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Neeraj and Ayan, good friends and employees of an IT major participated in a financial planning survey.  Neeraj has two traditional life insurance policies and ULIP. The total sum assured of the three policies was Rs 40 lakhs.

Like many of us, he had invested substantially in life insurance products but his total sum assured was very less to financially protect his family in case of his untimely demise. On the other hand, Ayan had been smart enough to keep his family’s protection needs and investment needs separate. He had insured himself with a term life insurance policy of Rs 1 crore. For the investment portion, he had a ULIP, PPF and a mix of debt and equity mutual funds.

Ayan was confident of being lauded by the surveyor for his financial prudence. However, to his dismay, the results of the survey showed that both of them were underinsured. Ayan already had a term policy of Rs 1 crore. Then could he still be underinsured?

To understand the logic behind the surveyor’s observations, we need to revisit the meaning of the term life insurance.

What is Life Insurance?

The purpose of life insurance is to provide financial assistance to the dependents of the life insured in case he meets with an untimely death. It aims to provide the amount that will be sufficient for the dependents to live the life that they would have led and accomplished various goals (higher education of kids, their marriage, spouse’s old age requirements, discharging outstanding liabilities, etc) as would have been the case if the breadwinner was surviving and earning. This kind of replication is possible only if the life insurance coverage amount (sum assured) has been chosen carefully considering the various liabilities and goals.

The easiest and simplest way to do this is by keeping life insurance (protection) and savings/investment needs separate. Most of us make folly of choosing bundled life insurance products i.e plans providing insurance and savings under a single umbrella. Such plans work best from long-term savings perspective but usually offer inadequate insurance coverage.

So, most financial experts suggest that for pure insurance needs it is best to choose a term plan. With a term plan, one can get high insurance coverage at nominal premium rates. However, only buying a term plan will not suffice, what matters is choosing the right sum assured amount else you run the risk of being underinsured. 

Also Read:- Assignment vs Nomination in Life Insurance

What is Underinsurance?

Buying a life insurance cover which is inadequate to provide financial security to your family’s future needs is referred to as being underinsured. It is akin to providing for only some of their needs and thus defeats the very purpose of Life Insurance.

Reasons Why People Buy Insurance Plans Which Provide Insufficient Insurance Coverage:

  1. Life insurance sales see a massive surge in the last quarter of the financial year as people tend to buy policies for tax benefits. Hurried decisions are taken, the coverage amount is the last thing that we may think of. We just look at the premium amount that is required for tax purposes and accordingly the coverage amount is arrived at (the sum assured is largely dependent on the premium amount). 
  2. Not being aware of term plans or not being comfortable with the idea of not receiving any amount if the life insured survives the tenure of the policy, some people may choose ULIPs or endowment plans for big coverage amounts thereby pushing up the premium significantly. This makes it difficult to pay the premium year on year. They may just stop paying premiums after a few years or make the policy paid-up which reduces the sum insured amount.
  3. Insurance advisors would tend to suggest products that offer lucrative commissions. As pure term plans offer lesser incentives than endowment plans, ULIPs, etc they may push these products which offer inadequate insurance coverage to the novice buyer.

Thanks to the reach of the internet and awareness campaigns by media and life insurance companies, more people are buying life insurance to safeguard their family’s future. However, unfortunately, many people do not realize in their life that they are underinsured. It is often the loved ones who realize this belatedly as they struggle with their various needs and liabilities when the breadwinner/life insured is no longer around. Hence, we need to review today whether we are adequately insured or not.

What Is The Right Life Insurance Coverage Amount?

There are different methods used for this calculation:

A common approach is to opt for an amount that is 8-10 times your annual income. Another option is to choose the sum assured as per your life stage. For eg: If you happen to be less than 40 years of age, a term plan with a life cover of approximately 20 times your annual income should be considered, if you happen to be in your 40s then a life cover of 10-20 times the annual income bodes well and if you are more than 50 years of age, then probably a life cover of 5-10 times the annual income could be opted. An expense-based approach recommends that the life insurance cover be 10-15 times the amount of the dependents’ annual expenses.

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However, every person’s liabilities, the current state of investments, future goals, etc are unique and all of the above approaches do not consider these whereas to arrive at a realistic life cover amount that can do justice to your family these important aspects need to be considered and provided for.

Points to be considered when calculating your coverage amount:

  1. What happens to the outstanding home loan if the person servicing it suddenly dies? Well in such a case the lender would ask for the outstanding loan to be settled immediately. In Ayan’s example, though he has a life insurance policy for Rs 1 crore, his outstanding home loan stands at Rs 55 lakhs. Should he meet with an untimely demise as on date, after settling the loan, his family will be left with only Rs 45 lakhs to meet their needs. This point needs to be considered by all who are paying the home loan EMIs.
  2. Inflation also needs to be factored in while calculating the life insurance coverage amount. Rs 1 crore may appear like a huge amount as of today. It may seem more than sufficient to meet your family’s future needs. But, assuming a constant rate of inflation of 7%, after 15 years the value of Rs 1 crore would come down to Rs 36.24 lakh. If the inflation rate were to increase to 10% or more in these years, the value would go down further.
  3. Inflation also needs to be factored in while calculating the life insurance coverage amount. Rs 1 crore may appear like a huge amount as of today. It may seem more than sufficient to meet your family’s future needs. But, assuming a constant rate of inflation of 7%, after 15 years the value of Rs 1 crore would come down to Rs 36.24 lakh. If the inflation rate were to increase to 10% or more in these years, the value would go down further.

It is a normal practice to review the performance of our various investments and take necessary steps if so required to correct any anomalies. Similarly, it is a prudent practice to periodically review our life insurance status and increase our coverage if the situation so demands. Milestone events such as marriage, the birth of a child, etc are times where a review of life insurance coverage is important as the financial responsibilities go up after these events. Many insurance policies have taken care of this and have an in-built feature to increase the sum assured at periodic intervals.

Life Insurance Article:- Whole Life Insurance: Everything You Need to Know

The table provided below (taken from ET wealth dated July 23, 2018) helps to arrive at an optimum life insurance coverage amount. Various online calculators help in this calculation.

*Policyholder’s expenses are assumed to be 20% of the household expenses and are to be deducted
**Does not include the place of residence as it cannot be liquidated to meet the family’s needs.

Conclusion

Our responsibility is not to just to buy life insurance. It is to buy adequate and sufficient life insurance coverage. Only then can our family members meet the various goals and live comfortably in our absence. 

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Sindu Ramankutty has 10 years of Life Insurance Operations and Customer Service experience. She has worked with two leading private life insurers. She has a PGDBM (General Management) from Narsee Monjee Institue Of Management Studies (NMIMS) Global Access, Licentiate from Insurance Institute of India (III) and ALMI from LOMA.