Wednesday, May 5, 2010

Part 14: Insurance

A guarantee to compensate for losses  by an insurance company for the payment of a fee called a premium – all of us know what insurance means – but few of us understand it. Insurance as a product is one of the most abused financial instruments worldwide, especially when sold in combination with other investments.  For the purpose of this discussion right now, we shall limit “insurance” to mean Life Insurance.

In case you die suddenly, you want your family or dependents to be provided for. For this, you make a payment called a premium to an insurance company which is a percentage of the amount insured. The insurance premium is calculated by the insurance company based on your age, state of health, and the term for which you want the coverage.  In case you don’t die, you get nothing (at least in case of pure term insurance). In case you die, your beneficiaries whom you have named in the policy, get the insurance  amount.

So let us look at various aspects of insurance.  To start with, what are the costs typically like, for a pure insurance product?  In India, a good benchmark to assume (and it’s just a rough thumb rule – premiums vary widely across companies) for a pure insurance product (called Term Insurance) is Rs.300 per annum per lakh of coverage for a normal healthy thirty-year old wishing to take a thirty-year policy. That’s roughly 0.3% per annum. The premium will increase if the age is higher, if the term is more, if the policy holder has some existing health problems, if he is a smoker or heavy drinker, if he is in a risky job like a helicopter pilot, or takes part in so-called risky activities like adventure sports regularly.

How much insurance do you need? Assume you are young and have just started working with no dependents. One or both of your parents are still working and they do not depend on you for support.  In that case you do not need any insurance. By the same logic, you should not be taking any insurance policy (or investment-cum-insurance policy) which pays you something on your child’s death. In case you are working and your spouse is not, and you have two growing children, the situation is very different.  You need insurance big time – lots of it! In case you are approaching retirement with most of your financial goals already met due to sticking to boring, conservative, financial plans and savings targets through your working life, why do you need any insurance?  You have already provided for yourself and your dependents, haven’t you?

How much insurance do you need?  This one is complex. Each person’s situation is different.  What experts “recommend” is coverage to the extent of 7 to 10 times your annual income. Let’s do a simple computation – assume you are thirty and your annual income is Rs.5 lakhs. 8 times that is 40 lakhs. 0.3% of that is about Rs.13,500 per annum.  If you have an insurance policy already and are paying a premium somewhere in that range, what is your coverage likely to be? Rs.4 lakhs?  Most likely, yes, since you would have gone in for a ULIP or Pension Plan, Child Plan or some plan that is nothing but investment masquerading as insurance. Of what use is 4 lakhs? Your family can’t even survive for one year on it. Could you have taken a coverage of 40 lakhs under the same ULIP? Yes you could, but your entire annual salary would have to be paid as the annual premium.  Think about that.

You may also wish to check on the insurance coverage provided by your company before you decide on the amount.  A thirty-year old could even follow a strategy of taking separate term policies for, say, Rs.10 lakhs for ten years, Rs.10 lakhs for twenty years, and Rs.10 lakhs for thirty years. This way decreasing insurance needs for a later stage in life as savings increase can be factored in. The same logic can be applied to take coverage against a housing loan – you should take a term policy equal to the loan amount for the period of the loan. There is no restriction on the number of insurance policies you can take.

Finally, how much insurance you actually take is a function of how much you are willing to spend on the premium!
Does it matter which company you take the insurance from?  For all practical purposes, it does not.  All companies have a certain minimum net worth, and follow norms laid down by the Insurance Regulatory and Development Authority of India (IRDA) – hence you can reasonably assume they are likely to be solvent in the long term.  In any case, you need to worry more about that if there is a savings element to your insurance plan which we recommend against. 

How do you choose which company to take the insurance from? That is simple. Go for the lowest quote. Insurance premiums differ widely across companies – one company may be more attractive for a thirty-year old, while another company may have the lowest premiums for a 40-year old.  Each company computes its premiums based on its own actuarial tables and the assumptions are likely to differ.  Before deciding, however, you must check the premiums offered by Aegon Religare.  They offer the lowest premiums for term insurance currently. Their policies are only sold on-line, so you need to visit their website to check on the premiums and to take your policy.

Should you consider any other policy like ULIP, Endowment, Money-back, Guaranteed Plan, Child Policy, Pension Plan, or any other kind of plan?  The short answer is NO. Please restrict yourself to pure Term Insurance. We shall examine the reasons in the next issue. What happens if you already have some insurance policies which are under one of these categories?  In that case, continue paying your premiums and let the policies continue.  You could examine whether it would be more beneficial to surrender them, but that’s a bit complex – I would suggest you should consult a trusted financial advisor who understands these products and is good at spreadsheet modeling!

Should you ask your insurance agent for advice? Again, the answer is NO.  Be very clear what you want before you talk to him and don’t get swayed by any of his arguments.  Better still, don’t engage him in any debate.  We shall see why this is so in the next issue.

In the next installment we shall examine the malpractices that are prevalent in the selling of insurance. It is very important to understand these since so-called insurance products are among the biggest wealth destroyers (for investors, not for the agents) in India today.  Bye till we meet next!

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