Ten insurance policies should be enough to give adequate cover to a couple. At least that's what Mumbai-based Madhukar Avhad and his wife Leena thought when they bought three endowment policies, three money-back plans, a whole life policy and three Ulips.
However, the cover is far from adequate. The 10 life insurance policies, for which the Avhads pay an annual premium of Rs 1.25 lakh, give them a combined cover of only Rs 20.6 lakh. Madhukar's insurance of Rs 13.6 lakh is not even enough to cover his outstanding home loan of nearly Rs 15 lakh.
The Avhads are not alone. After bank deposits, life insurance is the most favoured financial investment for Indians. Almost 20% of their total household savings flow into life insurance. The question is whether this money goes into the right policies.
The average cover offered by life insurance policies bought in 2010-11 was Rs 1.83 lakh, which is woefully low. A recent study by US-based financial planning giant, Ameriprise Financial, says that Indian investors tend to buy the right products, but for the wrong reasons. Only 56% of the respondents had bought life insurance to cover the risk of early death. Other buyers either sought high returns or tax benefits.
Does your insurance portfolio also resemble the collage of policies that the Avhads have collected over the years? Your insurance plans may not necessarily protect your family. As in the Avhads' case, a large number of policies does not translate into adequate protection.
Before you buy an insurance policy, ask yourself if you really need one. In certain circumstances, you may not even need life insurance. If you do not have dependants, who are you buying it for? Also, if your spouse earns well, he or she may not require any financial support when you are gone. More importantly, as you build assets, your insurance needs decline. As the table ( next page ) shows, a person's liabilities go up with age, but the increase in his asset base brings down the insurance requirement to a certain extent.
The life insurance needs of an individual depend on several factors. There are also different ways to calculate this need. One is the human life value approach, which calculates the value of your life based on your future earning potential. The logic is that the family suffers financial loss due to the death of the income earner. For the same reason, there is no need to insure children and housewives, says financial planner Gaurav Mashruwala.
There is also the need-based approach, which takes into account the amount of money a family would require to sustain its current lifestyle and meet future expenses. Mashruwala offers a simple formula to help calculate the life insurance requirement.
First, consider your expenses, including the immediate ones, such as the repayment of outstanding loans, future expenses like children's weddings, and day-to-day household expenses. When you have added these up, deduct from this figure the value of your current assets and investments. The difference between your expenses and assets is the amount you need to insure yourself for.
Financial planners advise that one should carefully assess one's need for insurance and the features of a policy before signing on the dotted line. But what should you do if you have already bought an insurance policy that you now realise is wrong for you? What if you find yourself saddled with policies that offer you neither high protection, nor high returns?
However, discarding such plans may not be an easy task. ET Wealth lists out some parameters that should help you decide which policies should be in your portfolio and the ones you should be rid of at the earliest.
How much cover does it offer?
The Direct Taxes Code, which is likely to come into effect from April this year, states that an insurance policy should provide a cover of at least 20 times the annual premium for it to be eligible for tax deduction and other tax benefits.
While this may be too stiff a benchmark for policies bought earlier, it's reasonable to assume that an insurance plan that doesn't give you a cover of at least 10 times the annual premium should be the first to exit your portfolio. "Typically, you should get at least five times the premium you pay for single premium policies, and 10 times otherwise," says Jayant Pai, vice-president, Parag Parikh Financial Advisory Services.
However, you shouldn't be in a hurry to discard a policy just because it offers a low cover. You have to pay surrender charges if you redeem a policy prematurely. The surrender charges are high if the policy is new, but these reduce over time.
The policies that are close to maturity should not be on the chopping block as well. Why get rid of policies that are maturing in 2-3 years and lose the terminal benefits? "Target those policies that are not too close to maturity but also not too far away. Rank them in order of residual maturity and exit those where the impact cost (in terms of surrender charges and fund value) is the least," advises Pai.
Mashruwala says Ulip investors should not discard their plans after the mandatory lock-in period of 3-5 years. "If your policy is more than a couple of years old, then the damage of high charges is already done and you might as well hold on to it. You should also retain single premium policies," he advises.
Does it fit into your financial plan?
All insurance policies serve some purpose or the other. Money-back policies give out periodic payments. Endowment plans help build a tax-free nest egg. Ulips help create wealth through equity investments. Find out if your insurance policy too has a role to play in your overall financial plan. If you have a steady job and a rising income, your money-back policy is of no real use.
An endowment policy will be unsuitable if you are not content with low, but guaranteed, returns. On the other hand, if you want to maintain a low-risk portfolio, a Ulip focused on equity may not suit you. "A lot depends on the life stage of the policyholder," says Pai.
At a younger age, a market-linked product like a Ulip may be more suitable, but as the policyholder grows older, he may need debt-oriented traditional policies that give guaranteed income. "However, it is not necessary that you chuck your Ulips when you grow old. You could switch to the debt option as you require a steady income and less volatility at an older age," says Pai.
When is the policy maturing?
When your policy matures is an important factor in separating the chaff from the grain. An insurance policy should ideally cover a person till he is earning. "If a 25-year-old person buys a 15-year policy that will mature when he turns 40, it will not serve much purpose," points out Pai.
This is because his financial responsibilities will not end when he is 40. In fact, this is the age when the liabilities are peaking and his need for insurance is the highest. If you have a policy that is scheduled to mature when you are in your 40s, it should be on your hit list. Retain policies that extend till your retirement and beyond.
Can you afford the premium?
Apart from your insurance needs, you must also check if you can afford the premium. You might want equity exposure through a Ulip or guaranteed returns from an endowment plan. However, if the premium is so high that it impinges on your other financial goals and lands you in a financial straitjacket, it does not make much sense to continue with such policies.
"Premiums are like EMIs, which crop up frequently, if not every month. It is a liability," says Pai. Ideally, one should not allocate more than 10% of one's income to life insurance. This means that a person with a monthly income of Rs 50,000 should not have policies that require a premium outgo of more than Rs 60,000 in a year.
Generally, your insurance need is lower when you earn more. With a higher salary, you also build many other assets. "If your assets are sufficient, then you may not need too many insurance policies," says Pai. When you are wealthy, your investment component is expected to be higher. "Hence, as per the formula (insurance = expenses - assets), your insurance need would be lower as your net worth is higher. The higher the net worth, the lower the insurance need," explains Mashruwala.
What should you do if you have bought the wrong insurance policy?
Let the policy lapse
The easiest way of getting rid of an unsuitable insurance plan is to stop paying the premium. The policy lapses automatically.
This should be the preferred option if you had bought the insurance policy just 1-2 years ago.
You will have to forego the premium paid in the first couple of years, but it is better than continuing with it and compounding the error.
Surrender the policy
If three years' premium has been paid, you can surrender the plan and get some of the money back.
Surrendering a policy also ends the life cover. Besides, the money you get is a fraction of what you paid.
If you terminate an insurance plan prematurely, the tax benefits availed of on the premium paid till then are also reversed.
Turn it into a paid-up plan
A better alternative to surrendering your insurance policy and losing the life cover is to turn it into a paid-up policy. As in the case of surrendering, this is possible only if three years' premium has been paid.
Instead of returning the money to the investor, the insurance company uses it to offer life cover to the policyholder. Every year, it deducts mortality charges from the corpus.
This feature was used to mis-sell Ulips. The new Irda rules say that if you stop paying the premium for a policy bought after September 2010, the plan will be discontinued.
Continue with it
If the policy is just 2-3 years away from maturity, it's best to pay the premium for the full term. If you surrender it at this stage, you lose several maturity benefits .
Turning a policy into a paid-up plan at this stage will not be of much use.