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Term life insurance: what, why, how much to get and from where?


02 Jun 2021 - Contact Sayan Sircar
19 mins read

Term insurance gives your dependents necessary financial support in your absence.

Term life insurance: what, why, how much to get and from where?

Term insurance is the most specific insurance policy: you pay the premium every year. If you die, the nominee gets money, and if you do not die, they don’t. The money you pay to the insurance company is the premium. The money that the nominee(s) gets is called sum assured.

Insurance allows risk transfer from a single person to a group of people. Since many people buy insurance, very few of them are expected to die within the time of coverage of the policy. It should be present at least for all earning members of the family before retirement age.

Term insurance is a critical part of everything you need to do before investing in your goals. Read more here: As someone who has heard about goal-based investing, how do I get started?.

Table of Contents

What is term insurance

Term insurance covers the unexpected death of the insured due to any cause as long as the insurance cover exists. This way:

  • daily expenses are not affected
  • future goals like children’s education and retirement for the spouse can be covered
  • you can pay off loans taken like home loans or higher education

Term insurance is like car insurance. You take it in case your car is damaged; or, alternatively keep a security guard to watch your house when you are away; or have a backup parachute when skydiving. Most people will be never get their car totalled, house burgled or main parachute fail. But when that unfortunate event does happen the will be very happy to have that safety net.

Term insurance works in the same way. It pays nothing if you don’t die. It pays a lot, compared to the premium, when you do. A 1 crore term plan costs 10-15k/year depending on age. Ideal insurance coverage is around 20 times annual after tax income, depending on time left up to retirement. We show the calculation method in this article. Every other insurance policy mixes a term plan with a savings component because it knows people cannot digest the “pays nothing if you don’t die” part, and also conveniently suppresses that the savings component is either paltry (you can get more from an FD or PPF) or market linked/uncertain which you can simply get by investing outside the insurance plan.

Who should buy term insurance

  • anyone with dependents: to secure the financial future of the dependents
  • anyone with a large secured loan. This ensures that the asset (like a home in case of a home loan) is not repossessed by the bank in case the person dies. Term insurance is an absolute must if you are stretching to buy your dream home?
  • anyone who does something expensive to replace: this is an example of key-man insurance. For example, a non-working spouse may be performing home and childcare activities that are expensive to replace by hiring housekeepers, tutors, and starting daycare

Why is this needed

Term insurance offers:

  • Protection against loss of income
  • A large sum assured at the lowest cost
  • Peace of mind for the earning member
  • Safety net for the financial situation for dependents (children, spouse, parents, siblings)
  • A contract that is easy to enter (online purchase possible)
  • Tax benefit under section 80C (please always check Income tax law changes before claiming benefit)
  • Covered under strict regulations from IRDA that all insurers must follow

How much term insurance do you need

As a thumb rule, typically, coverage will be 15-25x current annual income after tax.

There are two ways of calculating insurance coverage/sum assured needed. The coverage required typically changes every few years since financial goals and life events (like marriage, the birth of child etc. happen) change the requirement. Please review the term coverage needed every 3-4 years. The method of calculation of coverage required is called Human Life Value (HLV) method.

What should be the policy duration

Term insurance protects income so that daily expenses and goals are not affected. It would be best if you only took term insurance as long as you have income, i.e. up to retirement (typically 58-60). This is because plans until age 70 or 80 are more expensive than plans up to age 60. If invested for 30-40 years, the difference can create a corpus higher than the sum assured of the term policy.

If you are planning to take accelerated premium plan (either single period or typical 10 years reduced period payment plan) please note that

  • it is highly beneficial for the insurer to get money from you earlier than later
  • if you retire early or have paid off your goals, then term insurance is not needed. But if you have already paid all the premiums, that is money wasted for a policy that is not needed
  • for a single premium plan, check if it is cheaper to buy a gilt bond and use the coupon to pay the premium
  • simulate reduced payment period plan, take the full period payment plan (say up to retirement, 30 years) and invest the difference of the reduced period (say 10 years) and full period premiums in a money market debt fund for 10 years. After 10 years, start paying the premium from the money market debt fund.

An example below to clarify the last point:

  • full period payment premium is ₹22,000 until age 60 for 30 years payment
  • reduced period payment is ₹48,000 until age 40 for 10 years payment
  • take the first option and pay ₹22,000 per year for 10 years and also invest ₹48-22 = ₹26,000 in a money market fund for 10 years at around 4% post tax return
  • after 10 years, start paying the ₹22,000 premium from the corpus accumulated from the money market fund for the following 20 years

Term Insurance extrea premium invested

HLV Income method

Use a tool like Excel or Google Sheets to calculate using the following formula:

Coverage needed = PV(RealRate,Years_to_retire,-AfterTaxAnnualIncome,0,1)

Explanation:

  • The real rate depends on the industry and salary growth potential vs inflation in the country. A value like 0-2% can be assumed. If the real rate is assumed to be 0%, then the coverage amount is simply Income multiplied by Years_to_retire
  • Years_to_retire indicates how much time is left until retirement, typically from today to 55-60
  • AfterTaxAnnualIncome is simply the in-hand salary (plus components of EPF) that are received every year

Example:

Someone currently 32 years old in a high growth industry expecting to retire at 55 and having an after-tax annual income of 20 lakhs needs coverage of: PV(2%,55-32,-20,0,1) = 3.7cr.

If they already have a 1cr term plan, then you should take additional 2.7-3cr coverage.

Here are some lookup tables that can help you:

Case 1: Real rate = 0%

(click to open in a new tab)
Term insurance coverage amount in lakhs via HLV Income method: real rate = 0%

Case 2: Real rate = 1%

(click to open in a new tab)
Term insurance coverage amount in lakhs via HLV Income method: real rate = 1%

Case 3: Real rate = 2%

(click to open in a new tab)
Term insurance coverage amount in lakhs via HLV Income method: real rate = 2%

HLV Expense method

Coverage needed = PV(Real_Rate_In_Retirement,Years_In_Retirement,-Current_Annual_Expenses,0,1) + LoansOutstanding - Current_Investments - Existing_Term_Insurance where

Current_Annual_Expenses =

Salary credited in bank minus personal needs of the person being insured minus any EMI being paid minus any insurance premiums being paid

Example: (using the exact figures from above)

If spouse spends 30 years in retirement where the real rate of return is 0% (a reasonable assumption), 33 lakhs in home loan outstanding, 80 lakhs in investments (stocks/mutual funds/FD etc. but not house) having 1cr current term insurance will need

Current_Annual_Expenses =

In hand salary less personal needs of the person being insured (20 lakhs salary less two lakhs personal expenses) less any EMI being paid (25k/month, i.e. three lakhs/year for a home loan) less any insurance premiums being paid (11k/year for 1cr term plan)

= (20-2) - 3 - 0.11 = 14.89 lakhs.

Coverage needed = PV(0%,30,-14.89,0,1) + 0.33 - 0.80 - 1.00

= 4.47 + 0.33 - 0.80 - 1.0

= 3cr


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Minimum term insurance coverage amount

Goal-based investing planner

If you are using the comprehensive Excel-based goal planner then you will see the minimum term insurance you need to have based on:

  • the shortfall of current goals. If income stops, this amount, if invested, will fund current goals
  • the amount needed to sustain a retirement level lifestyle, including inflation adjustment, for the period income was expected to be there

This figure is the minimum since you need to add any ongoing outstanding secured loans (like home/car loan) or loans where family members may be coborrowers to this coverage amount. This means that if you have a 30 lakhs in outstanding home/car loan or an educational loan of 10 lakhs with parents as coborrowers, add those amounts to the term insurance coverage.

Do you need separate insurance

If you are already having a policy from your company, you should still take a term policy of your own because:

  • you might lose your job and the policy will lapse before you join another if there is a gap
  • you may not have enough coverage as per your needs from the corporate plan
  • the premiums will increase if you delay due to age or lifestyle diseases

How to buy a term policy

Step 1: Calculate coverage

Use the HLV method above to calculate how much you need. In both ways, a similar result came in the example (new 3cr policy required). However, the different methods require different assumptions (inflation, salary growth, time in retirement etc.). Therefore, the result is only good as the assumptions being made. You can choose whichever method you are comfortable estimating. If you select both, take the policy with higher calculated coverage since the premium difference will be small.

Insurance coverage changing with time

Your coverage amount will change over time: How your term insurance coverage changes with time

Step 2: Compare rates online

  • Many insurance portals offer quotes. These are effectively brokers, so the quotes and choices are based on their commission. But they may also provide support on documentation both before purchase and in claim settlement
  • Cross-check rates from the insurance company site

Step 3: Policy features

  • Ignore all riders like critical illness, accidental death etc
  • Choose annual premium (once a year premium)
  • Choose policy duration less than or equal to the expected retirement age (say 55-60 years). Do not choose coverage up to 70-100 years or more

Riders make the claim process complicated and may cause issues in claim processing by giving the insurance company more to investigate. You can take such riders separately from a general insurance company.

The annual premium is generally the cheapest compared to monthly/quarterly.

The duration of the policy should be no more or no less than the typical retirement age. The extra premium is wasted for longer durations since there is no income to protect. The money will earn more if invested as part of long-term goals.

Some policies offer shorter premium payment periods at much higher rates. This can be a single premium (which can be very high) or accelerated - high premium for 7-8 years and nothing afterwards. Choose this if and only if there is a chance of not paying all the premiums throughout the period. If regular income is available, the difference between accelerated and average premium can be invested for long-term goals.

Step 4: Choice of insurer

There are multiple insurers in India offering term insurance. The Life Insurance Corporation (LIC) is well known, and there are many more private insurers. The standard advice here is to

  • choose the insurer you are most comfortable with
  • choose the cheapest premium option without additional riders
  • research regarding customer service of these companies on social media and other sites

Some FAQs/myths on insurer choice and overall term insurance as a product are covered below.

You might be interested to read my personal experience with the LIC’s new Tech term online term plan here: My experience with the LIC Tech Term life insurance policy

Step 5: Fill the form carefully

  • Disclose all material facts like financial status, nature of the job, existing policies, medical conditions (no matter how big or small or old) honestly, including smoking and alcohol habits
  • Complete medical tests (do not agree on tele-medicals: this may cause issues with claim settlement)
  • Choose nominee(s): this is the whole point of taking insurance
  • Pay the premium and go for medical tests
  • The policy will be issued in some time after the tests are done

Misrepresentation of facts at this stage may cause claim rejection later.

Warning: Do not sign a blank Medical Examination Report (MER) Form or any other blank form and give it to the insurance agent for submission. If a wrong entry gets made in the form, the premium may get hiked or the proposal rejected.

Step 6: Set up a sinking fund to pay the premium annually

The annual premium is the cheapest compared to monthly/quarterly. If the annual premium is too high to be paid in a single month, use a sinking fund: see this detailed post to save the premium monthly and pay once a year.

Monthly/quarterly premium payment (apart from higher premium) may lead to operational issues due to payment failures that can cause the policy to lapse.

FAQs/myths on term insurance

Should I take the MWP option for term insurance?

The Married Women’s Property Act 1874 (MWP Act) ensures that upon the husband’s death, the insurance proceeds only goes to the wife/children (if the wife/children are nominees) and not to any creditor in case loans are outstanding in the husband’s name. A wife can also take a policy in her name and invoke the MWP option to ensure her children (if they are the nominee) get the proceeds instead of any creditors.

You must avail of the MWP option at the time of buying the policy, and it cannot be opted in once the policy has been issued. Opting into the MWP option does not change anything else in the policy terms.

If I do not die, then the premium is lost?

Term plan has the cheapest premium for a given level of coverage. Any return of premium plan (or investment plan like endowment, whole life etc.) has a higher premium but low returns (comparable to FD at best). Instead, a combination of term plan and investment in PPF, stocks and debt mutual funds for long term goals is expected to beat the return offered by all return of premium or mixed plans.

Example:

Term plan for 30y for 1cr coverage is available for 15k while a return of premium plan costs 30k.

Option 1: Term plan for 15k and another 15k invested yearly at average 10% say grows to 27 lakhs (use any SIP calculator to check). Even if you invest that 15k using after-tax money (10,500/year after paying 30% tax and then pay 15% tax say investments after 30 years, the pre-tax amount of a 10.5k/year, 30y SIP at 10% average becomes 19 lakhs pre-tax and 16 lakhs post-tax.

Option 2: Term plan with return of premium for 30k over 30 years will give back 30k times 30, i.e. nine lakhs which is a lot lesser than the previous option.

So don’t believe for a second that there is a loss in taking a simple term plan. Another way of looking at a term plan is by comparing it with vehicle insurance. If there is no accident, the premium is “gone” if there is one, then you will be relieved that you had the insurance coverage.

Do private insurers have high claim rejection?

Claim settlement ratio (CSR) is the percentage of life insurance claims an insurer has settled in a year vs the claims it receives in the period, including pending claims from last year. The definition of “settled” includes claims not paid out as well. So, in theory, a company can pay zero rupees in claims and still have 100% CSR.

CSR data is surprising since LIC (supposed to be the best in claims) does not have the best CSR. CSR depends on the individual claim (whether disclosures were correctly made or not and many other factors). See this snippet from IRDA 2019-20 annual report where LIC has 96.69% CSR:

IRDA Annual Report 2019-20

As per Section 45, Insurance laws of 2015 claims cannot be rejected past three years from the date of policy issuance. Also, as per regulations issued in 2017 all claims would need to be paid out in a maximum of 120 days. Please read both these documents in detail.

Private insurers may shut down

In such a case, the policy will be taken over by other insurance companies. The original company cannot simply shut down without a merger with another. As per IRDA laws, the insurer must have a solvency ratio of 1.5, i.e. they must keep 150 rupees of reserves for every 100 of coverage issued. Ultimately the choice of issuer depends on your comfort level with the company.

Who does not need term insurance?

Someone with good savings or government pensions / stable passive income may consider term insurance unnecessary. However, please consider taking term insurance if at least one of the following is true:

  • long term goals like retirement and children’s education are not yet funded
  • one spouse is not working
  • there are outstanding loans
  • significant expenses are coming: e.g. supporting a child through college
  • the family will face hardship if one income is not there

This topic is discussed in more detail here:

You do not need term insurance if

Policy issuance date and tax benefit

The premium (including GST) that you pay for term insurance is eligible for deduction under Section 80C under old tax regime thereby saving tax: How to plan tax deductions for salaried income?. If the premium is ₹15,000 with GST per year, you save around ₹4,500/year in taxes at the 30% tax bracket.

If you are buying the policy near the end of the financial year (FY) in March keep in mind that:

  • under normal circumstances, the date you paid the first premium will be considered for determining the FY for tax deduction
  • if there is a premium increase after the medical test, then the day you accept the higher premium (which might take a few weeks if it is LIC), then that day will be considered for determining FY for tax purpose

Insurance for the spouse without income

If you have a non-working spouse, you can use the expense method to calculate the coverage needed: typically use expenditures like home and childcare (if applicable). Some insurers may offer limited or single premium plans in such cases. This is often missed during financial planning for the family. There are nowadays joint term plans and “Saral Jeevan” plans that cover a non-working spouse.

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This post titled Term life insurance: what, why, how much to get and from where? first appeared on 02 Jun 2021 at https://arthgyaan.com


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