Thursday , April 26 2018

Types of Term Insurance Plans in India

Types of Term Insurance Plans in India

Term insurance is the cheapest of all forms of life insurance policies that float around in market. It is also the cheapest form that one can avail. The modus operandi of term insurance is very straightforward with no twists and turns, no heavy jargon and no extra fuss. A person, in case of term insurance, buys an insurance plan and insures himself or herself. If the person dies within the term of the policy, the nominee of the policy will get the sum assured. If the person doesn’t die within the term of the policy, no payments will be made. It is that simple! This is known as the Vanilla Term Plan.

However, as you can expect, behemoth insurance companies are always up to something. They have actually come up with variants of the Vanilla Term Plan to entice more and more people into buying these insurance products. In this article we will learn the following two things:

  1. A bit of details about Vanilla Term Plan – what it is and how it works?
  2. Different types of term plans that use the Vanilla Term Plan as the basic plan but add some twists.

So, without further ado, let us start with our mission. Stay with us till the very end. This article will be slightly long but it will be a worthy read when you complete reading this article.

Term Insurance Plans in India

What Precisely is a Vanilla Term Plan?

The name Vanilla Term Plan is nothing but a mouthful of a name. It is basically the crudest form of term plan or the most basic form of term plan than was first released in market by various insurance companies.

What really happens in this type of term plan is that you buy a policy for a certain period of time. Since it is a life insurance policy, it will provide you with death benefits. This means that once you buy this policy for a certain period of time, the sum assured will be paid out to the nominee only and only if you die of natural causes within the term of the policy. If you survive beyond the term of the policy, the insurance company will pay nothing. All the money you invested will be lost forever. There will be no maturity benefits.

Now we need to know about the following:

  • What is sum assured?
  • What is term?
  • What is death benefit?
  • What is maturity benefit?

The sum assured: It is the amount of money that the insurance company promises to pay to the nominee of the term policy in case you die before the policy expires.

Term: The term is the actual time period during which the policy will stay active. So, if you buy a policy for say 20 years, the term of the policy will be 20 years.

The death benefit: It is nothing but the amount of money the insurance company will pay to the nominee once the insurance holder dies.

The maturity benefit: Though maturity benefit is not applicable in case of Vanilla Term Plan, it actually refers to the amount of money the insurer promises to pay after the term of the insurance in over. This benefit is available in other types of insurance plans.

In case of Vanilla Term Plan, the sum assured you want will depend on your age, the premium you pay and the term of the policy. As a matter of fact, you will get to decide the sum assured you want and based on that, the premium to be paid will be calculated depending on your age.

In order to choose a term insurance plan of the Vanilla type, all you have to do is go for the one that gives you highest sum assured for lowest premium. Buy it online and the price can drip further.

A quick example to show how Vanilla Term Plan works

Let us assume that Mr. X, who is of age 30 decides to get a Vanilla Term Plan with a sum assured of 1 crore for a total term of 40 years from the date of policy purchase. Considering his age and the selected term of the plan, the yearly premium he needs to pay is say, INR 7,400.

Let us assume that he pays 10 premiums. That is, he pays till he reaches the age of 40. Before the next premium date, he dies. Then, the nominee will get INR 1 Crore.

If, he doesn’t die and continues to pay premium and then eventually dies at the age of say 71 (i.e. 1 year after the policy term ends), nothing will be paid to Mr. X because for this classic term plan, death before maturity is important for payment of sum assured.

Who should go for Vanilla Term Plan?

Now that’s a good question. This type of insurance is best suited for:

  • People who have a lot of money and know that whatever he has in bank account is enough for his family and that even if undetected expenses show up, the saved funds are sufficient to take care of such expenses.
  • People who are not looking for building wealth.
  • People who are not in need of monthly income flow.
  • People who do not required any hedging against inflation.

Now that we have more or less a decent understanding of Vanilla Term Plan, we believe it is time to look at other types of term plans that are available in market.

Before we start, you need to know that the Vanilla Term Plan is not very flexible. If you are looking for flexibility but still want to stick to a term plan, the different types mentioned below will help you to decide.

New Variants of Term Insurance Plan

There are three variants as of now. These are:

  • Sum assured broken down as monthly instalments.
  • Sum assured in lump sum + a certain percentage of the sum assured as monthly instalments for a certain period of time.
  • Sum assured in lump sum + increasing monthly instalments for a certain period of time.

Let us take a look at each of these variants individually.

Sum Assured Broken Down as Monthly Instalments

What really happens here is that once the policy holder dies before the term of the insurance plan is over, the nominee will get the entire sum assured. However, instead of giving the whole amount in lump sum, the insurance company will simply break the lump sum amount into smaller parts and pay it out as monthly instalments for a certain predefined time period (for example, say 10 years). When this happens, what the insurer will do is often make some inflationary adjustments to cover the ever increasing prices of goods and services.

This form has one benefit. It will allow a monthly income stream for the nominee. On top of that, this format is better if the nominee is not well-equipped to handle the lump sum payment. Instead of wasting the lump sum money in poorly decided investment avenues, the insurer will manage the fund and maintain a monthly income stream for the nominee.

Since the insurer will not have to pay out the whole money at once, it can be utilized for investments in market and hence, it allows for adjusting for inflation. However, any extra income that is earned by the money invested in market by the insurer is subject to taxation and hence, some taxes will be levied if inflationary adjustments are made.

Sum Assured + Certain Percentage of Sum Assured as Monthly Instalments for A Fixed Period of Time

In this format, the insurer will pay the nominee the following:

  • The whole sum assured to the nominee in lump sum after the death of the insured person within the term of the policy.
  • In addition to the lump sum payment, the nominee will also get a monthly income stream for a fixed period of time. This monthly payment will be a certain percentage of the sum assured.

Let us understand this with an example. Let us assume that the sum assured is INR 1 crore. And the monthly income stream as promised is 0.4% of the of the sum assured for a period of say 10 years. So, the nominee will get the following in the event of the death of the insured person:

  • 1 Crore as lump sum payment.
  • 4% of 1 Crore every month for a period of 120 months or 10 years. This stands to INR 40,000 per month.

So, the total sum assured actually stands at [1 Crore + (40,000 x 12 x 10)] = INR 1,48,00,000.

Sum Assured + Increasing Monthly Instalment for a Certain Period of Time

This is very much same as the previous option except that every year the monthly income will increase by a certain simple interest (for example, 10%).

So, here is a quick example:

  • The sum assured is INR 1 Crore.
  • The monthly income will be 0.4% of sum assured but this monthly income will increase every year at 10% simple interest.

So, apart from receiving the lump sum of INR 1 crore, the nominee will get:

  • INR 40,oo0 per month for first year
  • For next year, there will be a 10% increase in the monthly payment. This means, the monthly income will then become INR 44,000.
  • For third year, there will another 10% hike on the 0.4% of 1 crore. This means for the third year; the monthly payment will become INR 48,000.
  • Fourth year, it will become INR 52,000 and so on.
  • In 10th year, the monthly income will be INR 76,000.

A Quick Recap in Tabular Format

Benefits Vanilla Term Plan Term Plan Where Sum Assured is Paid in Monthly Instalments Term Plan Where Sum Assured is Pain in Lump Sum + Monthly Instalments Are Paid Term Plan Where Sum Assured is Pain in Lump Sum + Increasing Monthly Instalments Are Paid
Full life cover if the insured dies Yes Yes Yes Yes
Sum assured broken down in instalments No Yes No No
In addition to sum assured, additional monthly income that is tax-free No No Yes Yes
In addition to sum assured, additional monthly income that increase every year at a certain simple interest rate No No No Yes

Remember that in the last format where the monthly income increases every year because simple interest is paid, the monthly incomes will start attracting taxes from the year when the interest rates are applied. This interest is actually paid by the insurer by investing the whole term amount invested in the market by the insurer to earn profits. The interest that the insurer pays comes from this profit amount and hence, taxes will be applied.

Importance of Net Present Value

Before we dive deep into Net Present Value, let us take a quick example:

Let us suppose there are two insurance plans with the following features:

Features Plan 1 Plan 2
Sum assured 10 lakhs 10 lakhs
Term 10 years 10 years
Extra yearly payouts 1000 per year 750 per year
Time period for additional payouts 10 years 15 years

In the above example we see that in addition to 10 lakhs of sum assured, you will get additional 10,000 in 10 years from Plan 1 and from Plan 2, you will get additional 11,250 in 15 years.

Which plan is better? Plan 1 which gives you 10,10,ooo or Plant 2 which gives you 10,11,250?

If we go for absolute amount, Plan 2 is better because it pays higher amount. However, consider the factor that the higher amount comes at the cost of additional 5 years.

The question here is, what happens to the inflation during these extra 5 years? The problem with inflation is that it eats the value of money. Which means, the purchasing power of money falls.

Example? Today you buy a notebook for say RS 5o. 2 years later the same notebook will cost you say RS 80. So, 2 years from today, RS 50 cannot buy you the same thing. Its purchasing power falls. This same thing applies in case of Plan 2. In extra 5 years, the purchasing power of the extra money you get will be eaten away by inflation. So basically, the extra money you get will no longer remain as worthy as it would have been 5 years ago.

This is why, you need to consider inflation and also Net Present Value while deciding on which insurance plan to choose.

Now, what on earth in Net Present Value?

We just told you that money loses value over time and this is caused by inflation. This is exactly the premise on which the concept of Net Present Value is based on.

For example, you have Rs. 1000 today. You invest it somewhere and that investment avenue says that it will pay you 10% interest in one year. So, the next year, your money will grow to Rs. 1,100.

Now, what is this extra 100 bucks?

This is basically a cover for the inflation you will face in next year.

This means, 1000 today is equal to 11oo next year.

So, when finding out which insurance plan is good for you, you need to calculate the net present value. But how do you calculate that.

The formula for Present Value is:

PV = FV / (1+r) x n

Here PV is present value. FV is future value, r is interest rate in decimal format and n is number of years.

Now let us calculate the PV as per the following example:

You lend Rs. 500 to a friend who promises to pay you back 570 in one year. Should you lend to the friend or invest somewhere else which promises 10% interest rate for 1 year for an investment of 500 rupees?

So, taking the above example,

PV = 570 / (1 + 0.10) x 1 = 570 / 1.10 = 518.18

So, 570 one year from now is equivalent to 518.18 today.

Now Net Present Value = Present Value – Total Investment = 518.18 – 500 = 18.18

If you invested in alternative investment avenue the calculations would stand as:

PV = 550 / (1 + 0.10) x 1 = 550 / 1.10 = 500

So, 550 one year from now is equivalent to 500 today

Net Present Value = Present value – Total Investment = 500 – 500 = 0

So your net present value would be zero if you invested in an alternative place. Compared to that, lending money to your friend is beneficial.

Remember that a Positive Net Present Value is always preferred over Zero Net Present Value or Negative NPV. The greater the NPV, the more beneficial it is for you.

So, bottom line is simple. Whenever you are looking for insurance plans, check the net present value instead of simply checking the final amount you get. This way, you can take account of inflation and make informed decisions. There are various online calculators for checking NPV. You can use them to get the NPV for various insurance plans and then decide which one is best for you. However, do not forget:

  • Whatever Term Plan you take, it should be enough to cover the basic life expenses every month for your family.
  • Provides a good NPV to cover the inflationary jumps that the economy makes every now and then.
  • The company offering the Term Plan has high CSR or Claim Settlement Ratio.

Once you have sorted out these plans, go ahead and purchase the plan that suits you best.

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