What is Life Insurance?
Life insurance is an agreement under which one party agrees to pay another party a given sum of money known as the sum assured upon the happening of a particular event in exchange of the payment of a consideration. A life insurance policy provides a financial security to the insured individual’s family even after individual’s death.
Table of Content
The party that guarantees to pay in the event of a contingency is called insurer, the maximum amount that can be paid to the beneficiary is called sum assured, and the person who is covered under the benefits of the policy is called insured or assured. In case of life insurance, payment is guaranteed to be given on the contingency commonly called as death or life. The person who signs the application form and requests to be covered (self or others) by insurance is called the proposer and the consideration paid to purchase and renew the policy is called a premium. The document which is an official declaration of the contract between the insurer and the proposer is called policy.
Life insurance doesn’t have a standard definition, but it is most commonly agreed to be defined as a contract between two parties where the insurer, in exchange of a consideration known as premium, either in lumpsum or in form of any other periodical payments, agrees to pay to the assured or insured, or to the beneficiary/nominee, a stated sum of money on the happening of a particular event contingent on the duration of human life.
From the above description and definitions, the important features of life insurance can be summarised as follows:
- It is a contract between two parties that relates to human life.
- There need not be an express provision that the payment would be due on the insurer upon the death of the person.
- Under the contract, the insurer shall be liable for payment of lump sum amount of money. iv The amount is paid by the insurer either at the expiration of certain period or on death of the person as the case may be.
Need for Buying Life Insurance
Life insurance is a financial device that provides a dual benefit of savings as well as security. The following benefits explain why this investment tool should be an integral part of a person’s financial plans and one should consider buying a plan:
Provides coverage against risk of death
Life insurance policies provide a financial cover for the financial hardships arising due to the sudden death of the policyholder. In case of death of a policyholder, the insurer pays the amount of sum assured. Therefore, the family is shielded from the financial strain due to unforeseen and premature death of the policyholder who at times may be the sole earning member of the family.
Means of encouragement for savings
Life insurance premiums lead to long term savings. The need to make savings has a psychological effect on the individual who gets compelled to save. Willingly or forcibly when an individual saves over a period of time, a decent corpus is built to meet the financial needs at various stages.
Increases liquidity
Insurance facilitates and maintains liquidity for an individual. An insurance policy can be easily surrendered in case the policyholder is unable to pay the premium.
Leads to profitability
Unlike other forms of insurance, life insurance is not only financial security, but also acts as a source of long term investment. The insurers utilise the premium for investment in infrastructure and projects which offer assured returns. Insurance is a perfect example for observing the elements of investment which include:
- Long term savings
- Accrued capital
- Return on investment and capital
- Additional returns
Helps in unforeseen circumstances
A person who has responsibilities of family can look at a life insurance policy as a feasible option. In the event of sudden illness, death or accident of the sole earning member of family, an insurance policy helps the dependents by providing financial funds for education, housing, medical treatment etc. This is especially useful and true for middle-aged people with family’s expenses to take care of.
Protects against creditors and eases claim settlement
Nowadays, due to use of information technology and regulatory changes in the insurance industry, the claim settlement process is fairly simple and easy. If the nomination on the policy is made and documents are in order, the claim settlement is fast and easy.
Facilitates loan
Sometimes, financial institutions also offer short-term and long-term loans against insurance policies for business purpose or for domestic purposes. Thus, it may be possible for an individual to meet unplanned life needs without compromising the accrued benefits of the policy.
Provides tax benefits
In order to encourage people to buy insurance, government gives various tax benefits on life insurance. These benefits may be available on the premiums paid as well as on the claim proceeds. In some cases, where insurance is offered by the employers, the money paid towards insurance premium is deducted from the gross income and this becomes an investment.
Provides mental peace
The main cause of stress for a person who bears the responsibilities of a family is insecurity and uncertainty in life. When a person has a life insurance policy, he/she is assured that the financial needs of his/her family shall be taken care of in the event of sudden death.
General Classifications of Life Insurance
There are four divisions of life insurance provided by the insurance organisations:
Ordinary life insurance
This is one of the oldest form of life insurance. This type of life insurance is purchased by single individuals. The premiums are paid annually, half yearly or monthly.
Industrial life insurance
his insurance provides coverage to the industrial workers, who are unable to afford the insurance. The high premiums are paid mostly on weekly basis. A fixed amount is given on the accident or death. This type of life insurance has diminished over the decades and a variation of this product called Monthly Debit Ordinary (MDO) has emerged.
Group life insurance
This is called a master policy in which coverage is provided to a number of persons. It is generally purchased by the employer for its employees. The plans under group life insurance can be contributory or noncontributory. Contributory plans are those plans in which both employer and employee share the costs of the insurance whereas in case of non-contributory plans, only employer pays the insurance costs.
Credit life insurance
This type of insurance is sold by financial lending institutions to borrowers. This protects lenders and debtors against the financial loss. The life of borrower is insured for the outstanding balance of a loan. This balance is paid on the death of the insured. This insurance decreases in amount as the loan is repaid.
Types of Life Insurance Policies/ Products
In a life insurance contract, insurer promises to pay a designated amount of money insured upon the death of the policy holder or the insured person. This contract is being entered in exchange of the premium paid by the insured or the policyholder, the policy holder generally pays the insurance in a lump sum or in instalments.
Life insurance products can be broadly classified into the following two types:
Packaged life insurance products
These are insurance products that combine coverage from two or more types of life insurance, such as term insurance and unit-linked insurance into one product. The benefits under these products are pre-defined and customers have to select the plan that is nearest to this requirement. Moreover, the ability of the LIC agent to explain the various plans is a vital factor. Most LIC products fall under this category.
Non-packaged life insurance products
These include coverage from only one life insurance product. Here, two different insurance products cannot be combined. These products have specific basic features, such as endowment or money-back, which the customer can select according to his/her rider benefits-accident cover, disability benefits, critical illness cover, hospitalisation cover, etc. These products cater to niche market and have profit potential.
Types of Life Insurance
The types of life insurance policies are discussed as follows:
Term life insurance
Term life insurance policy is a policy which provides the benefit to the survivor family only if the death occurs within the specified time period of the insurance term. These are the most basic forms of life insurance. Such plans offer life cover without any savings/profits component.
Due to the simple nature of benefits, such plans are the most affordable form of life insurance as premiums are cheaper compared to other life insurance plans. Under term life insurance plans, a fixed sum of money – or the sum assured – is paid to the nominated survivors if the policyholder expires over the policy term. If the policyholder survives the period of insurance, there is no payout.
The advantages of term life insurance policy are as follows:
- The term insurance plans are relatively easier to understand in comparison to the other plans.
- The premium paid by the policy holder is exempted under the section 80 C of Income Tax Act, 1961 for the sum paid towards premium.
Endowment plans
In the policy of the endowment, the policyholder or the insured pays the premium on year to year basis and in case of a death or the specified period of the policy, a lump sum amount is paid back to the policyholder. Benefits at the time of maturity is the key differentiator between endowment plans and term plans.
Term plans pay out the sum assured, along with profits, only in case of an eventuality during the policy term. On the other hand, endowment plans pay out the sum assured under both situations, i.e., death and survival. Due to this complex benefit, endowment plans have higher premiums associated with them. The premiums paid for such plans are invested in asset markets – equities and debts which yield profits in result.
The advantages of endowment policy are as follows:
- The endowment plans provide a mix combination of the savings as well as insurance, as a fixed amount is being paid at the regular intervals which is against the premiums paid.
- The endowment policy is one of the flexible policies, as investor can opt for getting the fixed amounts on regular intervals or they can plan of receiving the fixed amount at the end of the insurance term.
Unit Linked Insurance Plans (ULIP)
Under these plans, a part of the amount is being retained by the insurance companies towards the insurance of the policy holder, while the part of the funds are being invested by the insurance companies in the equity or the fixed interest income instruments. ULIPs are a smaller sub-set of the conventional endowment plan. Under these plans, the sum assured or the investment portfolio if it’s higher, is paid out on death/maturity.
The advantages of ULIPs are as follows:
- The insured person gets the benefit of insurance, and hence his family is protected if he dies.
- Every investor does not have the expertise of making investment in security market, hence through the Unit Linked Investment scheme the investor can get the benefit of investing in the securities market.
Whole life policy
This policy as the name suggests, is not time bound, in fact it covers a policyholder over his life. The whole life insurance is an insurance plan wherein the coverage of the insurance is for the whole life. The premium paid for this type of policy is also much higher than the term insurance plans.
The policy expires only in case of an eventuality which is death of the policyholder as there is no pre-defined policy tenure. The whole life insurance plans are the best for individuals who are having the long term horizons of investment and who can pay the payments easily for twenty to twenty-five years.
The advantages of whole life policy are as follows:
- Under the whole life insurance policy, one gets the benefit of tax under section 80C of Income Tax Act, 1961.
- The premiums under the whole life insurance are fixed, while in other insurance plans, normally the premium keeps on changing as individual gets older and older.
Tax Incentives for Life Insurance
Income Tax Act, 1961 provides for the levy, administration, collection and the recovery of income tax from the tax payer. The income tax is applicable on the taxable income earned by an individual in his previous year. The tax is calculated as per the provisions laid in the act on the total income of the previous year.
The act provides various allowances and deduction to be deducted from the taxable income. Various investment options are provided in the rules for which deduction from the total income is allowed. The act allows deduction of the investment made in the life insurance policy and for the health insurance policy for the amount of premium paid during the previous year by the tax payer.
Thus, to encourage citizens for savings and mobilise funds for infrastructure development, the government offers tax benefits on the premium paid for life insurance policies under Section 80C of the Income Tax Act 1961. Maturity proceeds are also eligible for exemption under Section 10(10D) and Section 10(10A)(iii). Therefore, life insurance policies can be used as tax planning tool.
Deduction under Section 80C in respect of life insurance premium is as follows:
- Eligible assesse: Individual and/or Hindu undivided family.
- Maximum limit: Maximum deduction allowed under this Section is INR 1.50 Lakh and the sum includes payment on other allowable investment option available Under Section 80C of the Income Tax Act, 1961. It is to be further noted that combined maximum limit of deduction under Section 80C & 80CCC & 80CCD (1) is INR 1, 50,000.
- Deduction limit: For policies issued on or after April 1, 2012, deduction is allowed only for premiums up to a maximum of 10% of the sum assured. For policies issued before March 31, 2012, deduction is allowed only for premiums up to a maximum of 20% of the sum assured.
- Allowable on payment: Under Section 80C, only life insurance premium paid or deposited during the year are allowable as deduction.
- Disallowance: In case the policy is terminated willingly by the insured or the insurer or by failure to pay any premium if any deductions have been claimed earlier, the amount shall be taxable as income.
There are two situations in this case:- Single premium policy: If terminated within 2 years after the commencement date
- Regular premium policy: If terminated before premiums have been paid for 2 years
The insurance premium, paid for your parents, spouse, children or any dependents, towards your life insurance policy, are eligible for de- duction under Section 80 C. Please note that the insurance premium paid for the members other than the above prescribed is not allowed to be deducted. If the premium is paid for more than one policy then the deduction is allowed for all the policies in a combined manner.
Taxability of Maturity Proceeds
The maturity amount received from the insurance company for the life insurance is exempted unless and until it falls under certain pro- visions. Under Section 10(10D), any sum plus bonuses received under the life insurance policy are exempt other than the following:
- a. Any sum received under Section 80 DD (3) or Section 80 DDA (3); or
- b. Any sum received under the keyman insurance scheme of the policy.
- c. Any sum received for the policy taken after April, 2003 in which any amount is paid over and above the 20% of the actual capital sum assured. Thus, it means that only 20% of the capital sum assured paid during the years in the form of premium is exempt when the maturity amount is received. This amendment is of 20% is made available in the Finance Act, 2003.
Rate making, which is also known as insurance pricing, is the process of determining what rates, or premiums, should be charged for insurance. A rate is the price per unit of insurance for each exposure unit, which is a unit of liability or property with similar characteristics. Premium is the payment made by the insured to the insurance company against the promise made by the insurance company.
The life insurance premium can be single premium life insurance and continuous premium life insurance. In single-premium life insurance, a lump sum amount of cash is paid as premium. This kind of premium paid throughout your life. The size of the death benefit depends upon the amount invested, the health of the insured and the age of the insured. On the other hand, in case of continuous premium life insurance, premium is paid at regular intervals that may be yearly basis, quarterly basis or monthly basis. Premium is paid at regular intervals till the expiry of the insurance policy.
The main business objective of an insurer would always be to charge an adequate premium to cover losses, expenses, and allow for a profit; otherwise, the insurance company would fail to be sustainable. However, law regulates what insurance companies can charge, and thus, both business and regulatory requirements must be met.
A major challenge in setting premium is that actual losses and expenses are not known at the time of premium collection. Thus, various factors are considered for calculating insurance premium.
Before learning the calculation of premium, we should know the factors that affect the premium calculation:
- Expenses: The insurance company generally incurs some expenses for its day to day functioning. These expenses generally include the commission paid to agents, salaries of staff, and other expenses.
- Expected yield of investment: The expected yield cannot be predicted exactly, hence the insurance company makes some provisions about the same.
- Age of the insured: The age of the insured is another important factor which is to be kept in mind. If the age of the insured is higher, in that case, a higher amount of premium is charged.
- Mortality rate: The mortality rates are prepared by various insurance companies on the basis of their experience and various data available on various public platforms. These rates are a tabular representation of probability of losing the economic value of human life. The calculation is based on the compilation of the mortality rate and the sickness table. These are the tables which actually correlate the probability of getting sick and die.
This is clear that life insurance premiums are mainly based on mortality tables that tabulate the number of deaths for each age, which includes a population of many people. In determining life insurance premium, age is the most important factor in determining life expectancy. Apart from this, there are other well-known factors that have a significant effect, such as the health of the individual, any illness, and habits such as smoking drinking, etc.
For example, based on the mortality table, an actuary can estimate the average age of death for a group of 55-year-old females, who smoke.
Let us learn the formula for calculation of premium:
Gross rate = Pure premium + Load
Where pure premium is determined by the actuarial tables, this premium is necessary for paying losses and expenses.
Loading is premium that is necessary for covering additional expenses such as sales expenses. Gross premium (premium charged from the insured) = Gross rate × number of exposure units
Expense ratio = Load/ Gross rate
Life Insurance Contractual Provisions
Unlike other insurance plans, in life insurance, there is a certainty for the insurer that loss will occur thus, the insurer will have to pay the death claim eventually if the policyholder continues to pay the premiums. Life insurance will not be of any benefit to the insured if the insurer cancels or exits the contract after collecting premiums for many years, or by making changes in the policy terms and conditions in other ways, such as changing the company’s bylaws or charter, or by contesting that there were mistakes in the application.
There are various contract provisions that prevent an insurer from canceling the insurance unilaterally to protect the policyholder’s interest. Major contract clauses include the following:
Entire contract clause
This clause gives importance to the application filled by the proposer for life insurance and states that it is an integral part of the contract. The insurer doesn’t have the right to make changes in the contract without the insured knowing about it. Further, the insurer cannot make any reference to other documents, or anything else, such as the corporate bylaws or charter, that can change the terms of the contract. Changes in terms of the contract cannot be made without the policyholder’s consent.
Incontestable clause
In case of a misrepresentation discovered in the application form, the insurer can cancel the contract within the first 2 years of the policy period. After 2 years, the incontestable clause comes into picture, which prevents an insurer from cancelling the contract even if it is found that there has been a misrepresentation. In short, the incontestable clause gives the insurer 2 years to probe and discover any material misrepresentations; once this period is over, any death claim that arises shall be compulsorily paid by the insurer.
The only circumstances under which an insurer is allowed to deny payment of a claim, or to cancel the policy during the incontestable period is:
- The insurance applicant had no insurable interest in the insured
- The insured committed a major fraud, such as having someone else take the physical examination,
- The beneficiary murders the insured
Suicide clause
It is applicable to certain types of plans and it states that in case the insured commits suicide within 2 years (1 year for some policies) as per the policy, then the insurer is liable to refund only the premium. The general reasoning in favour of paying for a suicide claim is that the insured may be considered mentally ill. A waiting period of two years is to rule out adverse selection.
There is also a legal presumption against suicide. If the insurer wanted to deny payment because of suicide, the burden of proof would be on the insurer to prove that it was a suicide.
The grace period of one month is given in case of overdue premium. The main objective is not to suspend the policy due to temporary shortage of funds.
Change-of-plan provision
Most life insurance contracts have the flexibility that let the policyholder change the type of plan to incorporate for changing conditions or different situations. If the change is upgradation to a policy with a greater sum assured, then the policyholder must pay the difference; if the required sum assured is less, then the insurer refunds the difference to the policyholder.
Assignment
In some cases, it may be possible to transfer life insurance to another party which is called an assignment. The insurer in such case needs to be informed of the transference; else, the death claim will be paid to the beneficiary of the original policyholder. Transference can be of two types:
- Absolute assignment: It transfers all rights of the policy to the new owner.
- Collateral assignment: It assigns partial rights to a creditor to serve as collateral for a loan to the policyholder. All other rights are retained by the policyholder.
- Reinstatement: In case of lapsed policies, most contracts pro- vide a reinstatement provision that allows the policyholder to reinstate or revive the policy under certain conditions. The policy can only be reinstated:
- If the policy was not surrendered for its cash value
- If it is reinstated within a certain time limit, typically 3 to 5
- years
- If the policyholder must provide evidence of insurability 9If all overdue premiums plus interest is paid
- If any policy loan must be repaid or reinstated with interest
Although the policyholder can simply buy another policy in case of a lapse, there are several advantages in reinstating the lapsed policy:
- Lower premium due to the less age at the time of buying lapsed policy 9Higher cash values and, possibly, dividends
- Avoidance of acquisition expenses
- Continuation of time bound benefits
Misstatement of age
If age by the proposer at the time of policy application is misstated, the face value of the policy is reduced or increased to the amount that the paid premium would have bought in case the correct age was given.
