Money - A Friend in Need is a Friend Indeed (Part 2)

Okay.. It’s that time of the year when all salaried people rush to invest the money in order to save them from the Axe of Tax. In my earlier post, I tried to provide some pointers regarding investing in stock markets indirectly through Mutual Fund. One thing that I forgot to mention over there was that a person should ideally go with SIP as far as possible, so as to reap maximum benefits. Many people keep on waiting and analyzing as to when the NAV of any fund would reach low levels, so that they could invest the entire amount at that time in order to reap maximum benefits. However, they forget that if the market would have been that predictable, then there wouldn't have been any tension in life.. right.

Why do I need Insurance?

Let's now turn our attention to the second most sought after investment instrument - Insurance. First of all, let me clarify that insurance should not be treated as an investment instrument, as it defeats the very purpose of its existence. One needs insurance in order to protect his/her family in case the bread-earner dies, so that the regular family expenses are met, and the liabilities in form of loans etc could be easily taken care of. 

How much Insurance do I need?

The next obvious question that comes to our mind is how much insurance is enough for us. This is a kind of grey area that doesn't has any specific answer to it, because of the involvement of time factor. All the agents try to give you various perspectives on the insurance cover, and boom.. there comes the terms coined by the industry:

1.     Human Life Value (HLV)

2.     Underwriter's Thumb Rule

3.     Income Rule

4.     Income plus Expenses Rule

5.     Capital Fund Rule

6.     Family Needs Approach

Okay, please don't ask me about what all these things mean. If you want to get confused, please bug your agents and ask them to explain these concepts. All of them are quite fancy in nature. The purpose of my listing down so many approaches, to find out your insurance cover, is just to point out how much ambiguity is there for finding out the Sum Assured.

My Way

I believe that it's a very simple task. Just add on the transaction values for following Life Events:

1.     Car Loan

2.     Education Loan for Higher Education for self

3.     Home Loan

4.     Any other Personal Loans/Liabilities

5.     Amount for Healthcare

6.     Child's Education

7.     Child's Marriage

8.     Inflation adjusted monthly household expenses of your dependents

Which Type of Insurance Policy Should I Buy?

There is a lot of debate on this issue. I would like to dwell on two basic kinds of traditional policies available with the life insurers:

1.     Term Insurance: You need to pay a yearly premium for specified number of years, and upon your death the nominees would be given the Sum Assured. In case you are hale and hearty after the policy expires, you won't get anything in the end.

2.     Endowment Policy: You need to pay a yearly premium for specified number of years, and either upon your death or the expiration of the policy (whichever is earlier), a lump sum amount is paid to the nominees or the insured person respectively.

For the same value of Sum Assured, you need to pay significantly more amount of installment for Endowment Policy compared to Term Insurance. Hence, there is a classical debate on which type of policy is good.

My Verdict

It is generally advised by Financial Planners to go for a combination of PPF and Term Insurance, instead of going for Endowment Policy, as the returns offered in the former case is much more than the later. I believe that in order to fully secure the future of our family, we should go for a combination of PPF, Term Insurance and Equity Linked Financial Instrument (let's say, Mutual Fund). I have taken help of the following assumptions/ facts for my analysis:

1.     The Sum Assured in the case of Term policy as well as Endowment Plan is 50 lacs.

2.     The premium has been calculated for 20 years policy period; I have chosen Amulya Jeevan and Jeevan Anand policies of LIC for term and endowment policies respectively.

3.     The rate of interest on PPF is taken as 9% p.a

4.     The rate of interest on the Mutual Fund is taken as 10% p.a, considering the fact that the annualized rate of return of Benchmark Indices has been 15% for the last 5 years.

5.     The max amount that can be invested in PPF is 70,000 p.a

The premium for Jeevan Anand (267,133) is almost 12 times that of Amulya Jeevan (12,350).

In Scenario 1, suppose a person invests Rs 70,000 p.a in PPF and pays the premium for term insurance on yearly basis. In case the person dies after 20 years, the amount that nominee receives is 5.4 times the total investment. In case the person is alive, the person gets 2.4 times the total investment.

In Scenario 2, suppose a person invests into an endowment plan which offers the same insurance cover. Assuming that the person receives Rs 57 per thousand of sum insured, the total amount payable upon maturity after 20 years is only 2 times the total investment.

In Scenario 3, an assumption is made that a person has the capability to invest Rs 267,133 p.a (similar to the premium of the endowment plan). Here, the person invests Rs70, 000 in PPF, Rs12, 350 in term insurance and the rest in a Mutual Fund giving modest annualized returns of 10% p.a. In this case, if a person dies after 20 years, the nominees get an amount equal to 3.85 times the investment; else, in case the person is alive, the person gets 2.91 times the investment amount.

For more detailed calculations, please refer to the Insurance WorkSheet .

Conclusion

The major investments of an individual should be done in the following 3 instruments (in no particular order of preference):

1.     Term Insurance

2.     PPF

3.     Mutual Fund

In case a person is alive, the last 2 instruments would take care of the person and his/her family. In case of a misfortune that results in the death of the person, the 1st and 3rd instrument would take care of the person's family. In my next article, I would throw light on the remaining instruments – Health Insurance, Infrastructure Bonds and ULIPs. Happy Investing J