Last Updated on December 18, 2020 at 7:56 pm
This is a term insurance buying guide that covers all the need-to-know essentials before you purchase a term insurance cover.
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They say that it takes a genius to understand simplicity. Well, it is true in the case of Life Insurance. As humans, we are intuitively wired to think that if something is complicated, then it must be good. Or that if something is expensive, it must be superior. It may be true in some cases, but in the case of Life Insurance, it is just the opposite. Let us look at some common mistakes we do while purchasing life
insurance and how to protect our family most effectively.
What is Term Life Insurance? Term Life Insurance (Shortly referred to as Term Insurance too) is the purest form of insurance. It is a risk mitigation plan. You pay an affordable fixed premium for a fixed term, to the insurance company so that if something untoward happens to the policyholder in that fixed period (term), the company provides your beneficiaries with a pre-determined sum – called the Sum Assured, so that your dependents are financially protected (provided there is no misrepresentation or fraud etc.)
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Why Term Insurance? We need term insurance to compensate for the monetary loss caused by the untimely death of a bread-winner. That is it. It is not for getting returns; it is not for leaving behind a legacy; it is not for compensating for the sadness or agony caused by the death of the loved one.
When to take Term Insurance? Take term insurance when you are a bread-winner, AND you have financial dependents.
Debunking the Myths
Now that we have glanced over the “What” and “Why”, let us look at some of the common mistakes and misconceptions that we make while purchasing a Term Insurance because of which we either leave our family under-protected or waste our money.
Inadequate Coverage: How much coverage do we need? Most often we look at a snazzy value like 1 Crore. 1 Crore has a huge emotional significance and a psychological barrier in our minds. And we take Term Plan for 1 Crore. While something is better than nothing, 1 Crore is arbitrary; it may be too low, or too high.
Set the coverage so that the Sum Assured is at least 17 times the annual expense. For example, if your annual expense is 10 lacs per year, you need 1.7 crore coverage at least. Why at least 17? It is because, if the untoward happens today and your dependents get the 1.7 crores, and they are not too financially savvy, they can just deposit this in an FD at 6% in a safe bank and get monthly/quarterly payout which is equal to the same 10 lac per year (or 83k per month). Nowadays, interest rates are dwindling. So you may need Sum Assured/Coverage = 20X annual expense.
But won’t such a high coverage mean I have to pay a huge premium? No, this is where we need to get out of the “returns” and “moneyback” mindset. Premiums are very affordable. Because Term Plan doesn’t give you anything in return. If you die in the term, you get the sum assured. If you survive the term, be grateful, but you won’t get a penny. That is the point of insurance. When you pay a premium for car insurance, and you don’t have an accident in that year, do you get your premium back? No right? Life Insurance is similar. Because it is based on probability, not everyone will pass away in the term, and hence companies can afford to keep premiums low. In the above example, a 1.7 crore coverage can be purchased for as low as Rs. 1000-1500 per month (Depending on your age, health etc.)
But there are policies which give me premium back, aren’t they better? We love when we get discounts and money back. This is the best of both worlds. High Coverage and return of premium? No! If you compare similar policies which do not provide money-back and which provide money back, you will find that the premiums are much higher for the money back. You are better of using that money somewhere else, like investing for your goals or whatever.
Not only that, when you get money back in 20-30 years, it will be peanuts because inflation would have eaten away the value of your money. For example, if you pay 2k per month for a policy for 30 years, and at the end, if they give you back the 7.2 lac, it will have the same value as of today’s 1.1 lac, due to inflation and time value of money. So basically they have extracted the juice and gave you back the peel. So stick with no-money-back.
Taking a policy for too long a Term: How long should you take the policy for? Take the policy for as long as you plan to work and have financial dependents. Term Insurance is for compensating the premature death of a bread-winner. So if you plan to retire/have no income by say 55, then take the policy till 55. Not till your 80 or death. Because, once you don’t have any financial dependents or you are not actively earning income, then obviously you don’t need Life Insurance, and with what income are you paying the premium from?
But I would like to leave a legacy for my family so isn’t it better to take a policy till 99 years of age thereby almost guaranteeing that policy will be paid out? Here again, the “returns” thinking is our folly here. The above logic won’t work for two reasons.
- Insurance companies are not doing charity, when the term increases, they will increase the premium as per the risks and probability related with that term and age, so you will end up paying big premiums and wasting money.
- More importantly, if you take a policy for 70 years term instead of say 25 years, in those 70 years, the time value of money applies, and inflation will erode all the value. The value of today’s 1 crore Sum Assured will be only 1.3 lacs, that’s right 1.3 lacs after 70 years when you plan to leave a legacy at 99 years. So, as you can see, it won’t help.
- Then one may think, well, then I will take a policy for 10 crores. Won’t work, because most insurance companies have a limit. Like say 20x of your annual income etc., They won’t provide cover beyond that. And even if they do, you will be paying too much premium, so either way, it is a loss for us.
What premium payment mode should I choose? Choose the regular payment mode. That is, pay premium regularly: monthly/annually through-out the term. Avoid prepay or chunk pay. You may see banners like “Pay in 10 years and save 30%”. Avoid them for two reasons.
- Those banners conveniently neglect the time value of money, and they know that.
For example, 1k per month for 20 years on paper is 2,40,000. And 2k per month for 10 years on paper is the same 2,40,000.
But as you can see, if you take their inflation-adjusted values, then the 1k per month will cost you around 1.42 lacs while the 2k per month will cost you 1.85 lacs.
| Pay – Type | Regular Premium | Prepay Premium | ||
| Year | Nominal Value | Inflation Adjusted | Nominal Value | Inflation Adjusted |
| 1 | 12000 | 12000 | 24000 | 24000 |
| 2 | 12000 | 11280 | 24000 | 22560 |
| 3 | 12000 | 10603 | 24000 | 21206 |
| 4 | 12000 | 9967 | 24000 | 19934 |
| 5 | 12000 | 9369 | 24000 | 18738 |
| 6 | 12000 | 8807 | 24000 | 17614 |
| 7 | 12000 | 8278 | 24000 | 16557 |
| 8 | 12000 | 7782 | 24000 | 15563 |
| 9 | 12000 | 7315 | 24000 | 14630 |
| 10 | 12000 | 6876 | 24000 | 13752 |
| 11 | 12000 | 6463 | ||
| 12 | 12000 | 6076 | ||
| 13 | 12000 | 5711 | ||
| 14 | 12000 | 5368 | ||
| 15 | 12000 | 5046 | ||
| 16 | 12000 | 4744 | ||
| 17 | 12000 | 4459 | ||
| 18 | 12000 | 4191 | ||
| 19 | 12000 | 3940 | ||
| 20 | 12000 | 3703 | ||
| Total | 240000 | 141979 | 240000 | 184554 |
As you can see, time is money; a bird in the present is worth two in the future. And I am not even considering the opportunity cost of that extra 1000. Because of this, they can clearly offer “discounts”, because the sooner you part with your money, the better it is for them. So regular payment in small chunks in beneficial for us.
- Regardless of when you die, you are ensuring that the full premium is paid. So again it is a loss for you.
- Here again, if your income is very unstable or uncertain, probably you can consider prepayment. But for most people, regular payment would suffice.
Sum Assured payout options:
Sum Assured payout typically has a few options like:
- Full Lump-sum payout
- Regular income
- Increasing income
- Partial payout and partial income
Choose the 1st one, Full lump-sum payout. This is the simplest and the one in the best interest of your dependents. Get the money in your kitty. What to do about it is the next headache.
Here again, the time value of money applies. When you get a regular income, the bulk of the money is with the insurance company. Not to mention other risks, like if the company itself has some issue. Unwanted headache.
Regular income option is probably the worst. There is no inflation adjustment. And the dependents will make use of the full monthly income only to find it tighter and tighter to manage their expenses as inflation eats away the value of their income.
Increasing income option may sometimes look attractive, and if you add up all the figures, it may look bigger, but again time value of money applies. Since it is increasing, the huge chunk of the money comes towards the end, when, who knows, the dependent themselves may be too old by then.
So, A Full Lump-sum payout is the simplest and the most effective. It will allow you to take full control of your death benefit and take care of regular income as well as handle inflation.
I have a huge corpus already. Do I still need Life Insurance? Actually No, If you have enough corpus amassed so that, even if u pass away, your dependents can live off the corpus, then you don’t need life insurance. In fact, that should be our aim, to invest/increase income and amass a good enough corpus as early as possible so that Life Insurance becomes redundant.
Some special considerations
Married Women’s Protection Act (MWPA): If you are a married man, and are taking life insurance with wife and children as beneficiary, enable this option while taking the policy. This ensures that no one else, including debtors, can claim any rights on your Sum Assured, upon your demise and your wife gets exclusive rights on the money. You can’t even pledge this policy.
Full disclosure: Be transparent and disclose everything honestly, regarding health conditions etc. Better to take an extra hassle of submitting more documents or tests in the start, than the risk of your insurance claim being rejected while you are not alive. That is the last thing you want.
Riders: Avoid riders. Let the term plan be a pure vanilla term plan focused on only one thing. Riders will jack up the premium without providing many benefits. Riders like critical illness and accidental riders will have very tightly worded conditions that more often than not, we may not satisfy the condition. Hence, your beneficiaries won’t get the extra benefit. Put the rider money to better use in a powerful health insurance or personal accident policy which covers everything.
Keep your family informed: Provide the details and the insurance copy to your dependents and let them know the procedure to claim, else at least nominate someone to do so.
Mixing insurance with investment: This needs a separate article on its own but to give an idea, do not mix insurance with investment. That is, for Life Insurance, do not buy an endowment or ULIP plan. It is not an axiom for the sake of it. It has solid logic behind it. When we buy an endowment or ULIP plan, 90% of it goes towards investment, and 10% of it goes towards mortality charges which is life insurance. So we will be both under invested and under-insured at the same time. If you increase the Sum Assured of a ULIP to match the required Life Coverage, then the premium would be something one can’t even afford. On the other hand, even if you consider the ULIP as a conservative investment, you will still need a real Term insurance for risk mitigation. Still not convinced? Go and refer the Sum Assured of any ULIP. I will wait ☺
All these are too much complication, too many things to remember!
These are simple points, but all were explained in detail because, at a casual glance, they may look counter-intuitive. Basically, take the path of least resistance. The more frills you add to a Term Insurance, the worse it gets. Term Insurance is like a test match. Stick the basics. The most boring way is the match-winning way.
To re-iterate:
- Take a Simple Plain Vanilla Term Life Insurance
- Term: Till you work
- Sum Assured: At least 17X of your annual expense
- Regular premium payment
- No premium-back
- Payout mode: Full Lump sum
- Avoid riders and frills.
- Married Woman’s Property Act
- Full disclosure
- Keep family informed
- In parallel, strive to amass a corpus large enough so that you don’t even need insurance anymore.
Summary: A Term Life Insurance is the first and most critical step in personal finance, to ensure your family is not left high and dry upon your untimely demise. And by appreciating and understanding the true spirit of what a Term Life Insurance stands for, one can provide maximum protection and peace mind to one’s family, at the same time being the most cost-effective.
You are now ready to buy term insurance. Here are the next steps:
- Recognise that claim settlement ratio is not a probability of life insurance claim acceptance!
- How to choose a term life insurance provider in 30 minutes!
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