It is now accepted that buying insurance isa must as your need to cover your risk. When you plan for the long term you need insurance as you cannot allow sudden disruptions to impact your long term goals.When it comes to buying insurance there are a variety of products that are available in the market. But, conceptually insurance can be classified into two broad categories. Let us understand this classification in greater detail..
Endowments versus term insurance policies..
Broad there are two kinds of insurance policies.There is the plain vanilla term policy where you get a pure life cover with a much higher sum assured and a much lower premium. The premium paid on a term insurance policy is a sunk cost. Each year for the premium you pay on your term policy you get a life cover. At the end of that year the premium thus paid becomes a sunk cost and it is time to pay the next premium. Endowment plans, on the other hand, require you to pay a premium that includes a risk cover component and also an investment component. Unlike a term policy, the holder of an endowment policy will get some value even if he survives the entire term of the insurance. On the other hand, if you survive the tenure of a term policy then you do not get anything on hand. A term policy will pay the sum assured to your family only in the event of your death.
Why have endowments been traditionally preferred?
It is therefore interesting to understand why a lot of Indians traditionally preferred endowments over term policies, although that trend is gradually changing. Firstly, insurance has been sold in India and has never really been bought. The typical LIC agent was either your neighbour or your friendly chartered accountant who also doubled up as insurance agent.Some 20 years back, the equity cult had not spread across India in a big way and mutual funds were just about trying to make their mark. Hence endowments were the only insurance policies that these agents would peddle to customers.Secondly, with limited investment opportunities available in the market, most investors looked at insurance as a source of risk cover and investment. That explains the popularity of endowments over term policies.
Why you should ideally prefer term plans over endowments..
While the trend is shifting towards term policies, especially among the younger people, it is essential to understand why term policies score over endowments policies as a risk management product.Firstly, one of the basic tenets of financial planning is to keep your investments and insurance separate. Insurance should be seen purely as a risk management exercise and nothing else. Secondly, a term policy will be beneficial to you whichever way you look at it. Since term policies are pure risk covers, you can get a substantially higher risk cover for a much lower premium. Thirdly, in the past Indians used to under-insure them. Now people are realizing that your insurance cover needs to be at least 7-10 times your annual income so that your family does not have to worry in your absence. That kind of risk cover is only possible through term policies. Endowments will be too prohibitive.
Insurance is OK, but then what about investment?
The standard refrain to the term policy argument is that you are losing out on the investment play. Endowments offer you participation in growth through bonus and also have a residual value if you survive. Endowments can also be surrendered or borrowed against, in case liquidity is required. How do term policies replicate that? The answer is that you can use the money saved by the term policy to create a monthly SIP on a diversified equity fund. Let us simulate what the results will be in case we substitute our endowments policies with a combination of a term policy and a mutual fund SIP..
Term Plan + MF SIP
Age at starting
Age at starting
Age at ending
Age at ending
Nature of policy held
LIC Jeevan Anand
Term + MF SIP
Diversified Equity Fund
Tenure of Holding
Tenure of Holding
Monthly Term Outflow
Monthly MF SIP
The above live simulated table gives you a clear picture of the relative merits of the strategy. In the first case, the investor buys 15 year endowment policy at the age of 30 thinking that both his insurance and investment needs will be covered. During the period of the endowment, he pays a monthly premium of Rs.6600 and gets an insurance cover of Rs.10,00,000.At the end of the 15 year period, this amount has grown to Rs.21,00,000including bonuses.
On the other hand he would have been better off if he had chosen the second option. By combining a term plan and an MF SIP, his monthly outflow would still have been Rs.6600 only. But he would have paid Rs.600 towards his term plan premium and Rs.6000 towards his MF SIP. The term plan will give him a life cover of Rs.50,00,000, which will be valid for 15years. At the end of the 15 year period he receives nothing on the term policy but his MF SIP is worth Rs.57.27 lakhs. So clearly by combining a term policy and an MF SIP, he is benefitting in the form of higher risk coverage (almost 5times) as well as the eventual wealth accumulation (almost 3 times). The choice is quite obvious!
There are other costs to an endowment policy like upfront costs and loads which are not entirely known. If you add these up, then the combination us surely a much better bet!