Our life insurance requirements keep changing during the course of our lives. Life cover requirements increase when you assume greater financial responsibility such as marriage and birth of a child. Life cover requirement go down too as you achieve your financial goals or as your investment corpus grows. As your life insurance goes down, you may find yourself paying premium for the life cover you don’t really need. Your insurance company won’t typically allow reduction in sum assured. A life insurance ladder can be very useful in such cases. Under a life insurance ladder, you purchase life insurance policies with different tenors (term/maturity). Typically, maturity of the policies coincides with the term of a set of important goals. As you achieve major life goals and corresponding life insurance policies expire, your total premium outgo reduces. You can use these savings on premium to grow your investment corpus. We will analyze life insurance ladder in detail:
Why do we buy life insurance?
We purchase life insurance to bridge the shortfall between your existing assets and the amount required to fund all financial goals and major life events such as child education and marriage, retirement, purchase of house etc. For instance, let’s assume you have following three financial goals
Thus, your total insurance requirement is Rs 2 crores. When one purchases life cover, he/she should take into account the fund shortfall if he/she were to die immediately. Additionally, you are advised to be conservative while calculating life insurance requirements. High return expectations and low inflationary expectations can make you underestimate your insurance needs.
Needless to say, as your savings grow over a period of time, your life insurance cover requirement will go down. Additionally, as you achieve your financial goals (say daughter’s education), there is no need to provide for such goals. Hence, you may find yourself paying a premium for life cover that you don’t really need. You could have used this extra premium to build your investment corpus.
How does a life insurance ladder help?
In the example discussed above, you can either purchase a single cover of Rs 2 crores or buy three different covers for retirement, child education and marriage. Let’s see the impact with the help of an example. We have premium quotes for a term insurance product for 25 and 30 year old non-smoker males from the website of an insurance company.
Life insurance premium is dependent on age and health condition of the policy holder, sum assured and the policy term. So, greater the term/tenure of the policy, higher the annual premium for the same sum assured. As the policy term increases, the chances of demise during the policy term will increase. Additionally, the probability of demise also increases with age. Higher premium for longer policy term reflects this risk taken by the insurance company.
If you purchase a single policy of Rs 2 crore for 30 years (tenor has to be the farthest goal), you will have to pay an annual premium of Rs 20,575. On the other hand, if you purchase a separate policy for each of these goals (Rs 1 crore for 30 years, Rs 50 lacs for 20 years and Rs 50 lacs for 10 years), the total annual premium will add up to Rs 19,684. Additionally, as the policies with shorter tenor expire, total premium outgo under the ladder will further reduce. If you invest these premium savings, your investment will grow to Rs 4.06 lacs (8% per annum) and Rs 6.96 lacs (12% per annum) at the end of 30 years.
Multiple policies entail additional costs
There is an additional cost (administrative overheads) associated with purchasing a fresh cover. For instance, a cover of Rs 1 crore for a term of 30 years will cost Rs 10,287 per annum while two covers of Rs 50 lacs each (30 years) will cost Rs 11,607 per annum. Hence, breaking up your life insurance requirement across multiple policies will entail some additional cost. Hence, you need to weigh the benefits of laddering against these costs to arrive at the right laddering strategy for your insurance requirements.
Problems with life insurance ladder
You need to keep track of multiple premium payment dates. Additionally, if the particular life insurance plan expires before completion of corresponding goal, you may face some problems, especially if your savings for the goal have not reached the required level. In the above example, suppose your daughter does not finish his/her education in 10 years and funds earmarked for her education have grown only to Rs 35 lacs. In case of policy holder’s demise after policy expiry, there will not be enough funds to fund daughter’s education.
Life insurance requirement can increase too
Certain life events such as marriage or birth of a child of child can increase your life insurance requirement. Life insurance ladder can be helpful in such cases too. For instance, a person can buy a basic insurance cover before marriage. As the person adds responsibilities over a period of time, marriage or birth of a child), he/she may increase the coverage by purchasing additional life insurance. For example, a life cover of Rs 2 crores for a term of 35 years will cost Rs 17,366 for a 25 year old male. Assuming his existing insurance requirement is Rs 1 crore and he gets married after 5 years at the age of 30. Assume marriage adds Rs 1 crore to his insurance requirement. He can purchase life cover of Rs 1 crore at the age of 25 (for 35 years) and a further Rs 1 crore (30 years) after he gets married. By going for life insurance ladder, his total savings will be ~Rs 3.6 lacs (at 8% per annum) and ~ Rs 14.2 lacs (at 12% per annum) over 35 year period.
Whether you should create a life insurance ladder
Life insurance ladder may not benefit for everyone as the extra costs of purchasing multiple policies may nullify the benefit of an insurance ladder. You cannot purchase a separate term life plan for every long term goal. Overheads of too many policies will kill the benefits of an insurance ladder.
Better approach will be to club your goals into different buckets on the basis of time to achieve those goals. For instance, goals to be achieved in 5-10 years can be clubbed together and a single insurance cover purchased to cover those goals. You can repeat this for goals expected to complete in 10-20 years and so on. Exact ladder structure will vary based on individual requirements. In fact, there will be cases where a life insurance ladder may not be beneficial at all. A life insurance ladder does carry a few risks. As pointed out earlier, if the policy expires before achievement of corresponding financial goal and the investment corpus is not sufficient to fund the goal, the family may face difficulty in completing the goal in the event of policyholder’s death. You may seek services of a financial planner or a registered investment adviser in this matter.
Always remember getting adequate life insurance cover is of paramount importance. The choice between a single policy and an insurance ladder is secondary. If finalizing the right laddering strategy is too much for you, keep things simple and purchase a single policy for all your goals. Additionally, you must invest wisely for your long term goals irrespective of whether you opt for a single policy or an insurance ladder. Life insurance will cover the shortfall between the earmarked assets and required corpus if you die before fulfilling the goals. However, if you survive the policy term, you have to meet those expenses from your investment corpus.
By Deepesh Raghaw
Deepesh Raghaw is a SEBI registered Investment Adviser