As a financial advisor, while evaluating existing financial situation of clients, I have come across many people who have bought certain life insurance policies but have no clue what purpose a particular life insurance policy serves, because different life insurance policies are designed to meet different financial objectives. So, it is important to know what are the diverse types of life insurance policies and financial objectives they meet so that you can align your life insurance policies to your financial objectives & financial goals.
Firstly, in insurance you pay a small premium to insurance company & in return insurance company gives you an assurance that if you suffer a specific loss, then insurance company will compensate you for that loss. i.e insurance is taken to cover “Risk” of loss.
Now, different life insurance policies cover different risks, based on what type of risk a policy is covering, life insurance policies can be classified into following types:
Let’s look as each type in bit more detail:
- Pure Term Insurance Plan:
Pure term insurance plan covers the risk of dying too early. If you are the bread winner for your family, your early death can jeopardize standard of living of your family. To cover such risk term plan can be taken
Here If death of the insured happens within the policy term (early death), the family receives a compensation in form of adequate funds using which family can maintain desired standard of living in your absence.
However, if the death does not happen during the policy term i.e insured survives the policy term, then insured doesn’t get anything in return for the premiums paid.
- Pure endowment plan.
Such type of insurance covers the risk of dying too late. Dying too late is a risk because longer you live, more will be the money required for your medical & survival expenses. So, risk is you might outlive money that you have. Such risk can be covered using pure endowment plan, wherein if you survive the policy term you receive survival benefit OR maturity benefit in form of adequate funds to compensate for higher survival expenses.
However, if you do not survive policy term i.e death happens within the policy term, then you do not receive anything in return for the premiums paid.
- Traditional Endowment Plan Or simply “endowment plan”
This is a combination of “Pure Term Plan” & “Pure endowment plan”
i.e it covers both – “risk of dying too early” & “risk of dying too late”.
So here if death happens within policy term (early death) family receives compensation i.e “Death benefit” so that insured can cover risk of dying too early. However, if death does not happen within policy term i.e insured survives the policy term, then insured receives “Maturity Benefit” to compensate for survival expenses to cover risk of dying too late.
There following 2 popular variants in endowment plan:
- Money Back Policy:
Here just like normal endowment plan if death happens within policy term, family receives compensation for early death and if insured survives the specified term, he receives survival benefit to cover risk of dying too late. However, the survival benefits ae not given at one go, rather they are given in parts.
For example, in a 25-year money back policy, if death happens within 25 years, compensation is given as death benefit to family to compensate for early death. However, if insured survives specified term, the survival benefits which are to be given, are given in parts – say 25% at the end of each of 10th, 15th,20th and 25th year, instead of entire 100% at the end of 25th year.
So, such policy may be useful if you can align cashflows from such policy to any of your financial goals like higher education expenses of your child, planning your retirement cashflows etc.
- Whole Life Policy:
Here life cover continues for the entire life. So here just like normal endowment plan if death happens within specified term (early death), family receives compensation for early death and if insured survives the specified term, he receives survival benefit to cover risk of dying too late. But crucial point is, even after disbursing the survival benefit, life cover continues and family is given compensation on death no matter when death happens (i.e covers whole life).
So, as it can be seen, in such policy family receives compensation on death of insured irrespective of when death happens (early or late). So, main motive of insured to buy such policy is to ensure that he leaves something behind for family whenever he dies i.e. such policies are usually used as one of the instruments for estate planning.
- Investment linked insurance plan:
In India, such plans are called as “Unit Linked Insurance Plans”.
Here In addition to covering risk of dying too early Or dying too late, such plans also offer
Investment opportunity to policy holders. So, premiums of such policies have 3 parts:
- Part of the premium is used to cover expenses related to managing the policy.
- Part of the premium is used to cover mortality risk i.e. risk of dying too early or dying too late.
- And part of the premium is invested to generate return on investment for policy holder.
Such investment can be in:
- Debt Funds (i.e. funds investing in fixed income instruments like government bonds, corporate bonds, debentures, fixed deposits etc.) Or
- Equity Fund (i.e Funds investing in stock markets related investments) Or
- Combination of above two i.e balanced funds.
Policy holder can choose in which type of funds he wants his investment to be.
- Insurance linked annuity plan:
In such type of plans policy holder invests certain amount (usually lump sum) and in return he receives a regular cashflow of certain amount at fixed interval of time
The cashflows can be monthly or quarterly or semi-annually or yearly.
Such type of plans are usually used to create post retirement cash flows. Because when one retires his earned income stops and he can maintain his standard of living using such regular interval cashflows.
There can be 2 variants of insurance linked annuities :
- Immediate annuity: Here as soon as investment is made, annuity starts immediately
- Differed annuity: Where once investment is made annuity starts after a certain “deferment period” from date of investment.