LIFE INSURANCE

LIFE

INSURANCE

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Chapter 1:

Life Insurance Basics

The other day, Amit, a 26 something techie, was told by Sumit ( a

certified financial planner), his financial advisor and planner to buy life

insurance cover. As Amit never had the time or acumen to understand

about investments or insurance, he asked Sumit to explain the basics

first. Sumit started explained the following:

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1.1 What is life Insurance

Insurance is a contract between two parties

whereby one party (known as insurer or

assurer) agrees to bear the risk of another

(known as insured or assured) in exchange

for a consideration known as premium and

promises to pay a fixed sum of money (called

sum assured or cover) to the other party on

happening of an uncertain event (death) or

after the expiry of a certain period (called

tenure of the policy).

Insurance is structured to reduce the

uncertainity risk and to protect the financial

condition of an individual¡¯s family in the case

of unexpected loss of life.

Individual

Insured

Premium

Assurer

Life Insurance

Company

Accepts Risk

Sum assured

Received by

insured

Sum assured

Received by

insured

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1.2 How life Insurance Works

The underlying concept behind life insurance is

sharing of risks by pooling of funds. Groups of

people having similar risk come together and make

contribution towards a pool and the money so

collected is used towards compensating for any

losses suffered by members of the pool. When this

pool of money is managed by a company it is called

life insurance.

EXAMPLE

What happens if 25 persons dies?

ASSUMPTIONS

? Number of Persons = 5000

? Age and Physical condition = 60 years and

healthy

? Number of persons dying in a year = 25

? Economic value of loss suffered by family of each

dying person = Rs. 2,00,000/? Total annual loss due to deaths = Rs. 50,00,000/? Contribution per person = Rs. 1,200/-

UNDERLYING ASSUMPTION

All 5000 persons are exposed to common

risk, i.e. death

PROCEDURE

Everybody contributes Rs. 1200/- each as

premium to the pool of funds

Total value of the fund = Rs. 60,00,000

(i.e. 5000 persons * Rs. 1,200)

25 persons die in a year on an average

Insurance company pays Rs. 2,00,000/- out of

the pool to the family members of each of the 25

persons dying in a year

EFFECT OF INSURANCE

Risk of 25 persons is spread over 5000 people

Two concepts emerge out of the above example

- criteria for insurable Risk and Underwriting.

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1.3 Why life insurance is necessary

Insurance planning is an essential feature of every

personal financial Plan because of the following

reasons:Number of nuclear families increasing

Earlier joint families was the norm in Indian society but

now-a- days an increasing trend of a higher percentage

of nuclear families in the total number of households

compared to joint families increases the need for

life insurance as the dependency ratio increases

significantly.

Increase in Debt levels

With the change in Indian economy in last 20 years

and subsequent growth with it, people¡¯s appetite for

loans (home loans, car loans, personal loans etc) have

also grown exponentially. Banks and other entities are

ready to give them credit. As the proportion of debt

increases there is a greater need for term insurance.

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