Wake up call: Is your safety net wide enough?

Life insurance is a ‘monetary’ protection available to the family in case of untimely death of the breadwinner in the family. It seeks to provide ‘financial’ support to the family in case of any such unfortunate eventuality.

The question, therefore, one needs to answer is ‘How much financial support would the family need in case the regular income stops?’.

How much sum assurance is enough
Generally, one would like to maintain the same standard of living. No one would like to say move to a smaller house or sell the car and buy a two-wheeler or cut down on normal expenses one is used to etc. This means that the same level of income should continue.

Assume that the head of a family earns Rs,15,000 p.m. The family has no debts, no investments and no long-term financial needs such as for education, marriage, housing etc. The family spends all the Rs.15,000 p.m. - on food, clothing, rent, education, travelling, entertainment etc. It does not save any money as it has no long-term needs.

Given this scenario, if the head of the family dies, the family will need about Rs.26 lakhs to get an interest/dividend income of Rs.15,000 p.m. (assuming 7% rate of interest/return). Therefore, in this simplistic case, the sum assured should be about Rs.26 lakhs.

Now suppose, the family already has assets & investments aggregating Rs.15 lakhs and debts such as home loan, credit card outstanding, etc. of Rs.5 lakhs. Since, the family already has a net balance of Rs.10 lakhs, it needs only additional Rs.16 lakhs to meet its’ objective of Rs.15,000 interest income per month. Thus in this case it will need insurance of only Rs.16 lakhs.

Or suppose the family will require Rs.5 lakhs lump-sum after 5 years for the children’s higher education and Rs.7 lakhs for their marriage 10 years’ hence. These will have to be built into the family’s financial plan, as they will have to start saving and/or earning more to meet these needs. Accordingly, the sum assured would also have to be suitably worked out. In the first year this would be around Rs.33 lakhs. This will progressively reduce every year as the investment corpus builds up through the savings.

Basically speaking, we are replacing the lost ‘job’ income with ‘investment’ income. This insurance amount should be reviewed every 1-2 years as the assumptions may have changed, inflation would have its’ impact, your needs may have changed etc.

Having worked out the insurance need, the selection of the ‘right’ policy is extremely important.

Two types of insurance policies
Before we proceed further, it is important to understand the different kinds of insurance policies. Fundamentally, there are two types of insurance policies – pure protection policy and protection-cum-investment policy. All types of insurance policies can be classified as one of these two.

The pure protection policy provides only insurance cover. In case of demise of the insured during the policy term, the family receives the sum assured. The premium paid provides this cover. But, if the insured survives, he doesn’t get back anything. Term policy is an example of a pure protection policy.

The protection-cum-investment policy provides both the protection and the returns. While a part of the premium is used for providing the cover, the balance is invested which earns some returns. Should something happen to the insured during the policy period, the family gets the sum assured + profits till that date. Else, at the end of policy term the insured gets back the sum assured + accumulated profits. ULIP, Endowment, Moneyback etc. are examples of such policies. 

What policy to buy
We are usually uncomfortable with paying something for nothing. Therefore, most of us prefer to buy a protection-cum-investment policy rather than a pure protection policy. Secondly, we buy an insurance policy based on how much premium we can afford rather than how much sum assurance do we need. Thirdly, we usually buy an insurance policy for tax saving and not for cover per se.

In view of the foregoing and the fact that the premiums of a protection-cum-investment policy are much higher as compared to the pure protection policy, we end-up with policies with inadequate insurance cover.

Ideally speaking, one should buy a pure protection policy. This will ensure adequate protection with a much lesser premium outgo.

However, if you want to go in for a protection-cum-investment policy, it may be noted that (a) the premiums will be substantially higher for buying the same amount of cover and (b) the returns from such a policy are generally lower than other comparable investment options. Some policies such as ULIPs with equity option do take care of the returns issue, but the costs especially in the initial years are quite high.

It is generally recommended that one should keep the insurance and investment separate for greater transparency, flexibility, liquidity, simplicity, convenience and returns.

Insurance is, after all, a cost paid for an intangible product viz. security. Therefore, buying insurance is a highly personal choice as the perception of benefit varies from person to person. But having decided to buy insurance, one should (i) do a detailed evaluation one’s need and (ii) buy the right product at the right price.

The author is an investment advisor. He can be reached at smatai@hotmail.com