Last year I was speaking with a life insurance advisor. Among other things, I urged him to recommend only term life insurance plans to his clients. Term plans are straightforward protection plans and are in the best interest of the insurance buyer. He said while more clients are now opting for term plans there are still many who do not want to buy term plans. I asked him the reason behind the preference for non term plans. He said, “Two words, Survival Benefits”. I understood the psychology underlying the customer preference. If we do not die during the term of our insurance policy, then it may seem that the premiums paid in the insurance policy term are a waste of money. In a non term traditional insurance policy you get the sum assured plus guaranteed additions. Therefore in the minds of some people, since untimely death is unlikely, non term traditional plans are better than term plans. We should understand that this thinking is flawed both conceptually and financially.
The concept of protection
Why do you have circuit breakers in your house? If the electrical wiring in your house has been done properly and all your electrical appliances are in excellent condition, then you should not expect a short circuit to take place. In that case do you need to install a circuit breaker, do you? Yes, you still need to, because a short circuit, however unlikely it might be, can cause severe hazard not only to your expensive electrical or electronic gadgets but also to your family. Installing a circuit breaker provides you protection from the risk of electrical hazards. We need protection from both likely and unlikely risks. In fact, unlikely risks are much more dangerous than likely risks because we are less prepared for it. An untimely death, however unlikely, is the most dangerous risk that our families face. Life insurance provides protection against this risk. Now going back to our circuit breaker example, apart from protection against short circuits, do you expect the circuit breaker to serve any other purpose. Do you, for example, expect your circuit breaker to double up as a door bell? It is a ridiculous example, but hopefully it reinforces the point that, the purpose of a protective device should be to provide protection against specific risks, nothing more. Similarly, the purpose of life insurance is to provide financial security to your family in the event of your untimely death. It is nothing more and nothing less.
Non-term traditional plans may cause you to be underinsured
Let us now understand with the help of an example, why non-term traditional life insurance plans, like endowment plans, money back plans, pension plans etc are detrimental to your life insurance objective. Let us assume you are 30 years old and your annual income is
र 20 lacs. How much life insurance is adequate for you? To get a proper estimate of your required life insurance cover, you should factor in, how much debt you have, how much monthly income your family needs to meet their expenses and future expenses of your family, like children’s education, marriage etc. For the sake of simplicity let us go with a rule of thumb which suggests that your life cover should be at least 10 – 12 times of your annual income. Based on your annual income of र 20 lacs, you life cover or sum assured should be र 2 crores. Estimating your life cover is one thing and being able to afford it is another. Let us come to affordability now. Assuming your annual income is र 20 lacs, your estimated net monthly income after mandatory deductions like Provident Fund and income tax, will be around र 1.2 lacs. Let us assume that after paying for all your normal monthly expenses like rent / EMI, food, utilities, transportation, school fees etc, you are able to save 30% of your net monthly income. Many readers would agree that 30% is a very healthy savings rate. Most people are able to save less than 15 – 20% of their monthly income. Assuming you are able to save 30%, in this example, your monthly savings will be र 36,000. This is the amount you have for investment and insurance. Let us now assume you want to buy a non term traditional life insurance policy. As discussed earlier, your ideal life cover or sum assured should be र 2 crores. Based on premium rates of one of the largest life insurance companies in India, your annual premium for an endowment policy of 20 year term and र 2 crores sum assured, will be र 10 to 11 lacs. Since your monthly savings is र 36,000, naturally you cannot afford a र 2 crores sum assured policy. So how much can you afford? Let us assume that you are ready to pay a premium of र 25,000 per month or र 300,000 per annum. With an annual premium of र 300,000 per annum, based on premium rates discussed above, you can buy a 20 year endowment policy of र 60 lacs sum assured. In the event of an unfortunate death, your family will get the death benefit of र 60 lacs. Let us assume that your family invests the money in a risk free assured return fixed income product yielding 8%. Assuming you have no loans, your family’s annual income will be र 4.8 lacs or र 40,000 on a monthly basis. Under normal circumstance, you spend र 80,000 – 85,000 on a monthly basis for your normal expenses. But in the event of an untimely death, your family has to survive on less than half of that amount. Just imagine the lifestyle hardships your family has to endure and the sacrifices they will have to make. If you have a loan, the financial distress gets much worse. There is no doubt in this example, that your decision to buy a non-term traditional insurance cum savings plan has left you underinsured. Buying a non-term plan therefore severely compromises your life insurance needs.
What if you survive the policy term
Some of you may be asking, why assume the worst? The answer to your question is that, the very purpose of life insurance is to protect your family in the worst case scenario. But ignoring that point, let us now discuss the more likely scenario, which is, that you survive the policy term. Based on historical data, the internal rate of returns (IRR) of life insurance endowment plans is around 6%. The IRR of money back plans are even lower. Some insurers may have given slightly higher returns, but let us go with 6% in our example. If the IRR of your non-term traditional plan is 6% and you pay an annual premium of
र 300,000 (as in our case study), your policy maturity amount will be र 1.1 crores. Many life insurance agents position the maturity amount of your policy as part of your retirement corpus. As discussed earlier, your normal monthly expenses are र 80,000 – 85,000. Applying a 4% long term inflation rate, assuming you are 30 years old, by the time you retire, your monthly expenses will be र 2.6 – 2.8 lacs. Let us see how much your policy maturity amount will earn you, if invested in an annuity product yielding 8%. Your annual income will be र 8.8 lacs. On a post tax monthly basis, you will earn little more than र 65,000. This does not even meet 25% of your income needs during retirement. 75% of your income needs has to come from some other investment. So is this a good investment? I am sure you will agree that it is not. Non-term traditional life insurance plans, like endowment plans, money back plans, pension plans etc are detrimental to both your life insurance and investment objectives.
Life Insurance Premium is eligible for 80C tax savings
One of the selling points of life insurance policies is that, life insurance premium is eligible for tax savings under Section 80C of Income Tax Act. It is unfortunate that, tax savings has to be the selling point for a financial product, as critical as life insurance. Be that as it may, you have several investment products which are eligible for 80C tax savings and which, historically, have given much superior returns compared to traditional non-term investment plans. For risk-averse investors, Public Provident Fund (PPF) will give much better investment returns compared to traditional non-term life insurance plans. However, for investors who can afford to take risks, Equity Linked Savings Scheme (ELSS) is the best tax saving option for investors to create wealth. What about life insurance? The answer is Term Life Insurance Plans. Term plan premiums are much lower than non term life insurance plans and leave the investors with substantially higher surplus savings to invest towards their long term financial goals.
Buying a term plan and investing in mutual funds is better than buying non-term life insurance
Continuing with our previous case study, you need a life cover or sum assured of
र 2 crores for your life insurance needs, but instead of a non-term traditional life insurance plan, you choose a term insurance plan. Based on premium rates of the same life insurer discussed in our earlier example, your annual premium for 20 year term insurance policy for a sum assured of र 2 crores will be around र 31,000. As discussed in our case study, your monthly savings is र 36,000 or in annual terms, your saving र 4.32 lacs. You can easily afford the premium of the term policy. By opting for a term plan, you can ensure that you have enough cover to provide protection to your family in the event of an unfortunate death. Even after paying the premium of your term policy, you have around र 4 lacs savings left for investment. Let us first focus on your 80C tax savings. Your र 31,000 term insurance premium is eligible for 80C benefit. Let us assume, to meet your balance 80C requirement you invest in र 1.2 lacs per annum in an ELSS fund. That still leaves you with another र 2.8 lacs of savings per annum that you can invest in a diversified equity fund. Over the last 20 years period, top performing ELSS funds gave in excess of 20% compounded annual returns. However, let us be conservative and assume that you get 15% annualized returns from your ELSS investment. With an annual investment of र 1.2 lacs in an ELSS fund yielding 15% returns, you can accumulate a corpus of over र 1.2 crores. What about the returns from the balance र 2.8 lacs of savings that you can invest in a diversified equity fund? The average Systematic Investment Plan (SIP) returns in diversified equity funds over the last 20 years has been 17%. Assuming average historical rates of return, if you invested the balance र 2.8 lacs in diversified equity funds through monthly SIPs, you can accumulate a corpus of over र 4.6 crores. While your term plan will have no maturity benefits, your investments in ELSS and diversified equity funds will generate a corpus of र 5.8 crores over 20 years. Compare this with the policy maturity amount of र 1.1 crores from an endowment plan, as discussed earlier. There is simply no comparison. Let us now see, what annuity income your corpus of र 5.8 crores can yield, on a post tax basis. Assuming a pre-tax annuity yield of 8%, as discussed earlier, you can get an annual income of nearly र 32.5 lacs on a post tax basis. On a monthly basis you will earn over र 2.7 lacs. You will recall that, based on 4% long term inflation rate, by the time you retire, your monthly expenses will be र 2.6 – 2.8 lacs. Your annuity income will be sufficient to meet your monthly expense needs. Therefore, a combination of a term insurance policy and mutual funds will help you address both your life insurance and investment needs. You should note that these two needs, life insurance and investments, are different in nature. Therefore the financial instruments addressing these two needs should also be different. You may like to read how to select the best term life insurance plan for you
What about non traditional insurance plans
Some insurance agents argue that a non traditional, or in other words, unit linked insurance plan (ULIP) is very similar to the combination of a term plan and mutual fund. While there are some similarities in terms of structure, the major difference is in terms of cost. On an average equity oriented ULIP funds have given 15 – 18% annualized returns over a 10 year investment horizon. However, your effective returns can be much lower because a substantial portion of your premium will go towards the mortality charges (life cover) and various fees like premium allocation, policy administration, fund management etc. These fees are deducted from your premium and only the balance amount is invested in the units of the fund. In the initial years of your policy life as much as 10% of your premium can go towards these fees and not be invested to buy units. We have compared ULIPs versus a combination of term policy and mutual funds in our article, Term Insurance and Mutual Fund or ULIP: Which is a better option? Based on our analysis, a combination of term plan and mutual fund can give better returns than ULIPs.
Life insurance is a critical financial need to protect our family against the adverse consequences of an untimely death and loss of income. Going back to the circuit breaker example, discussed earlier, the purpose of a protection device is to provide protection against risks; nothing more and nothing less. Just like you cannot expect a plumber to do an electrician’s job and vice versa, you should separate your insurance and investment plans. In this blog, we have discussed why non term traditional plans and also unit linked insurance plans are detrimental to your financial needs. Unfortunately, the commission structure in insurance selling does not preclude the perverse incentive of selling the wrong product. That said the preference of many insurance buyers for survival benefits is not helpful towards their own life insurance and investment objectives. You should educate yourself about insurance and investing, so that you can make the best decisions on both fronts. Having an unbiased financial advisor is also always helpful.