The Cost Of Life Insurance

Published Date: 02 Nov 2017

No one is aware what the future is holding. But, when the loved ones pass and things get tougher, the right kind of life insurance policy helps as the source for those who are left behind and have to start their life afresh. Therefore, it is always better to understand the details of calculations of rates set by the life insurers which are paid in the form of premiums (see exhibit 2); learn on what benefits to be taken and what to avoid when purchasing buying a life insurance plan; gather tips for saving money—and protect your loved ones today.

In real terms, premium is cost of purchasing insurance at commencement and at periodical installments. The term life insurance cost which is pure risk cover is determined by the correlation among three components (see exhibit 3) :

The Policy Expense Cost

The Interest Cost and

The Mortality Cost

The Policy Expense Cost - Here, the cost component which stays relatively ‘constant’ includes the company's expenses that the policyholder needs to pay towards operations of the company such as agent/ life advisor’s commission, administration charges, underwriting expenses, medical test expenses, legal fees, salaries, rent, postage, etc. Term life insurance expense costs are usually much lower than the expense costs of cash-value life insurance. The amount charged to cover each policy’s share of expenses of operation is known as ‘expense loading’. This cost area differs from company to company based on its operations and efficiency.

The Interest Cost - Companies invest the premiums in bonds, stocks, mortgages, real estate, etc. The assumption here is that, the invested funds will earn a certain rate of interest.

Mortality Cost - This cost is a ‘variable’ component that majorly accounts for the changes in term life insurance costs which is determined by probability of deaths at a given point of time. There is a direct relationship between the amount of premium and the age of the person. More the age of a person, higher the chances of death and proportionately higher premiums will be charged by the insurance companies. The probabilities are calculated by ‘actuaries’ who are business professionals and deal with the financial impact of risk and uncertainty. Their job involves calculating insurance risks and payments for insurance companies by studying how frequently accidents, fires, deaths, etc. will happen. These are called as actuarial statistics. ‘Mortality Tables’ (see exhibit 1) are used to give the company a basic estimate of how much money it will need to pay for death claims each year. By using a mortality table a life insurer can determine the average life expectancy for each age group. In other words, Life Insurance is based on the principle of sharing the risk by a large group of people. Hence, the ‘amount at risk’ is known to predict cost to each member of the group.

"INSURANCE IS NOT BOUGHT BUT SOLD’

i.e.

Insurance is a matter of solicitation, by creating appetite for it, cannot be forcefully sold

Life Fund

In normal trading business, the excess of income over the expenses (including depreciation, allocation to reserves etc.) in any accounting year, would be considered as profit and will be distributed among the owners as dividends. This is not so in life insurance. First of all, the contract for which the premium is paid does not come to an end at the end of the year. It is a long term contract. The profit, if any, can be determined only after the contract comes to an end. The premiums are yet to be paid in full. At any point of time several contracts will be continuing to be in force. The liability continues and the insurer has to keep aside the excess (of income over expenses) money to meet such liabilities.

First 3 years, it takes to cover expenses. Therefore, accumulation account is made after 3 years. It is said that :

If policy is lapsed after paying 1 year premium, then called policy ‘lapsed without generating any value’.

If policy is lapsed after paying 2 years premium, then also said the same.

But, if policy is lapsed after 3 years of paying premium, it is said, policy lapsed after some value generation.

Determination of Cost for ULIPs

A linked insurance plan is an investment product that links your return to the market or an index. These plans are transparent and the amount you invest can be segregated into what is invested and what goes off as costs.

In Unit Linked Insurance Plans, unlike traditional plans, out of the premium deposited by the policyholder, the charges are made known to the holder of the policy through various sources like :

Advisor – The agent or the life advisor who sells the policy to the customer on behalf of the insurance company is supposed to give full information about, out of the premium charges. It is also the right of the customer to take full information from him.

Brochure – The brochure of the policy in particular mentions the details of the charges which will be deducted by the insurance company out of the premium deposited by the customer. The same can be compared, throughout the industry offering similar type of products.

Sales benefit Illustration – In order to maintain transparency, sales benefit illustration which is a part of the policy document, gives the complete details of different types of charges which will be charged throughout the term of the policy, so as to make the customer well informed about the amount which is being deducted and simultaneously invested out of the premium deposited by him.

The structure of different types of charges in ULIP products is broadly the same throughout the insurance industry varying in amounts and percentages. However, the important ones are listed as under :

Premium Allocation Charges – These are the charges which are deducted upfront from the premium deposited by the client. There is an initial advice and distribution charge related to policy issue that is a percentage of the premium received. For example; agents commission, cost of underwriting, cost of medical tests etc. Top-up premiums are usually fully invested, approximately 99%.

Fund Management Charges (FMC) – The annual fund management charge is a percentage of the fund value and is towards managing the policyholder’s money efficiently to earn him/ her handsome returns. The choice of fund options that allows the policyholder to balance his/ her risk profile with the tenure of investment, the premiums are invested net of initial charges in stock market (blue chip, mid cap or small cap), money market instruments and government securities or in combination. The FMC varies from fund to fund even within the same insurance company depending on the underlying assets in the fund. Usually a fund with higher equity component will have a higher FMC.

Policy Administration Charges – In order to recover the expenses incurred by the insurer, these charges are deducted on a monthly basis on servicing and maintaining the life insurance policy like paperwork , work force etc. Usually there is no administration charge for annual premiums of Rs. 1 lac and above.

Partial Withdrawal Charges – These charges are expressed as a percentage of amount withdrawn out of the policy. Usually no partial withdrawal is allowed in the first 3 policy years.

Switching Charges – If the policyholder wants to switch between funds like aggressive, moderate, cautious, conservative and secure according to his risk return profile, the first four or five switches in a year are usually free and approximately Rs. 500/- is charged for any additional switch.

Mortality charges – These expenses are charged by life insurance companies for providing a life cover to the individual. This is the cost of life cover and will be levied generally by cancellation of units on a monthly basis. The expenses vary with the age and either the sum assured or the sum-at-risk i.e. the difference between sum assured and fund value of the insurance policy of an individual.

Rider Charges – In return for providing the additional booster benefits (riders), some charges will be recovered by cancellation of units on a monthly basis.

Balance premium after deducting management expenses and mortality charges is known as ‘allocated premium’. For example; the premium amount in a policy is Rs. 10,000/-.

Allocated Premium = 10,000 – (management expenses) – (mortality charges)

Note : Allocated premium is invested and units purchased as on that date. All funds contain units and the money is invested as per the customer’s chosen option for funds.

In the latest draft guidelines issued in Oct 2012, the Insurance Regulatory and Development Authority (IRDA) has proposed that, the minimum death benefit for linked insurance plans, where a portion of your money is linked to market, will be sum assured plus the investment amount instead of higher of the two in contrast to the earlier where the ULIP had offered higher of the fund value or sum assured to the beneficiary in case of death of the policyholder.

In terms of returns, it is noted that, the earlier case was in benefit to the customer because one cost head called insurance charge or mortality charge was levied only for a shorter period of time and the overall charge structure for the plan used to come down substantially. Since the policy offered higher of the sum assured and the fund value, it levied mortality costs till such time, the fund value exceeds the value of the sum assured. On the other hand, now the insurance cost in these new proposed guidelines will be levied till the end of the policy. This will impact your return but in its place you get additional protection in terms of both sum assured and the fund value.

However, the insurance companies have full right to revise charges and fees levied to the policyholder over a period of time. Since the costs are known, IRDA has capped the costs for unit-linked insurance plans (Ulips) and has proposed caps costs in other linked plans called index-linked insurance plans. These are now called variable linked insurance plans under the draft proposal.

Hence, ULIP is a plan which gives full transparency about the percentage of various charges deducted and the growth of fund over a period of time.

Determination of Cost for Term Life

Since ‘risk’ on the life of customer is the major factor on which the cost of getting insured depends, it is examined by the insurance company in various ways and through various sources. Mainly the proposal form of the customer, who is applying for the insurance, becomes the base; however, each individual case is unique and is examined in different way. The factors that contribute to determining the term life insurance costs are as follows :

Age - Older the age, more the risk of mortality is the principle. More the age, higher the premium.

Sex – Women are usually eligible for slightly lower premiums as the researches over a period of time have proved that the life expectancy of woman is higher than that of men. (Refer a note at the end of ‘Misstatement of Age or Sex Clause’ in chapter 9).

Marital Status - Rates for bachelors are normally lesser in comparison to the married couples.

Driving Record - Poor driving record leads to higher premiums.

Home Ownership Status – The people who are the homeowners are eligible for higher premiums, as more money is at stake.

Number of Dependents - Smaller families garner competitive rates.

Medical History - Unhealthy persons (habit of smoking, drinking, overweight, cardiac and blood pressure problems etc.), more the risk, leading to high premium. Usually a smoker is likely to pay up to four times more than a non-smoker. Overweight applicants cannot qualify for preferential premiums. It is noteworthy that if you have had an unhealthy medical history in the past, you need to provide evidence that you have controlled them.

Family History - More the family history of deaths due to fatal diseases (which are usually generic in nature), more will be the cost (premiums) of the policy.

Lifestyle - This includes habits of the customer like drug or alcohol abuse, driving record, hazardous hobbies, more risky activities and higher frequency of travelling.

Occupation – Job of the customer applying for insurance policy matters in terms of risk. If it’s a low risky work, premiums charged will be lower.

All the above information is filled by the applicant in the proposal form which is thoroughly scrutinized by the insurance underwriter followed by the decision of cost of policy to the applicant based on his/ her life conditions.

Points to Ponder

It is important to estimate costs and get quotes, before making a purchase decision of a term life insurance policy, since it is an asset with no accumulating value. The basic premium rate is set by the insurance company and is further provided to the insurance agent. By law, the agent is not allowed to quote differently, so it will not matter from which agent you buy it.

It is always better to calculate the approximate cost of insurance you are planning to buy, different websites provide calculators for the assistance and if those are assessed properly by providing correct information, prove to be an accurate online quoting system.

After estimating the cost of insurance, the person should always explore from different insurance companies and purchase the policy for which he/ she qualifies, the variance is only the rate category which the insurance company will put him/ her during the underwriting process. It is seen that sometimes the experienced insurance agents, take the advantage of this for capturing the policy and neglect the importance of providing valid proofs in the application form. The policyholder realizes the mistake later when the insurance company rejects the claim and the payouts are held up.

‘Coverage’….the name of the game ! Try to get maximum coverage within the predetermined budget as often a higher level of protection can be purchased with only a slight increase in premium. This takes explore and comparison shopping for right coverage at the right price. See exhibit 3 while shopping at affordable prices.

For the new plan the premium of old continued plans should not be compromised. If neglected, that could leave family members without death benefits when they need them most.

COST COMPARISON METHODS

After deciding which kind of life insurance fits your needs, now is the time for purchase of reasonable cost policy. The chances of finding a best buy will increase, if compared on the scale of two index numbers which have been specifically developed to aid in shopping for life insurance. One is called the Surrender Cost Index and the other is the Net Payment Cost Index, both under ‘Interest-Adjusted Cost Method’ (explained later in the chapter). The mentioned indexes help in comparing the relative costs of similar policies. Look for policies with low cost index numbers.

What Is Cost?

Cost is the difference between amount paid and amount returned back. For example; in case of life insurance, the amount paid is premium and if nothing is received in return, the cost for death protection is the ‘premium’ itself. If something is received back later on, like cash value, in this case, the cost is smaller than the premium. Similarly, the cost of some policies can also be reduced and that is by dividends; these are called ‘participating’ or ‘with profit’ policies. The premiums and cash values of these policies are guaranteed and are comparatively higher but mostly dependent on the dividends actually paid. Past trend of the company giving dividends can be known before purchasing the policies but the future can never be guaranteed. The policies which do not pay dividends, their costs are fixed and the customer knows in advance what will be the future cost of the policy, it is known as ‘guaranteed cost’ policy. These policies are also called ‘non-participating’ or ‘without profit’ policies.

The Cost of Life Insurance

There are 2 methods that are commonly used to determine the cost of life insurance: the traditional net cost method and the interest-adjusted cost method. The main disadvantages of these methods are the need to project what dividends, interest rates, and cash values will be in the future. Assumptions about these values can result in small variations in the net cost index from different companies with similar policies.

Traditional Net Cost Method

Interest-Adjusted Cost Method

Traditional Net Cost Method

The basic technique is to make summation of the total premiums paid over a period of time (usually 10 or 20 years), subtract the projected dividends and then subtract the projected cash value of the policy. This is the total net cost of the policy over the selected period. Now divide the result by the face amount of the policy (in thousands) and again by the number of years in the period to arrive at the net cost of insurance per thousand dollars of coverage per year.

There is no accounting for the time value of money. This method often yields a negative price for the insurance, but, of course, it can't really be negative, since that would mean that the insurance company is paying you so that they can pay big money to your beneficiaries if you die while the insurance is in force! You can take it for granted that insurance companies are not that generous.

It uses a complicated calculation formula, but the basic process works in this manner :

Annual Cost =

Total Premiums paid over a given time period (-)

Projected Dividends paid (+) divided by

Cash Surrender value of the Policy at the end of the time period Number of Years in the Period

Weaknesses of this approach are:

The net cost method ignores time value of money.

It can assume inaccurate assumptions based on the ledger statement for projected dividends and cash value. For example; consider the illustration based on a Rs. 162.80 annual premium, Rs. 10,000 participating policy surrendered at the end of 20 years.

You pay out:

Premium for 20 years Rs. 3,256.00

You receive:

Dividends for 20 years Rs. 1,046.00

Cash value at the end of 20 years Rs. 2,620.00

Rs. 3,666.00

Subtract total from premium Rs. 3,666.00

Cost of Insurance for 20 years - Rs. 410.00

Cost per Rs. 1,000 (divide by 10) - Rs. 41.00

Cost per year per Rs.1000 (divide by 20) Rs. 2.05

Notice here; the cost is negative.

As per the traditional net cost formula, you can cash in the policy for Rs. 2,620 and come out without having paid a cent for 20 years of life protection.

Only the company loses (to the tune of Rs.410 or Rs.20.50 a year) and yet companies are happy to sell such policies.

Obviously the formula leaves some cost element out of picture. The most significant factor omitted is interest. When you receive a fixed sum may be just as important as the amount. For example; these are the first 3 year’s dividends on two policies. Which is the better way to buy ?

Policies

Dividends

1st year

2nd year

3rd year

Total

A

None

Rs. 20

Rs. 30

Rs. 50

B

Rs. 10

Rs. 18

Rs. 22

Rs. 50

Both pay a total of Rs. 50 for the first 3 years and at the first sight there doesn’t seem to be any reason to choose one over the other. But, if the dividends are compounded at 4% annually, as they would be, if you put the cash each year into a 4% savings account. Company B’s policy emerges as the better deal.

Adjusted for interest it pays Rs. 51.54 against Rs. 50.80. Those interest differences widen after many years with the increase in dividends and the compounding of interest and become a crucial cost factor.

Whether you actually deposit the dividends in a savings account or use them to reduce premiums or buy additional insurance doesn’t matter.

What really counts is that in theory you have the opportunity to earn interest on the money.

Similarly if one company charges a Rs. 200 annual premium and another only Rs. 180 for the same policy, the second company gives you a chance to earn interest on Rs. 20 difference by putting the money into the back each year.

That’s why the interest adjusted method of calculating policy costs was born.

Interest-Adjusted Cost Method

The interest-adjusted cost method does take into account the time value of money by adjusting the factors by an interest rate.

The Interest-Adjusted Methods of Determining the Cost of Life Insurance

First let us see what are Cost Indexes ?

‘Cost Indexes’ developed by the NAIC (National Association of Insurance Commissioners) in 1970 assist in shopping for life insurance before the hand held calculator came to be. It is to be noted that these indexes are used only for comparing the relative costs of similar policies. In order to compare the cost of policies, you need to look at :

Premiums

Cash Values

Dividends

One or more of these factors are used by cost indexes which gives a convenient way to compare relative costs of similar policies. While comparing costs, attention must be paid for an adjustment, to take into account that, money is paid and received at different times. Adding up the premiums you will pay and subtracting the cash values and dividends you expect to get back is just not enough. In fact, these indexes take care of all the arithmetic for you. Instead of adding, subtracting, multiplying and dividing many numbers yourself, you have to just compare the index numbers which you can get from life insurance agents and companies:

Surrender Cost Index

Net Payment Cost Index

These alternative and simplified methods provide exactly the same answer but are calculated in a manner familiar to the students. At that time it was necessary to use the present and future value tables, today with the ready availability of the personal calculator it is easier to calculate the present value formulae, and therefore, these simplified methods should be considered. An example of the NAIC method is as follows :

Premiums of Rs. 132.09 per year for a Rs. 10,000 policy

Dividends of Rs. 24.92 per year

Maintain the policy for 20 years and then cash it in for Rs. 2,294

Assume an interest rate of 5%

Surrender Cost Index

If cash value levels are of primary importance to you, this index may be useful. It will help in comparing costs, if at some point in time, such as 10 or 20 years, the policyholder wants to surrender the policy and take its cash value. In other words, it applies an interest adjustment to the yearly premiums and dividends. It measures the cost of Rs.1000 of insurance assuming that the policy is surrendered at a specific time. It is calculated by the following method :

Calculate the future value of total premiums over a selected period such as 10, 15 or 20 years. Most policy illustrations use a 5% interest rate.

Calculate the future value of the projected dividends using the same time period and interest rate.

Subtract the future value of the dividends from the future value of the total premiums to arrive at the net premiums paid over the specified period.

Subtract the total cash value and terminal dividends from the future value of the net premiums to arrive at the total net cost of the policy over the specified period.

Divide the result by the future value of the annuity due factor for the rate assumed and the period selected. The result is the level annual cost for the policy.

If necessary, divide the level annual cost for the policy by the face amount of the policy (in thousands) to arrive at the interest adjusted net annual cost per thousand dollars of coverage.

Among the weaknesses of this approach, it gives misleading results if the policies being compared are not similar and the unreliability of the projected cash values and dividends 10 and 20 years into the future.

Illustration

You pay out:

Premiums for 20 years, at 4% compounded Rs. 3256.00

You receive:

Dividends for 20 years at 4% compounded Rs. 1421.45

Cash value at the end of 20 years Rs. 2620.00

Rs. 4041.45

Subtract total from premium Rs. 4041.45

Cost of Insurance for 20 years Rs. 1000.03

Cost per Rs. 1000 (divide by 10) Rs. 100.03

Interest-adjusted cost per year per Rs. 1000 Rs. 3.23

That final Rs.3.23, the interest adjusted cost represents the amount that would have to be put away each year in a 4% account to accumulate to the Rs.100.03 net cost of Rs.1000 of insurance protection for the 20 year period.

Illustration

Total premiums for 20 years, each accumulated at 5% Rs. 4,586

Subtract dividends for 20 years, each accumulated at 5% Rs. - 824

Net premiums for 20 years Rs. 3,462

Subtract the cash value at the end of 20 years -Rs. 2,294

Insurance cost for 20 years Rs. 1,468

Amount to which Rs. 1 deposited annually at the beginning of

each year will accumulate to in 20 years at 5% Rs. 34.719

Interest-adjusted cost per year (Rs.1,468/Rs.34.719) Rs. 42.28

Cost per Rs.1,000 per year (Rs.42.28/10) Rs. 4.23

A suggested alternative is to bring all of the numbers to the present rather than to the future and then back to the present.

Present value of premiums for 20 years at 5% Rs. 1,728

Present value of dividends for 20 years at 5% - Rs. 311

Present value of net premiums for 20 years Rs. 1,417

Present value of cash value received in 20 years - Rs. 865

interest-adjusted cost per year Rs. 552

Divide by the present value of an Annuity Due factor (13.0853) Rs. 42.26

Divide by 10 to obtain the cost per thousand Rs. 4.23

A still easier method is to simply start with the numbers per thousand dollars of coverage rather than per ten thousand dollars of coverage.

Premium of Rs.13.21/year Rs.13.21

Present value of the dividend of Rs.2.49 which is received

at the end of the year so it must be discounted for

one year 1/1.05×Rs.2.49=0.9524×Rs.2.40 (-) Rs. 2.37

Present value of the cash value received at the end of

year 20.

(1/1.05) XS229.40 = 0.3769×Rs.229.40 (-) Rs. 6.61

Cost per Rs. 1,000 per year Rs. 4.23

Do not get confused between the interest-adjusted cost or the traditional cost illustrated earlier — with your actual out-of-pocket expense, which consists of the annual premium minus the annual dividend, if any. The interest-adjusted formula combines the premium, dividend and cash value data into a single cost index. There is nothing particularly mysterious about the new method. It merely cranks interest into the old formula to arrive at a more realistic index for comparing policies.

Weaknesses of this approach are:

The formula assumes surrender of the policy, so it doesn’t measure the cost of retaining a policy until the policy holder dies. Experts have been developing other, more sophisticated methods to evaluate the cost at death, raising the possibility that eventually life policies can be ranked by 2 formulas.

Policies have to be compared at the same purchase age and for the same surrender period. A policy with a relatively low cost when issued at 25 and surrendered in 10 years might sow up with a high cost at 35 and 20 years.

Each company sells a number of different variations of cash value policies and you can’t categorize its complete line by the cost of any one policy.

Companies usually discount premiums for policies with higher face amounts. Thus costs per Rs.1000 of coverage have to be matched against policies of the same size.

Applying different interest rates will produce different sets of interest-adjusted costs. The 4% rate employed for the tables was suggested by the committee mentioned at the beginning because it approximates the after-tax interest return likely to be attainable over a long period.

Companies revise premium and dividend scales from time to time. Its not always safe to rely on a previous year’s figures as a buying guide.

Of course the same can be said for using last year’s prices of cars, bread or any other product.

The interest-adjusted formula doesn’t evaluate many peripheral cost factors such as the rates at which cash values can be converted into paid-up or term insurance. For that matter, however cost figure is not the only factor to consider in buying insurance. Other matters, such as agent’s service and pay-out methods need to be explored too.

Net Payment Cost Index

If the amount of death benefit provided is of primary importance to you, this index may be useful. It helps in comparing future costs, such as in 10 to 20 years, if the policyholder continues to pay premiums and does not take the policy’s cash value. Usually in the textbooks, it is calculated in the same way as with the surrender cost index but omit the cash value. They take the premiums and dividends out from the future value and then bring them back to the present value. It is much easier to simply subtract the present value of the annual dividend from the premium.

Total premiums for 20 years, each accumulated at 5% Rs. 4586

Subtract dividends for 20 years, each accumulated at 5% - Rs. 824

Insurance cost for 20 years Rs. 3762

Amount to which Rs.1 deposited annually at the beginning

of each year will accumulate to in 20 years at 5% Rs. 34.719

Interest-adjusted cost per year (Rs.3762/Rs.34.719) Rs. 108.36

Cost per Rs.1,000 per year (Rs.108.36/10) Rs. 10.84

The simplified way is,

Premium of Rs. 13.21 per year Rs. 13.21

Present value of the dividend of Rs.2.40 which is received

at the end of the year so it must be discounted for one year

(1/1.05) × Rs.2.49 = 0.9524 × Rs.2.49 (-) Rs. 2.37

Cost per Rs. 1,000 per year Rs. 10.84

The main disadvantages of these cost indexes are:

Need to project what dividends, interest rates and cash values will be in the future.

Assumptions about these values can result in small variations in the net cost index from different companies with similar policies.

Points to Ponder

In general, it must be noted that, only if you are comparing similar policies, a smaller cost index is normally a better buy than an equivalent policy with a larger index number. While making your decisions, also consider the under mentioned guidelines for using indexes :

The cost comparison will be more reliable if the policies are identical in nature to the extent that same basic benefits, same premiums and similar amount of time should be provided by the policies.

Index numbers should be compared only specifically for the type of policy of your age and the amount you propose to buy. It is very difficult to find out one single company that will offer the lowest cost for all types of insurances at all ages and for all amounts of insurances, better is you obtain the indexes for your actual policy, age and amount which you intend to buy. You should never carried away by the influence of shopping guides or the agents which may tell you about the particular policy of a particular insurance company which may be a good buy for your age and your proposed amount, it should not be assumed that all the products of the same insurance company are equally good buys.

You should be very sure of the fact that you will be able to afford the premiums and you are aware of other features of the policy like dividends, its cash value, death benefits etc. You should be fully convinced that the company will be fair in paying back the claims and will provide good service in future as well.

It should be remembered that the cost indexes are applicable only to the new policies and not for taking a decision whether to continue or drop the existing policy in exchange of the new. If you are actually wanting to discontinue the old policy, it is always better to consult that very insurance company and understand its after effects, charges and penalties (if any) before you take any action.

Even though the indexing procedure seem to be complex, but it has been noted that rates on similar coverage vary dramatically, so it is important for a person to understand it completely. Some of the people have even saved upto 50 % on their life insurance by these comparisons. It is always better to explore around and take the right decision that best fits your requirement.

TAXATION OF LIFE INSURANCE

Life Insurance is a critical part of an individual’s personal insurance portfolio. It’s strategic part of the future security that one must provide for one’s family in the face of the inevitable. The proper type and the appropriate level of life insurance can be a matter of life and death. Securing the long-term financial security and quality of life for the people, you love the most, is crucial and the first step in securing it, is life insurance. Many individuals also look at life insurance from tax planning perspective. For selecting and purchasing that insurance policy which offers maximum tax saving is a very minor factor to consider. Rather the most important factor is to see the adequate protection provided by the policy. However, cash value policies are frequently advertised and sold as tax protected form of saving instruments. The protection is that, as long as the policy is in force, the interest earned on the cash value (savings portion) is tax-deferred.

Triple E principle of Life Insurance - In reality, life insurance follows the Triple E or Exempt-Exempt-Exempt principle when it comes to tax matters. It says that ;

insurance premiums paid are tax-exempt,

the profits earned on the policy are tax-exempt and

the sum assured paid out is also tax-exempt.

(The Triple E status of life insurance policies is afforded by Section 10 (10)(D) of the Income Tax Act).

Refer Chapter 17 (Income Tax Act, 1961) for important income tax deductions and computation of Income.

FACTORS TO CONSIDER WHILE BUYING LIFE INSURANCE

"Insurance is the subject-matter of solicitation".

Take a look at the wide variety of companies, both in the private sector and in the public sector who are offering their services to help you insure your life, your automobile, your home, your valuables, your family etc. But how does one sift through the real guys and the fake ones ? How does one make sure that one’s hard earned money does not line another man’s pockets but is actually making one’s family life comfortable even after one’s passing ?

"If you buy things you don’t need ,

one day you will have to sell things that you don’t need"

Quote of Warren Buffet

It’s never too early to plan for the future; especially if you consider the fact that the premium that you pay when you are young is usually lower than what it would be if you purchase the same policy later in life. In fact you should start saving systematically ever since you are a teenager and should plan your finances all through. Similar initiative has been taken by IDFC foundation to educate the youth of India to be financially independent through a movie which launched on 23rd Nov 2012 named ‘One idiot’. It says that it is very necessary to explain money management to the teenager neighbors in the society you live. Moreover, in the case of policies that double up as an investment vehicle, you benefit from the power of compounding if you begin investing early.

Anyone can avail the benefits of insurance at anytime. An unexpected illness or accident could give you a set back; early adulthood is also the good time to purchase medical insurance cover. The earlier you buy a health insurance plan, the more likely you will have a comprehensive cover. If you are young, single, working and unmarried, you can at an early stage of your professional life take up an insurance plan as explained earlier. If you get married, then post marriage, there is an added responsibility on your shoulders and as they grow, so do your insurance needs. At this point in time, it is very critical to be adequately insured. If working couple, your cash flow is still comfortable, so there is no better time to plan your life aims. At this point of time, goals can be classified as short term (holidays abroad or buying a car), medium-term (purchasing a house) or long-term (building a corpus for your retirement years).

Finally, you may be a few years away from your retirement, but post hanging up your boots and securing your children’s futures, if you plan on leading a comfortable life, again it is an insurance policy which will provide all the help. Hence, anytime in life it is important to :-

to purchase an adequate insurance plan that will help in giving access to the funds, without putting a strain on your cash flows.

protect your dependents. For example; parents against outstanding liabilities, such as a loan taken and/or credit card dues in the unfortunate event of your sudden, untimely demise.

protect your hard earned income against an accident or injury, sudden disability, illness etc., that could impair your earning capacity permanently or temporarily.

start planning for your retirement.

save and invest money for your children so that you can leave a legacy for them.

All this can be achieved by purchasing a right insurance plan at right time in life.

What to consider when choosing insurance ?

It is known that Indians have a fascination for purchasing insurance policies but though they love to buy insurance, they are not buying the insurance they really need. Many events in life propel one towards thinking about whether certain decisions were right or not. Some of the decisions may concern one’s state of finances. A lot of people invest their hard earned money in financial products of companies and banks recommended by friends, family or agents without understanding how it works. What is also common is the post investment stress and series of doubts about whether the investment has been the right step. In fact investors need to strike a balance between the risk cover and investment in their insurance portfolios. Most of the time, there is a skew towards an investment, it is generally seen that the insurance gets every time neglected. Every insurance policy is designed to serve a specific purpose. Some offer a large risk cover at a low price, others help in saving for specific goals or create wealth over the long term.

One does not need a financial planner to ascertain that an insurance policy is a must in any financial portfolio. This mitigates the risk associated with the loss of life or property, but, if one is entering into a long term contract spanning 10 years or more, one should be thinking a lot longer about where to put the money.

In a long term contract of say 10 years or more, it is difficult to make changes or amend the contracts in any way during the policy term. Hence, it is advisable that one spends a little time researching these products to ensure one does not have regrets later. It may not be possible to understand all the intricacies of a life insurance policy, but there are certain factors one can weigh in while choosing a plan.

Choose the type of your policy - There are various insurance plans that help fulfill your varied needs. There are policies that offer protection, fulfill your savings and investments needs, help meet your retirement goals and accord you those much needed tax benefits. You can choose a policy and budget that suits your needs and pocket the best service available. Also, when you buy a policy, you need to pay premium at a given frequency (usually every quarter, half yearly or every year) to keep it active. Make sure, you can comfortably service the premium payments, on the policy you select.

Purchasing insurance can be a rather difficult task. There are many different companies, options and prices to decide on. Finding the right insurance for you and your family doesn’t have to be a dreaded task. There are sites which can help you find, what you are looking for. Research the different companies as well as the coverage’s to ensure, you are getting what you need in your policy. Seek tips to help you with getting the right policy for the right price. Do not pay too much for a policy that will not give you the desired coverage you need, in the end. Be an informed consumer by knowing what you are getting into and what will work for you.

Invest as per your need - Your life goals and ambitions are what come into play when you decide how much to invest and where. Is it a comfortable retirement which you were looking for ? Do you need money for your child’s education abroad ? Or do you wish to buy a home some years down from now ? Assess your needs, as this will help you to select the right policy. The standard thumb rule is; one’s annual income, so that the dependents are not impacted financially in case something were to happen to the main breadwinner.

Any pre-existing medical complication or property loans, mortgages or outstanding should be taken into account while selecting the life cover. You need to create a corpus for your child’s education (there is a whole host of products from various insurance companies available today to ensure the funds that you had planned for your child’s education), irrespective of whether you are around or not. Know that insurance is a protection-cum-long-term investment and savings tool. Define your needs and work towards them. Buy policies that will help you realize your future end goals.

Compare and shop - There are a whole series of insurance plans suiting all kinds of budgets and profiles available today. Once you have zeroed on the policy of your choice, conduct a background check on the insurance provider. Many insurance companies have comprehensive information and disclosures on their websites and most information relating to the policy structure, customer service capabilities, scope of network, online platforms (in case someone wants to buy a policy online), are some of the aspects you should investigate.

Secondly, do some comparison shopping on your own. Many sites help compare various policies as well as their premiums. Use these facilities and choose the one that fits your budget, need and profile. You will find that different insurers in your area will offer different rating scales, discounts and premiums. Be sure and compare 3-5 different policies before you commit to an important, long term contract like insurance.

Make sure the company is licensed to do business - Make sure you do not get saddled by policies from ‘fake’ companies. This is very rare, but even licensed agents have been fooled into selling products from such ‘fake’ insurance companies. Check out the company you prefer thoroughly, speak to some their clientele, investigate them online and in person and then, transact with them.

Get an experienced and a licensed agent - The services of a qualified insurance professional are really what you pay for when buying insurance from an agent. Anything less, underestimates the value of your decision which could be painful, if you have an uncovered claim. Adding to the problem is yet another issue of license to practice. Make sure that your agent is duly licensed. This may sound obvious, but many stories have circulated about unlicensed agents selling fake policies. They collect an upfront coverage and then disappear. (Refer chapter 17 for more details)

You have to maintain an ongoing and active relationship with your agent. Not only will this great value but it will also provide you the necessary security for the risks you face today. You will need someone that can analyze all your possible risks and takes time to understand your needs, reviews the policy with you from time to time as things change with the risk. With changing circumstances, policies change and require adjustments to meet those risks, so as to provide the policy holder, the necessary security and peace of mind.

Know your policy - If you have selected your product, depending on your requirements and the track record of the company concerned, start getting to know your policy, specifically those aspects related to the policy term, premium-paying term, maturity date and charges. Familiarize yourself with the benefit structure of the policy. Every ULIP for instance, comes with a benefit illustration at 10% and 6%, which discloses the charges and what the status of your investment would be on a yearly basis.

These simple but the effective steps will put to rest some of your common concerns. Your policy will then be a source of relief and assurance in your life than otherwise; in case you have second thoughts about a policy after buying it, you can make use of the ‘free look’ facility, which allows you to return the policy to the insurance company within 15 days of buying it for refund.

Check fund performance - If it is a ULIP (Unit Linked Investment Plan) that you are looking at, know that this acts as an investment vehicle too. So do go and check the past history and the way the company and the fund have performed of late. Most insurance companies offer details of their funds’ performance, online. Investigate how stable and consistent this has been. A company with a good fund performance will have a consistent track record with the fund performance neither being erratic not extremely risky. Once this is checked out, you will know where best to park your money.

Investigate claim settlement services - Do you have toll free number to call if you suffer a car accident out of town? Can you check your claims status online? You certainly want to know how your claims will be handled before you need to file one. This is a critical factor to be considered when purchasing insurance. In fact many experts suggest that the claims settlement ratio of an insurance company should be taken into account when buying a product. However, this should not be worrisome if your policy forms have all the accurate information. Since the insurance segment in India is highly regulated, the probabilities of a rightful claim not being settled is absolutely rare. In fact, the average claim settlement ratio of the insurance sector is above 80% and most companies have healthy ratios.

Do not be casual about insurance - Taking up insurance without conducting a comprehensive risk and disaster study of each realized risk factor, be sure that really a disaster is waiting for you. For example; after the through medical check up, you adopt a healthy life style as a risk management strategy, to lessen the risk of the premature loss of your life. Similarly, you have to adopt a stringent route of exploring this asset fully before purchasing it. There are inherent problems with examining just the price while making a decision. You may find to your concern that at some time in the future when you are presented with a claim and expect everything to be covered, it may just be contrary to your expectations. That time you may feel that insurance is just a terrible concept. Insurance is not akin to a bubblegum which can be mindlessly bought off on some vending machine or at the click of the button over the Internet. Understand that while insurance cannot prevent death, it can assist with the possible financial aftermath of your death.

Other general tips - While you are warned to be cautious of sacrificing coverage to save money, sometimes it makes sense to raise your yearly deductible or forgo an option because the premiums are too high, but make sure you understand what you are signing up for.

While you are zeroing in on your preferred choice of insurers, do take a look at an insurance company’s financial ratings. The internet makes it very easy to research an insurer’s financial ratings to make sure your company will be around when you need them!

Clear up any concerns before you need to use your policy. If you are the sort that travels a lot, do not wait till the last minute to discover that you health insurance does not cover overseas medical services! If you need to have transportation every day and your car just happens to break down one morning, find out whether your car insurance policy will provide a rental car.

Hence, it should be well understood that, insurance is not just a commodity that you take down off the shelf and carry to the checkout counter for its payment. It is actually a lengthy contract, where every word contains some meaning, which has to be understood and absorbed properly, so that when need arises, it can made use of fully. For example; there are many times, when a person while purchasing an insurance policy, compares the insurance value on a structure, the liability limit and medical coverage but will never ask about when the component parts of the policy will kick in and provide coverage for the different areas at different points of time in their life or a much less look is given at the internal limits provided by the contract; the things that can really make a difference and vary from policy to policy. How then, is it possible for ordinary people to just walk up take down a policy from a shelf and be confident of what they bought? No wonder then, that there are guidelines to help you think this through and lead a well-planned life.

Insurance Mistakes

No Insurance

Not Enough Insurance

Too Much Insurance

"One rule of thumb dictates that multiplying your salary by a certain number will provide an adequate level of insurance while another calculates need based on normal living expenses."

Buying life insurance is a big step in life and once considered in the long term, it will likely be your biggest life investing later on purchasing a house and car. There are a lot of life insurance companies offering up different quotations, all claiming to have the best rates available, but just however do you separate the "weed" from the "chaff" as we say ?

A conventional saying, "Life insurance is sold not purchased."

In other words, some people are reluctant to discuss the importance of owning life insurance and others are simply unaware of the need to have life insurance. Do you have better investment alternatives for your investment funds than life insurance ? That is the decision you need to make when considering life insurance other than term life. Life insurance is an important component of a sound financial plan. Buying insurance involves asking a variety of personal lifestyle and financial questions. If you are not already working with an insurance professional, you may want to consider the advice of a fee-for-service financial planner who can offer you an objective review of your insurance options. Some important factors to be considered while buying life insurance (see exhibit 7).

Exhibit 7 : Factors to consider while buying Life Insurance

Step 1 : Determine if you need life insurance ?

If no one, such as a spouse or a child, depends on your income, then it’s pointless for you to insure yourself.

Life insurance is protection against lost income-no more, no less. Similarly, if you are well-off financially, your family may not need an influx of cash when you die.

Step 2 : Calculate how much coverage you’ll need ?

Determine how much your beneficiaries need to live on and for how long.

Losing a loved one is difficult emotionally and financially and many dependents will want a period in which they won’t have to worry about money.

While two years is the average cushion, some people may want to make sure their beneficiaries are set for life.

Calculate all expenses for the covered period, including big ticket items like college and mortgages, as well as living expenses like clothes and food. Then subtract the amount of money you think your beneficiaries will make from salaries and investments (remember, they may not go back to work right away). By subtracting all estimated expenses from the income that you estimate your beneficiaries will earn, you get a basic idea on how much insurance coverage you need.

Step 3 : choose what type of coverage best meets your needs ?

Insurance is a protection not an investment.

Think of insurance in terms of decreasing responsibility as you get older.

When you are younger and have kids and a mortgage, you need protection. As you get older, your kids have graduated and you likely have few or no payments left on your mortgage, so you need less protection.

Step 4 : Term Life Insurance is the simplest way to go

You pay the premium and are covered for a specific benefit for the period during which you want coverage. When you stop paying, you stop being covered.

Term is a much cheaper option in the long run, and you can invest the money you would have otherwise paid for whole life insurance in mutual funds.

Steps 5 : Universal Life Policies allow you to adjust your premiums as well as your death benefit.

Variable life lets you choose how to invest the policy’s cash value.

A portion of what you pay in premiums goes into a cash value, which could increase over time and can be redeemed before your death.

Unfortunately, the mortality expense of all cash value policies goes up significantly after age 60, so that you could be in the situation where your payment goes up drastically or your investment account used to pay your premiums quickly dries up.

If you dies with a large cash value balance, your beneficiary still gets only the face amount, not the face amount plus the cash value.

Step 6 : Whole Life Insurance has significant drawbacks.

First, the premiums are generally for more costly--especially in the early years of the policy, when you’re mostly paying commissions rather than building cash value.

Second, if you have to cash out the policy early, you may have to pay a surrender charge.

Step 7 : Check the Ratings.

Insurers run the gamut from shaky upstarts to household-name institutions. Most companies are rated for financial strength and claims paying ability by independent rating agencies. Ratings from A.M. Best, Moody’s, and Standard and Poor’s are the most often cited.

Still, one thing which makes us rest assured is about the financial health of an insurance company. Given the fact that, how highly regulated this sector is as a whole, all companies operating here need to maintain a solvency ratio to ensure that the customer does not suffer.

Points to Ponder

The first decision you must make when buying a life insurance policy is choosing a policy whose benefits and premiums most closely meet your needs and ability to pay.

Find a policy c is also a relatively good buy.

If you compare ‘surrender cost Indexes’ and ‘Net Payment Cost Indexes’ of similar competing policies, your chances of finding a relatively good buy will be better than if you do not shop.

Remember, look for policies c lower cost index numbers.

a good life insurance agent can help you to choose the amount of life insurance and kind of policy you want and will give you cost indexes so that you can make cost comparisons of similar policies.

don’t buy life insurance unless you intend to stick to it.

a policy that is a good buy when held for 20 years can be very costly if you quit during the early years of the policy.

if you surrender such a policy during the first few years, you may get little or nothing back and much of your premiums may have been used for company expenses.

Read your new policy carefully and ask the agent or company for an explanation of anything you do not understand.

Whatever you decide now, it in important to review you life insurance program every few years to keep up with the changes in your income and responsibilities.

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