Dummy's guide to the basics of life insurance

A quick snapshot about the fundamentals of the concept of life insurance.

Illustration: Dominic Xavier/Rediff.com

The concept of life insurance still remains a mystery for a majority of Indians. Things are changing for the better now; with the growth of media channels and online news platforms, more and more people are becoming aware of the significance of life insurance.

What is life insurance?

As the self explanatory term suggests, life insurance covers the risk of life.

Life insurance policy is a contract between the insured person and the life insurance company to provide a pre-determined sum of insurance to the nominee/s in case of death of the policy holder/insured.

The insured amount should be sufficient to replace the income of policy holder. However, there is no compulsion to equate one’s income to the sum insured under the policy.

How much insurance should you buy?

Majority of the times, life insurance policy holders are not able to determine the exact amount of insurance coverage that they require.

As a thumb rule, the amount of insurance should be 8-10 times of the annual income of the policy holder.

For instance, if one’s income is Rs 4 lakh a year, then the amount of insurance coverage should be in the range of Rs 35-40 lakh or more. This way, in case of the death of the policy holder, her/his dependents can invest the insurance amount in government securities or bank fixed deposits, and earn interest income.

The income derived from interest can thus replace the income of the policy holder in case of her/his demise.

However, keeping in mind the average rate of inflation at 5-6 per cent, the amount of insurance should be higher than 10 times an individual’s annual income.

The income from the insured amount should support policy holder’s nominees, and may be utilised for education, marriage and other necessary expenditure. The purpose is to ensure financial security for the people who depend on the income of policy holder.

Types of life insurance

In India, life insurance policies are broadly available in five types. Here is an overview of all of them.

Term insurance

Under this type of insurance policy, one is expected to pay premium amount against consideration of a certain insurance coverage. The amount of premium is treated as expenditure as a term insurance plan does not give any returns or money back.

Term insurance plans can be taken for a period ranging from 5 to 30 years.

After the reforms in the insurance sector in India, the premium rates for term insurance plans have gone low.

Endowment policy

Under an endowment policy, the policy holder receives whole of her/his money paid as premium amount back after expiry of a pre-determined policy period.

In case of death of policy holder, his or her nominee receives the full sum insured under the plan. These kinds of policies are typical and generate returns in the range of 4-7 per cent.

They are suitable for people who do not want to take many risks and look for secured investments in government securities and debt instruments.

Unit Linked Insurance Plan (ULIPs)

As the term suggests, Unit Linked Insurance Plans (ULIPs) are purchased in units. The price per unit is announced by an insurance company as per the Net Asset Value (NAV), which is declared every day.

ULIPs provide the dual benefit of life insurance and investment. The amount of premium paid towards a life insurance plan is investment in equity markets, which work on the principle of risk and rewards.

These types of policies generate better returns as compared to other types of plans, in the long term.

Group insurance policy

Such policies are taken for a group of people. Generally, organisations provide group insurance policy benefits to their employees.

It depends on a company whether or not it charges employees to contribute towards group insurance scheme. Governments also provide group insurance schemes to citizens.

Are there any additional benefits also?

In India, there are hardly any public social security schemes for people. Thus, one has to organise financial security from his or her own resources. The sum assured from the recently launched government insurance schemes are fine but not sufficient enough in most cases.

Perhaps, the government also knows that it is not doing enough for its citizens. Thus, there are some great incentives at one’s disposal when it comes to buying life insurance.

• Income tax benefits are offered to those who buy insurance.
• An investment of up to Rs 1.50 lakh in life insurance is eligible for claiming tax exemption under section 80C of the Income Tax Act 2000.
• Until the end of fiscal year 2013-14, this limit of income tax exemption was Rs 1 lakh. This limit was raised by Rs 50,000 during the Union Budget provisions for fiscal year 2014-15.
• With the upcoming budget of 2017, this limit is expected to go up further.
• If you are investing large amount, you can consider buying more than one plan for yourself from 2-3 different companies. This can provide you benefits of diversification.

Overall, by buying a life insurance product, one can ensure peace of mind and get the satisfaction of discharging her/his duties towards her/his dependent family members.

Naval Goel is CEO and Founder, PolicyX.com