Before purchasing any financial product there are a few basic questions that an investor should ask oneself such as; does the asset fit in his risk reward matrix and investment needs; what is the financial goal for which you are purchasing this investment product etc.
Today in this article, we will discuss the things that you should remember before purchasing a life insurance policy.
Who should purchase a life insurance policy?
A person having dependents in the family is a perfect candidate for a life insurance policy. If you have dependent spouse, children, parents, sibling who would not be able to meet their financial requirements or goals on your sudden demise, then you are the ideal applicant for life insurance. If your family would get drown in debt like, home loan, business loan, vehicle loan, personal loan, credit card loans after your demise then you should take a life insurance policy immediately.
However if you have no dependents or debt to be repaid then life insurance is not the product meant for you. As you move towards retirement and steadily met all your worldly goals such as purchase of a house property, children education, children marriage the requirement for a life insurance policy decreases and becomes nil once you start your retired life.
How much insurance cover do you require?
There are basically 3 ways to calculate the amount of life insurance required in by a person; income replacement, need analysis and human life value (HLV).
- Income Replacement Method is one of the most basic methods of calculating the insurance requirements. In this method you multiply your gross annual income with the number of years left for retirement. For example – suppose your age is 40 and you earn an annual income of Rs. 6 Lacs, then the amount of life cover that you should have is Rs. 1.20 Crores (Rs. 6.00 Lacs* (60-40)).
- Human life value is the most commonly used methods for calculating the insurance cover required. This method takes into account income, expenses, liabilities and assets while calculating the life insurance requirement. It’s the present value (PV) of all future economic contribution made by the insured for his or her family members.
Economic contribution = Annual Income – Income tax paid – Life insurance premium paid for self – self maintenance expenses
As stated in the above example, if your current income is Rs. 6.00 Lacs p.a. and you spend Rs. 1.50 Lacs towards income tax, life insurance payments and self maintenance expenses then your economic contribution towards your family is Rs. 4.50 Lacs (Rs. 6.00 Lacs – Rs. 1.50 Lacs). Therefore, your monthly contribution is
This surplus is capitalised at a discounting rate say 8% for the years left for retirement. For calculating the PV of the life insurance required we could either use the formula as stated below of use “PV” function of excel.
Present Value= PV (rate, nper, pmt, (FV), (type))
Where rate is the rate of interest which in this case is 8% on an annual basis and 0.67% on monthly basis
nper is the total number of months left, i.e. 20 years / 240 months
pmt is the monthly contribution which in this case is Rs 37,500
FV is future value, which in this case is 0
Type is either 1 or 0 depending upon whether the contribution made by you is at the beginning of the month or end of the month. Obviously, the contribution made by you at the beginning of the month. Therefore we will select 1.
Thus, Present Value= PV(0.67%, 240, -37500, 0,1) = Rs 45.13 lacs
Therefore the amount of life cover required as per HLV is Rs. 45.13 Lakhs.
What does HLV really signify in life insurance terms? If you buy a life insurance cover equal to your HLV, in the event of an unfortunate death, the sum assured paid by the insurance company will be able to replicate the economic contribution made by you towards your family.
- Need Analysis method is based on the family requirement for various amenities in life - it takes into account, loans, children’s marriage & education, providing for financially dependent parents, spouse and sibling, dreams, aspiration, special needs etc.
Whatever be the method the idea is not to apply a monetary value to someone’s life but it helps to pay off the undeniable financial cost associated with the loss of a person.
Types of Life Insurance
There are basically two types of life insurance in the market - the traditional plans where insurance is mixed with investment and the non traditional or the term insurance plans which is also known as the pure life insurance policy.
- A Term Insurance plan there is no survival benefit for a term insurance policy holder, if the policy holder lives to see the end of the tenure in a term policy then there is no benefit that the policy holder or insured shall receive. On death of the insured the nominee of the policy or the beneficiary shall receive the sum assured. However, there are certain term plans where you can get your premiums refunded on survival till the term ends but premium of these term plans are higher.
- On the other hand traditional Insurance plans are policies that take care of both your investment as well as insurance needs; it includes endowment plan, whole life policy, money back policy, unit linked insurance plan (ULIP) etc. Endowment policy is a life insurance plan under which the insured shall receive a specific sum of money at the end of the specific term or on death of the insured whichever is earlier as the case may be. As the name suggest a whole life insurance policy covers the entire lifetime of the insured provided the premiums are paid regularly. Thus in a whole life policy it’s the nominee that receives the benefits of the policy. Money Back policy returns a percentage of sum assured at certain intervals and pays the final amount by deducting these money back amounts at the end of the tenure. A ULIP policy is an ultimate mixture of insurance with investment where the investments are done in stocks, bonds and other market linked investment products.
Tax Rebates on Life Insurance premiums paid
It is a common knowledge that any life insurance premium paid, upto the maximum limit of
र 150,000, during the financial year, is allowed as deduction Under Section 80C of the Income Tax Act 1961.
Life Insurance proceeds are tax free in the hands of the investor
It is a common notion that the amount of sum received including the bonus on the death of the insured or maturity or surrender of the policy is tax free in the hands of the beneficiary Under Section 10 (10D) of The Income Tax Act 1961. However, there are certain conditions under which it might not be exempted.
- Group life Insurance policy sponsored by your employer
- Policies where premium paid in any year is more than 20% of the sum insured and was bought after 1st April 2003 but before 31st March 2012 OR it is more than 10% of the total sum assured if it was bought after 1st April 2012
- Payout on annuity or pension plans
TDS on payment of life insurance proceeds:
Have you ever heard of tax being deducted at source (TDS) on life insurance proceeds received? In the budget speech of FY 2014-15 the finance minister announced that if a life insurance maturity proceeds does not qualify to be exempt under section 10(10D) of the Income Tax Act , then the insurance company is liable to deduct TDS at 2% for all payments greater than
र 1.00 Lacs. If the beneficiary does not provide his or her PAN details while claiming the maturity proceeds then the insurance company shall be liable to do TDS at a flat rate of 20%.
Termination of life insurance products
As stated earlier life insurance products are usually purchased at the end of the fiscal when the employer demands you to submit a proof of investments for claiming tax rebate. Though these policies do suffice the immediate necessity of saving tax, the policy holders may later realize that the policy he or she has purchased is not even returning back the capital. Its then that they in anger commit the second mistake of surrendering the policy before paying the minimum number of premiums required to qualify for income tax deduction.
They do not realize that on account of non payment of minimum number of years of premium paid or remain invested with the policy the deduction claimed in the earlier year would also be reversed. For a ULIP policy the minimum years to remain invested is 5 years from the start date of the policy. However, other than ULIP the minimum numbers of years for which the policy need to be held is 2.
No financial product should be purchased just for the sake of saving taxes. Insurance historically has been purchased during the later part of the year when we have to submit proof of investments made under section 80C of the Income Tax Act, 1961. This has to stop and insurance should be kept away from investment or saving requirement. Insurance and investment are two different subjects that have to be treated and dealt with differently, a mixture of both creates mess.
Insurance is the subject matter of the solicitation.