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Before you start investing to meet a life goal, you should create what we call ‘protective assets’. This refers to a portfolio with instruments meant to help you protect your family’s existing standard of living.
An important component of protective assets is life insurance contracts. In this article, we discuss certain issues relating to life insurance, including whether you should buy such protection and, if so, how much.
Indemnifying loss
Insurance helps you recover a loss; you should not consider it as an investment. In the case of life insurance, a family is protected from loss of income due to the death of an earning member. Therefore, life insurance is a hedge for the family against the mortality risk of an earning member. So, a family that will suffer a decline in standard of living due to the demise of an earning member requires life insurance. This will be the case for families where the earning member is a salaried employee or a professional such as a lawyer or a chartered accountant. In some cases, life insurance may not be required.
This is true typically for business families, as the business and the family income will continue even after the demise of the person managing the business.
What kind of insurance should you buy? Insurance is quite unlike an investment product. If you redeem your units in an equity mutual fund, you will salvage some value even if the market tanks. But in the case of life insurance, if the person whose life is insured is alive at the end of the contract period, the insurance company will not pay at all!
This drives many individuals to buy insurance with survival benefits. However, you should not buy such plans.
The premium on term insurance policies is significantly lower than that on with-profit or survival benefit plans for a sum insured. The premium on a term insurance plan is Rs. 20,000 per year for a sum insured of Rs. 1 crore, while the premium on a with-profit plan is Rs. 1 lakh per year.
You should consider buying the term insurance and investing the premium-differential of Rs. 80,000 in an equity mutual fund. The returns you will generate will be typically higher.
Life goals
How much insurance protection should you buy? The insurance company will typically decide how much protection it can offer you based on your premium-paying capacity. But your objective is to provide your family with existing comforts even after your demise. So, if you have a large outstanding loan including a home loan, ensure your life insurance covers for the loan repayment.
This is important because your demise will not only leave the family with loss of income, but will compound the issue with the need to continually gather cash flows to repay the loan.
Your insurance should also cover the cost of education of your children. And of course, it should cover the existing lifestyle expenses of your family. Lastly, purchase your protection from an insurance company that settles its claims in full without much hassle, and not necessarily from a company whose plan is cheap.
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