The Basics of Life Insurance

Dear friends welcome to The Complete Guide to Buying Insurance, a 6-part series that I have launched in association with Policybazaar as my knowledge partner to understand every minute detail about insurance. I have chosen 'Life Insurance' as the topic of this article. According to my opinion, Life Insurance is an insurance product which you must buy before making any investment. As it is an insurance product for your family if something happens to you, as an earning member it will provide financial protection to your family. In this article, I will try to understand 3-4 things.

First of all, what is life insurance and why is it important? Second, what are the basics of life insurance that you need to know before buying? Third, what are term insurance and maturity benefit plan? And then fourth, how can you buy life insurance? All right, let's get started...

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Why Is life insurance important?

The way I explained in the first part, life insurance basically works on the basic formula of insurance and you say if 'X' happens, which is death in this case, give financial protection to my family.

Now how does this work?

Usually, in the case of life insurance, at some appropriate age, you buy life insurance, and you buy it for a term or for a duration. In my opinion, 20's is the best age to buy insurance, and I will explain why. And you should buy your insurance till your retirement age. Let's say you are 25 years old and you will retire at 65, so then you can buy a 40-year life insurance plan. Which will mean that you will pay a premium to the insurance company every year, which will be a fixed amount. I will also explain its benefits and why is it a good thing that you pay a fixed amount and then at the end of the term, either you will get something in the case have a maturity benefit, or endowment plan or you may not get anything in case you have a term plan.

What is a term plan, maturity benefit, or endowment plan

Now let's try to understand what is a term plan, maturity benefit, or endowment plan. A term plan may seem to be a childish or a random kind of product but in my opinion, it is the most powerful product. Let me tell you why does it seem random. Term plan says that when you buy life insurance: let's again consider you buy it at the age of 25 and you buy it up to the age of 65 years. This means you buy a term plan for 40 years, so every year you pay a premium to the insurance company to give you a cover for your death. This means, God forbid if something happens to you then to your family, whomsoever you decide as a nominee, which could be your spouse or could be your parents, they will get that amount that you have insured. But, During these 40 years if nothing happens to you, which we would all love. God willing nothing happens to you for very long life, then you are not going to get anything. Nothing at all that the age of 65. When you would have been paying a premium to the insurance company for a period of 40 years, at the end of it you will get no benefit, in case no adverse thing happens to you. So that is why it seems to be a very random type of product, why would somebody take it? Like why would anyone in their right mind pay an insurance company a premium for 40 years, and after that, I would, of course, wish nothing happens to me, and if nothing happens then I won't get anything at all. The reason why term insurance is a good product to consider is that the insurance company doesn't have to pay you back or they don't have to pay you back, or they do not have to return you the premium, or they do not have to generate a return, they ofter the maximum cover for the lowest premium possible. This means at a very nominal amount you can get maximum insurance. How much cover should you thank? Let's discuss it. Usually, if your salary is 'xx annually, then according to me the minimum cover should be 10 times it so that your nominee would get a lump sum of 10 years of your salary in one go. According to me, the ideal cover should be 20 times, so if your salary is Rs 5 lakh annually, then the minimum cover should be Rs 50 lakh and ideally, a cover should be Rs 1 Cr, which means its best benefit is that the amount or the premium is fixed for the entire duration. You must have heard about inflation and you also must know that due to inflation the value of our money keeps reducing every year, which means that, let's say for this premium of Rs 1 crore, you are paying a premium of Rs 5,000-10,000 every-year, then its value every year will keep reducing. This means after 40 years, when you would be paying Rs10,000 annually, frankly that 10,000 will have no value, you would give it away just like that. Yes, today these Rs 10,000 seem a lot, but the best thing about insurance is that it is a fixed premium product, and that means you find it difficult right now, but in the future, that difficulty will reduce only, not increase. This is a great benefit for buying a term insurance plan. 

The second benefit is that all the amount that you pay as a premium, applies in your deductions under section 80C. This is a way for the government to encourage people to buy insurance. Endowment plan on the other hand are plans which say, that you keep paying a premium for some term or duration, and then after that, we will give you a return. That return would be giving back your premium or may keep getting a monthly income for some year, or you keep getting a lumpsum amount for some years or quarters, and so on and so forth. There are many other ways for this endowment plan to work, but the biggest thing that you need to recognize is that you are basically putting the responsibility on the insurance company that whatever premium you are paying them, they have to generate a return on it. So, you are not buying an insurance product, but an investment product and this is my personal recommendation, this is not something that you should take at face value. Please do your research, I am not an expert. But my personal recommendation is that the premium you will pay them, and the return that they will generate on it, you can do that yourself if you were to invest directly.

But the biggest disadvantage of these endowment plans or these maturity benefit plans is that you have to pay a far higher premium for the same cover. So, a cover of Rs 1 crore which you can get in Rs 5,000-6,000, if you take a cover of Rs 1 crore in a single benefit plan, you may have to pay a premium of Rs 20-25 thousand. This amount can increase by 2-3-4 times. Why would you want to do that? Only because you are getting the facility of a return, that's why you are taking it.  As I said, if you are a wise investor or a wise principled finance person, then you can generate that return from somewhere else as well.

Things to keep in mind while buying a term insurance or endowment plan

Let's discuss that while buying term insurance or an endowment plan, what are the considerations that you are taking a life insurance product, which means you are insuring your life, so everything that you consider has to be according to that. Firstly, if the income is stopped due to your death, that is, of course, the obvious thing, and also 2-3 other reasons maybe, God forbid, you got a critical illness and because of that you can not work anymore, or God forbid you to meet with an accident or have a disability, because of which you can not work, so you have to take these into consideration as well. These are called add-ons. Add-ons are the thing that you can add to the cover insurance product. The 2 most important that I would ask you to consider is, 

1. Critical illness add-ons

This means if you get a critical illness during this term, then you are covered for that as well.

2. Disability add-ons

This means that if you become disabled in any way, and you cannot earn any more because of that, you will get benefit cover for that as well.

In addition to this, there are 2 more add-ons, which is...

3. Premium waiver on critical illness

If you get a critical illness, then after that you do not have to pay the premium, the insurance company will give that premium on your behalf. So, this is a good one because due to critical illness, you are unable to earn anymore but the premium needs to be paid, so if you take this add-on then that premium also gets waived off.

4. Premium waiver on disability

If you get a disability and you are not able to earn because of it, then you will get a cover for sure,  but along with it, the premium will also be waived off through this add-on.

So, these 4 add-ons; critical illness, Disability, Premium waiver on critical illness, and Premium waiver on disability. According to me, these 4 are important mandatory add-ons, that you should consider while considering life insurance in general.

Which life insurance should you buy?

There are so many products in the market, Max, HDFC, SBI, Tata, so on. According to me, there are 2 more considerations that are very important...

1. Reputed brand

Because you're buying life insurance, which by design, by nature, is a long-duration product, so naturally, you want to be comfortable that this company, this brand, will stay for that duration. So, you obviously bet on brands that you trust and you trust immensely.

2. Based on their claims ratio

Second, a very important consideration in life insurance is something called claims ratio. This means if 100 claims are made, (claims means someone has died or they are claiming the cover amount that they had insured from the insurance company) so what percentage of those claims are actually paid out. It's never 100% because people try to fraud in many things or it is proved that the claim did not happen because the insurance company got to know something, let's say you were already ailing, but you did not disclose it to the insurance company and because of that unfortunately you died, after that when the claim happens then the insurance company figures it out that you did not disclose an existing illness, then it is quite possible that they will not settle that claim or your nominee will not receive your covered amount. These could be legitimate reasons but it is important to know that, what is the claim ratio of that company or brand. The higher ratio is, the better it is because that then allows you to have that comfort, that if something happens to me, then my family will not have to run around to get this amount in their bank. 

Another thing is that whenever you take life insurance, then please disclose everything that you should a 100%. It is life insurance and you do not want like I just explained, that if something happens to you then your family has to run from pillar to post to get this amount. This should be something that they get easier and that is possible only when you have cleanly and transparently disclosed everything, whether it's an illness, whether it's the fact that you smoke or you have a certain lifestyle, so on and so forth. Please do not hide anything, because if you do and then it comes out in the open, then it may make things complicated.

Final things, it is better to buy life insurance as soon as possible. As I said, the right age to buy life insurance is within 20s. If you take it too early then maybe your income will not be that much that you can take a good cover, and if you take it too late then the premium would become higher, because you have reached a certain age, and that naturally increases the chances to death. So, according to me, the right age is between 25-35 year. If you buy life insurance between the age of 25-35, whether term or endowment plan, that will give you the best combination of a good cover because your salary would be good enough to cover the 20 times of it and also the right premium, because it won't be very expensive.