then term insurance is the product for it.