on buying insurance

8/13/2019 On Buying Insurance

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What distinguishes an endowment policy from

a pure term insurance policy is that the premium for

the former has an additional component .

.

.

Prof i t to Insuranc e Company

Market ing and

Administrat ive Expenses

Risk Premium

Investment


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One way to look at an endowment policy is as

a packaged product containing two products

within : insurance and investment. But this sort of aview overlooks the complementarities between the

two.

To understand the complementarities

between the insurance and investment component

in an endowment policy, we will have to redefine the

protection function of insurance.

What does the insurance seek to protect ?


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Financial distress could take two forms :

A threat to survival / maintenanceof desired standard of living of the

dependents of a householder.

A non-fulfillment of theaspirations of the dependents or

aspirationsof the householder for the

dependents.


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The first is taken care of by a pure term

insurance policy; the second requires an

endowment policy.

Let us see why.

Aspirations or aspirational goals are thedesires of a householder for her dependents or of

the dependents themselves, for which the

householder intends to make a financial provision

as she works and earns. Education of the childrenor settling them up in life are the most prominent.


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As the householder works and earns, she

sets aside as savings a part of her earnings to

make this provision. The savings investedappropriately, are expected to grow into a corpus

which would serve to fulfill the aspirations.

But an adverse event like the death or criticalillness of the householder may upset this plan (as

the householder cannot now contribute to the

corpus) and leave the aspiration un-fulfilled.


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An insurance policy that seeks to offer

protection against this financial distress should

ensure the continuation of the savings andinvestment plan.

A pure term insurance policy which pays a

lump sum on occurrence of the adverse event can

offer relief against the immediate financial distresscaused by it in the form of threat to survival /

maintenance of desired standard of living of the

dependents of a householder.

But it cannot ensure the continuation of the

savings/investment plan.


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An endowment policy with a waiver of

premium ridercan ensure the continuation of the

savings/investment plan. On occurrence of theadverse event, the insurance company pays into

the policy account the premium that the policy

holder would have paid. The plan therefore

continues, thereby creating the corpus that thehouseholder had envisaged. The fulfilllment of the

aspiration is therefore protected.


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InsuranceInvestment


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That is the complementarity betweenthe insurance and investment component

in an endowment policy.


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There are two variations on this basic model

of an endowment policy.

END

OWMEN

T

Conventional

U L I P


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.

.

.Investment

Risk Premium

Profit to Insurance Company

Marketing and Administrative

Expenses

The premium cannot be broken down into its

constituent parts : risk premium, administrative

charges, insurersprofit and the investment.

Conventional


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The f inanc ial structu reof a conventional

endowment plan is very similar to that of a pure

term insurance plan. The pool of premiumscollected during the year, plus the investment

income, is used to meet the claims arising during

the year and the expenses. What remains behind

is the surplus.

Premium

income+

Investment

income

minusClaims+

Expenses

Surplusequals


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Premiumincome

+Investment

incomeminus

Claims

+

Expenses

Surplus

equals

To whom does this surplus belong ?

The endowment insurance plan has two

stakeholders :

the shareholders of the insurance

company

the policyholders


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How is the surplus calculated ?

The calculation of surplus in an endowment

plan is not as simple as

Premiumincome+

Investmentincome

minus

Claims

+

Expenses

Surplusequals

Surplus is a result of an actuarial

valuat ionof assets and liabilities of the insurer.


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Actuarial Valuation

Premiumincome+

Investmentincome

minus

Claims

+

Expenses

Surplusequals

Increase in

expected

claims

+


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How does an ULIP differ from a

conventional endowment policy ?

You can analyse the

difference between an ULIPand a conventional endowment

policy at three levels.

1

2

3


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1

2

3

In an ULIP a policy holder has the freedomto direct the investment component of his

premium into an asset of his choice, depending

on his target return and risk tolerance.

The superficial difference

is the fact that while a

conventional endowment policy

has rigid regulations governing

the investment of its fund, the

ULIP is more flexible.

In an ULIP it is possible to invest in equity up to

levels far beyond what conventional endowment policy

permits.


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2

1

3

We can go a little deeper to

seek a more basic difference : an

ULIP is far more transparent than

a conventional endowment policy.

In an ULIP you know before handhow much of your premium goes towards

mortality charges, how much goes towards

the expenses and how much is invested.

In an ULIP you know where your fund is invested

and what is itsworth at any given time.


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3

2

1

We can go even deeper to

seek an even more fundamental

difference.

In a conventional endowment

policy, the company as well as the policy

holders bear the risk of any adverse

variation in mortality and expenses.

In an ULIP the mortality charges andexpensesare separated from the investment right in

the beginning.


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Any variations in mortality and

expenses, and the resulting increase or

decrease in claims, are borne entirely by thecompany; the policy holder has no part in

either the gain or the loss; just like in a pure

term insurance policy.


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Let us now look at

another aspect of ULIP

which differentiates it from aconventional endowment.

4

2

1

3

In a conventional endowment, the SA goes onincreasing as the surplus is distributed to the

policyholders by way of the reversionary bonuses.


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If the adverse event occurs during

the term of the plan, then the SA (withaccumulated bonuses) is paid to the policy

holder; this is called the c laim amount. If the

term ends without any adverse eventoccurring, then the SA (with accumulated

bonuses) is paid at the end of the term or

maturity; it is called the matur ity amoun t.


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But in an ULIP, the risk premium and the

investment component are separated right from

the beginning. The risk premium goes towards thesecuring of the SA. The risk premium of all the

policy holders under the plan are pooled together

to constitute the r isk prem ium poo l, from where

the SA is drawn out if and when the adverse event

occurs, and the claim amount is paid.

The investment component is invested

separately. Itsvalue at any point of time is calledthe fund value.


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If the adverse event occurs during the term of

the plan, then the claim amount is paid to the policy

holder. In an ULIP, the claim amount is the

greater of the two : the SA and the fund value.That is, if at that point of time the fund value is less

than the SA, the SA is paid as the claim amount; on

the other hand, if at that point of time the fund value

is more than the SA, the fund value is paid as the

claim amount.

If the term ends without any adverse event

occurring, then the fund value is paid at the end ofthe term as the maturity amount, irrespective of

what the SA is.


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We said that if the adverse event occurs

during the term of the plan, then the claim amount

is paid to the policy holder. In an ULIP, the claim

amount is the greater of the two : the SA and thefund value.

What is important here is to note that both the

SA and the fund value are not paid as claimamount; one of the two is paid.

Now, when the fund value is paid as the claim

amount, the insurance company does not have to

draw anything out from the risk premium pool to paythe claim amount; it makes the payment entirely out

of the investment corpus of the policy holder.


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If the insurance company does not have to

draw anything out from the risk premium pool to pay

the claim amount, that is, if the insurance companydoes not carry any risk on the life of the LA, then

should the insurance company charge a risk

premium to the policy holder ?

No. If the insurance company does not have

to draw anything out from the risk premium pool to

pay the claim amount, that is, if the insurance

company does not carry any risk on the life of theLA, then the insurance company does not charge a

risk premium to the policy holder.


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Such a situation arises not only when the fund

value exceeds the SA; even when the fund value is

less than the SA, but is positive, the insurance

company has to draw from the risk premium pool

less than the full SA. In other words, at such times

the the risk that the insurance company takes on

the life of the LA is less than SA. Therefore it cannotchrge risk premium for the full SA. It has to charge

risk premium for only that part of SA which it needs

to actually draw from the risk premium pull.

This part of SA which it needs to actually drawfrom the risk premium pool is called the

sum at r isk.


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Sum at Risk = SA - Fund Value

In an ULIP, therefore, the risk premium is

charged not on the entire SA, but on the Sum at

Risk only.

Sum

at

Risk

Fund

Value

Fund

Value

Sum

at

Risk

Fund

Value

Sum

at

Risk

Fund

Value

Sum

at

Risk

Sum Assu red

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