To be insured is an important and vital requirement to manage financial risks. And therefore, all of us might be insured to some extent in some or the other way. It is essential to be able to measure the amount of our insurance needs, so that we can be correctly insured.
Categories of Plans
It is important to keep in mind that Insurance is not an investment. It is a cost which we pay to mitigate financial risks. Generally, there are two categories of products viz Term plan and Endowment Plans. Term Insurance provides cover without any benefits on maturity. Endowment plans offer insurance along with maturity benefits. Endowment schemes club insurance with investment. Buying these means we are actually buying an investment product along with risk cover at the same time. We should therefore be able to analyze the insurance part, as well as the investment returns portion for their suitability.
Who Needs Insurance ?
We need to understand that Life insurance is not a lifelong requirement. One needs to be insured only when there is some dependent who could face financial distress in the event of any unforeseen happening. The earliest this can happen in life is probably when one marries and the spouse is not working. The requirement will increase with addition of children and then start to decline towards retirement phase, eventually becoming zero. Most of us have standard liabilities like education, house and marriage of children. Factoring the retirement benefits and pension, the present cover of group insurance schemes might be adequate. The money being spent on surplus risk cover can be better utilized to grow your net worth.
Measuring the Requirement
In simple words it is the financial shortfall/risk that the dependents would face in case of any unforeseen contingency which affects the earning potential of the bread winner. Calculate the sum total of the liabilities, both one time and recurring; factor your Net Worth, inheritance, the regular income in the form of pensions, and existing insurance. The difference is the additional insurance requirement.
Sample calculation of Insurance requirement
Which One is Better-Endowment or Term Insurance
When taking an Endowment plan-whichrisk cover and investment, one needs to analyze both the insurance and investment part. It would be interesting to note that such plans are far short of the complete risk cover requirement. The the returns from investment are also far less than simple risk free returns. One should not fall for the appealing cashflows overtime and possible corpus at the end of the plan. You must convert the projected cashflows into annualized returns for correct assessment. The Internal Rate of Return (IRR) of these schemes would generally be less than risk free returns. Or, almost equal to them with a long lock in period. Another big disadvantage is that once committed, exiting midway has significant costs. This is why the agents offer attractive gifts/cashbacks on first instalment.
The monthly instalments restrict your capability to invest in growth instruments. You are gen doomed if you exit, and doomed if you don’t. Once we are in the trap, we try to find solace with whatever one is getting. Nevertheless, at any stage, one should compare the cost of continuing or exiting. And, one should not hesitate to exit if that works out to be beneficial. Term plan on the other hand gives only Insurance to the extent required at much less cost. WE must review the scheme every year as per change in liabilities.
Recommendations
(a) Evaluate the exact financial risk and buy a Term Plan which should be revised periodically.
(b) Buy Insurance only when there are dependents who could face financial risk.
(c) Insure only the earning member and not the dependents. Buy risk cover only till such time as they remain dependents.
(d) No need to buy insurance if your Net Worth is adequate to meet all future liabilities.
(e) Evaluate the cost of continuing/exiting any running Endowment Plan. And do not hesitate to exit midway for a more beneficial option.