We're back to Abacus and Sharma, who chatted about the EMI conundrum last week.
"I need some more help," said Sharma. "I'm getting hounded by calls for buying life insurance."
"Before we go there," said Abacus, "do you understand how car and home insurance works? You pay some premium every year, and if something goes wrong you get paid, but either ways the premium's gone. And you're fine with that. You insure your car or house against damage, so that you can replace their services without losing a lot of money."
"Yeah, so what is he getting at?" wondered Sharma
Reading his thoughts, Abacus continued: "You want to buy life insurance for yourself for the same reason. If you die, your family will be very sad, but since they're dependent on your income, how do they survive the rest of their life? It's not a difficult calculation. You said your home loan was covered under a separate insurance package, so let's leave that alone.
"Say you're 33 and you spend 50,000 rupees per month; add to it your annual holidays and extraordinary spends of about 2 lakhs a year, and you end up with annual expenses of 8 lakhs a year. If you die now and your family continues to have the same expenses at 6% inflation for the next 30 years, they will need 7.2 crores if they have no other income."
"Abacus, are you crazy? There is no way I can save 7.2 crores now."
"Dude, relax. When you have 6% inflation, the 7.2 crores of 30 years later is worth just 1.25 crores of today's money. Heck, that 50,000 you spend today will be equivalent to spending 46 lakhs then."
"Oh, okay," said Sharma, battered by numbers too large to fit the drink he was sipping.
"Now, if you insure your life, the money your family will receive is a 'corpus', along with your savings. That corpus will earn some return - say, 8% pre-tax - when invested in safe avenues. If you calculate the amount you need based on this return and the corpus going to zero, you'll need about 2 crores for your family to survive thirty years."
Abacus then told Sharma to download a calculator, enter Retirement as 0 years later, current expenses, current age and lifespan expected, and hit the 'Calculate Retirement Corpus' button. "Oh yes, you need to enable Macros. For your age of 33 and a lifespan of 30 years more, you are likely to see about 2 crores - that's what it came to for me."
"Two crores? Dude, for the kind of insurance they're selling me, I'll have to pay 20 lakhs of premium per year!"
"Come back to basics, Sharma. They're trying to sell you that ULIP voodoo, or insurance plans where you put premium and get the money back. If you buy a 'pure term' plan - a plan insurance agents generally don't want to sell you because it is, hold your breath, cheap - you pay substantially lower sums of money. But, like your car or home insurance, you don't get your premium back. Anything where your premium is returned is an investment. Let's not confuse insurance and investment.
"For your age, you should get term insurance for Rs 350 per lakh, so a 25-year, 2-crore policy will cost you Rs. 70,000 per year. That's about 6,000 per month.
"The premium is tax-deductible, but under section 80 C, where many other exemptions apply under a single 1 lakh limit, you may not fully benefit.
"Better still, buy four term policies of Rs 50 lakh each. As you save money, your savings go up so the insurance needs come down. So you simply stop paying one of the policies every time your savings go up by 50 lakhs. There is no "penalty" for stopping term policies, just stop making annual payments. Finito."
"That's so much cheaper than that agent mentioned on the phone. He said Rs. 50,000 a year, for a 5 lakh cover. You're saying 70,000 a year for 2 crores. What a revelation! Anyway, whatever I need to invest, I'll invest separately - why confuse the two concepts?"
"It might be useful to have both clubbed together if the costs were comparable. But these insurers charge hefty commissions on their investment products, and provide extremely low insurance covers for the amount paid. Yes, they ask you to think long term, but then why don't they think long term and spread the commissions through the product?" said Abacus, obviously miffed.
"Also," he continued, "buy from an insurer you know will pay out money - some insurers offer low premiums but when you check the claim statistics at www.irdaindia.org, you find that some of them reject a substantial number of claims. What you don't want is to buy cheap insurance, but the real cost is that your claim doesn't get paid to your family."
Abacus then told Sharma about two charts that demonstrate claim rejection statistics as of December 2009. (1, 2.) "Some of the outliers are new insurers but you still need some confidence in their claim paying history before you buy - if an insurer has rejected 50% of the claims they get, there's no point giving them your money. The established insurers such as LIC charge a lot more, but as you can see have a very low rejection ratio."
Sharma paused. "Good point. Oh wait. What you're also saying is - buying insurance for my kids, who have no dependents, is useless. Since they have no income, there's no point insuring them."
"That's correct. Insurance companies play on emotions, so you are made to think that you must plan for your children's future. That is investment, not insurance. And there are far cheaper avenues to invest than insurers, believe me. We'll do that talk another day."
"So, my parents shouldn't buy insurance either?"
"Technically, if they already have enough savings, the answer is no. But this is where it gets a little weird. You see in India, there is no tax on insurance money received, so older people buy insurance - although it's costly at their age - to transfer money to their heirs tax-free, and also to reduce hassles of validating a will. But that's just a regulatory loophole, and could get plugged anytime, so it's not without some risk.
"But again, pure insurance is plainly to defend against loss of future income. If there is no future income, there's no protection needed, so no life insurance. Still, you must buy them health insurance. Not only is that useful for them, you get a tax benefit on the premium too."
"Whoa. That is quite eye-opening! Why don't those agents tell me all of this?"
"Sharma, maybe you should try taking them out for a drink."