Risk Analysis and Insurance Planning

will represent the net economic gain in terms of HLV meant for the family. f) This surplus value generated for the family's benefit can be represented by the financial assets and real assets known as estate', either purchased or managed. This is the result of savings/investment portfolio managementby the earning individual. g) This economic value in the shape of estate (immovable and movable, securities, cash) devolves to the nextgeneration upon the earning individual's death. Thus the HLV forms a link in between two generations. h) This surplus estimated in terms of economic gain for the family will be funded till such time that the earningindividual continues to survive with his productive efforts. Upon his death or permanent disability orunemployment, the surplus generation activity is discontinued depriving the family of their subsistencesupport as well as the net economic gain. i) Therefore, to provide full security cover to the family it is necessary to protect this estimated future economicvalue being contributed to the family through a life insurance policy. j) As observed by Prof. S.S. Huebner \"The HLV is a creator of all the utility in tangible property. The life valueis the cause and property values are the effect. Were it not for HLVs there would be no property valuesat all\". k) This tangible property value is to be protected through purchase of a life insurance policy. Thus, the central point in this maxim is to capitalize the estimated future earnings of an income earner with theapplication of a reasonable rate of interest. This present capitalized value will give us a fair idea of requiredadequate life insurance cover with a view to protecting an income earner's economic value to his family (including potential earnings). This can be arrived at with application of an appropriate discounting factor. The entire exercise is an attempt to find out today's value of one rupee in the pocket after a lapse of twenty or twentyfive years reckoned as on date. For example a Re. 1 due after forty years at the interest rate of 5% will have a present value of 14 paise. In simple language, to earn one rupee after forty years @ 5% compounding we have to invest only 14 paise today. On this premise discounting factors are tabulated at different rates of interest made applicableto different terms on annualised basis. 189

Corporate HLV In the context of what is explained above we have already seen that HLV of an individual can be measured interms of economic value to his family unit, which can be well protected through life insurance. Likewise, thereexists a parallel assumption of HLV in terms of economic value to a business / service / manufacturing enterprise.For example, in an organization, an identified individual's self-contribution is quite significant, well proven interms of growth and ever-rising profit levels. It is mainly because of the specialised skills, techniques, expertise of this particular employee / manager / engineer / technician / executive, that the company is not only survivingbut growing. This individual's life is very precious in terms of his pecuniary contribution, treated economic value,which the company may like to protect. Such a person is known as a Key-man'. Based upon the past profitearnings, the company can arrive at a fair estimate of sum assured for which a policy can be taken on the life ofthis key-man to ensure that the loss of available expertise through him is protected just to avoid any loss or damagethe company would suffer on account of his death or disablement. At least to some extent this purchased coverwill enable the company to readjust with the profit loss over a short period till such time a suitable replacementis found to take over the function, performed earlier by the deceased key-man. The income tax authorities haveallowed the organization an exemption to the extent of the premium paid under the policy since such a premiumcan be directly charged to profit and loss account. To sum up, we can say that the principle of economic value i.e. the surplus contribution concept is shifted from a family economic unit to a profit earning business organisation/enterprise. 3.2.2 Replacement of Future Income of the Insured HLV: PV OF ANNUITY OF ANNUAL INCOME NET OF SELF MAINTAINANCE, TAXES & PREMIUMS 1st Step - Estimate the gross annual income of the breadwinner 2nd Step- Determine the net annual income that would be available to the family 190

Gross Annual Pre Tax Income : XXX Less: Taxes Payable : XX Less: Self Maintenance Expenses : XX Less: Life Insurance Premiums Paid : XX XXX Net Annual Income Available To Family : XXX 3rd Step- Calculate PV of the net annual income (due annuity) SET : Begin (HLV is always calculated as a due annuity signifying expenses annuity) N : Years to Retire (Since the basis of calculation is income) I : Post Tax Growth Adjusted Interest Rate PV : Solve (Gross HLV) PMT : Net Annual Income Available To Family FV : Ignore Shetty's present age is 38 years and wishes to retire at age 60. Present salary is Rs 3,00,000 p.a. Total Life Insurance premiums paid Rs 30,000 p.a. Income Tax amounts to Rs 45,000. Medical expenses are being reimbursed by the company and self maintenance expenses Rs 36,000 (including entertainment, club membership, sports). Find HLV @ 8% interest p.a. given a current portfolio of Rs 10 Lakhs. Gross total Income = 300000 Less: Self-Maintenance charges = 36000 Less: Taxes payable = 45000 Less: Life insurance premium on policies = 30000 111000 Surplus generated = 189000 PMT=189000, N=22,1=8, BEG, PV= 2082176 Gross Human Life Value = 2082176 191

Net Human Life Value = 2082176 - 1000000 = 1082176 Variable Annuity - Increasing Income Approach In the 3rd step I will be calculated as: (((1+I)/(1+G))-1)*100 where G means fixed growth rate of income. All other calculations will remain the same as previous approach. 2] Find HLV for the abovementioned situation if Mr. Shetty's income is increasing @5% p.a. Gross total Income = 300000 Less: Self-Maintenance charges = 36000 Less: Taxes payable = 45000 Less: Life insurance premium on policies = 30000 111000 Surplus generated = 189000 Set -Begin PMT=189000, N=22,1=8, G=5 Therefore, I'={(8-5)÷1.05 Thus PV =3142945 Current Portfolio = 1000000 Net HLV = 3142945-1000000 = 2142945 3.2.3 Case Study HLV: PV OF ANNUITY OF ANNUAL EXPENSES NET OF SELF MAINTAINANCE, TAXES & PREMIUMS 1st Step- Estimate the gross annual expenses of the family, including the breadwinner 2nd Step- Determine the net annual expenses of the family, excluding the breadwinner Gross Annual Expenses of Family : XXX Less: Taxes Payable : XX Less: Self Maintenance Expenses : XX Less: Life Insurance Premiums Paid : XX XXX Net Annual Expenses of Family : XXX 3rd Step- Calculate PV of the net annual expenses (due annuity) 192

SET : Begin (HLV is always calculated as a due annuity signifying expenses annuity) N : Life Expectancy of Family (Since the basis of calculation is expenses) I : Post Tax Post Inflation Interest Rate PMT : Net Annual Expenses of Family PV : Solve (Gross HLV) Mr. Joshi is the sole income earner in the family. Mrs. Joshi is a homemaker. They are aged 40 and 36 respectively. Life expectancy for both of them is another 35 & 40 years respectively. They have no children. Other information you have is: Current investment portfolio - Rs 20 lakh; Estimated final Expenses - Rs 1 lakh.; Present annual expenses - Rs 4 lakh (including a lakh of Mr. Joshi's personal expenses); Assume an inflation rate of 4% p.a. and an interest rate of 6% p.a. Calculate additional insurance requirement for Mr. Joshi. Total expenses = 400000 Less: Mr. Joshi's personal expenses = 100000 100000 Required Annual Resources = 300000 Begin, N=40 I = (6-4)/1.04 PMT=300000, PV=Solve = 848425 Gross Human Life Value =8478425 Additional insurance required = 8478425 + 100000 – 2000000 = 6578425 Notes regarding Human Life Value Calculation 1. Under income replacement method, human life value is calculated as the present value of all future incomes of the client till his/ her retirement, discounted at the expected interest rate which the family will be able to earn post death of the client. (a) Under this method, income can be assumed to remain constant (level) or grow at a fixed rate (variable). 193

2. Under expense based method, human life value is calculated as the present value of all future expenses of the family of the client (excluding the client) till the life expectancy of the longest surviving dependent, discounted at the expected interest rate which the family will be able to earn post death of the client. (a) Under this method, expenses can be assumed to remain constant (level) or grow at a fixed rate (variable). 3. Since human life value represents a fund which the family of the client will be utilising for funding their living expenses post death of the client, thus human life value is always calculated as the present value of a due annuity. 4. The difference between the human life value and the present value of all net financial resources available with the family post death of the client can be managed by purchasing additional insurance. Practice Sums 1. Calculate the HLV to recommend total insurance cover required by Mr. Apte, Managing Director of Hindustan Tyres Limited. His present age is 45 years and as per board resolution his retirement age is fixed at age 70 years. He has a total annual income of' 21,00,000. He has paid following taxes: Corporate professional tax' 5,000 and Income tax' 4,10,000 as per his individual tax return filed. He pays total life insurance premium of' 55,000 (life cover of' 22,00,000) for self; Reasonable maintenance charge for a person of his stature is assumed as' 1,00,000 p.a. Applied interest rate to arrive at a present value of his future income is 5%. Total Income = 2100000 Less: Corporate Taxes = 5000 Income Taxes = 410000 Life Insurance Premium = 55000 Self Maintenance Expenses = 100000 (570000) Net Income 1530000 Begin, PMT=1530000, N=70-45, i=5 PV =22641922 (Gross HLV or Total Insurance Cover) 2. Mr. and Mrs. Rao, aged 46 and 42 years, both have a life expectancy of another 35 years. Calculate the insurance requirement for Mr. Rao, based on need based approach. You have the following information: Current investments' 25,00,000, Current Annual Expenses' 3,00,000 (including' 1 lakh of Mr. Rao‘s personal expenses), Mr. Rao's income post tax' 3.5 lakhs p.a., Final costs' 1 lakh, Post tax, post inflation 194

rate/discount factor: 3%. Total expenses = 300000 Less: Mr. Rao‘s personal expenses = 100000 Required Annual Resources = 200000 Begin, PMT=200000, N=35,1=3 PV =4426367 Resources available to the family = 2500000 HLV=4426367-2500000+100000=2026367 3. Avinash, at age 35 years, had annual earnings of' 6,00,000 growing at 7% p.a. He purchased life insurance based on income replacement method assuming retirement age to be 58 years and interest rate as 9.5% p.a. Today, after 5 years, his annual earnings are₹ 9,00,000 growing at 9% p.a. If other assumptions remain the same, how much additional life insurance cover should he buy? Step 1: Calculation of HLV at age 35 Set=Begin N=58-35 I = (9.5-7) ÷1.07,Pmt= 600000 PV = Solve = (10830035) Step 2: Calculation of HLV at age 40 Set=Begin N=58-40 I = (9.5-9) ÷1.09,Pmt= 900000 PV = Solve = (15586286), Step 3: Calculation of additional life insurance cover 15586286-10830035=4756251 3.2.4 Provision in the Life Cover of Certain Financial Goals and Financial Liabilities There are several areas to be considered here. These can be categorised as: • funeral and other final expenses; • final medical expenses; • repayment of debts; and • establishment of an emergency fund. 195

Funeral and Other Final Expenses Such expenses are inevitable. Funeral expenses will vary, but an amount in the vicinity of ₹20,000 would take care of most situations, and would probably cover other small costs that are also incurred (such as domestic / overseas phone calls, ambulance and conveyance costs). There are also likely to be legal expenses; for example, the deceased's lawyer will most likely need to be engaged to assist the executor in the distribution of the estate. Final Medical Expenses In the last topic, the incidence of a number of illnesses and diseases was discussed, as was the extent to which these lead to death. The medical, hospital and other costs associated with these conditions can be significant and need to be provided for. Repayment of Debts The repayment of debts can be a considerable drain on income. As we saw in Topic 3, as families develop, they pass through a number of stages —from the young family, to the situation where the children have all become independent and the parents have entered retirement. Total household costs and / or the ratio between debt and earnings are normally greatest in the early stages, and least when approaching retirement. In providing for dependants, one thing that can help considerably is to eliminate any debts, so that the amount needed for ongoing living expenses is minimised. The larger the debt, the greater is the drain on income. By repaying the debt at the time of death, it will not be an ongoing drain on the dependants' income stream in the future. This is the approach that should be taken with all debts. The types of debt that may be encountered include the following: House mortgage: This would be the largest debt that may be encountered. Making funds available, so that this can be repaid in the event of death, will significantly reduce the amount needed for living expenses. Personal loans and loans for motor vehicles or similar types of loans: These loans are usually for reasonably significant amounts, and once again to continue with the repayment program will be a drain on the income available to dependants. The better approach would be to have these loans paid out at the time of death, freeing the available income of this burden. 196

Credit cards, charge accounts and similar continuous credit facilities: These can, depending on the outstanding balance, create a drain on income. While credit facilities are a part of everyday life, a high level of debt at the time of death may be too great to be met from the post-death income. The better approach is to clear all the debts. Credit cards and other credit facilities can continue to be used, but within the scope of the post-death income. Other debts: There will likely be debt of some other sort. The higher the amount involved, the more problem it may be in future when it has to be met from the post-death income stream. The best approach is for them to be paid out completely, so that the post-death income stream is able to commence without any undue burdens on it. Much of the information in relation to these items will be revealed in the client interview, and recorded on the fact finder (see Topic 3) or other client data collection form used in the interview. Establishment of an Emergency Fund At the time of death, there will be a number of unexpected expenses, not necessarily large in nature, but they can accumulate. In the period immediately following death, any dependants will go through a time of adjustment as they adapt to their new economic circumstances. This period could last for 6 -12 months. An emergency fund can ease this period, and assist adjustment. The amount to be set aside would vary according to the family's circumstances. 197

3.2.5 Review of Coverage for Changes in Income, Assets and Financial Liabilities An earning individual's total potential will be equal to the value of his estate as on date plus current surplus income and future estimated potential earnings generating surplus economic value. This represents the total estimated wealth. For illustrating this concept let us make a notional Balance Sheet format where the total value of the estate or wealth will be on debit side and its notional liabilities will appear on credit side. In other words, the creation of wealthy a causal effect of an individual's total earning capacity, the wealth so created represents a capital investment i.e. the individual's earning capacity being invested as capital. This investment can be protected by risk cover offered by a life policy. HLV (Notional) Balance Sheet (Capital Redemption) Liabilities Assets Present earning capacity including Current Assets - Cash, Bank savings, contingent liabilities Financial Assets, Real Assets Estimated potential earnings in future Life Insurance Policy (HLV) From the above it is quite dear that the HLV will be a representative value to cover the 198

potential earnings in future out of which an estate can be created for the family. The same balance sheet can be represented in another form but it can be explained only when we go for analysis of individual/family needs. Once we accept the capital formation through HLV represented by present assets plus potential earnings we can extend the principle of capital redemption. This can be explained by the following examples: Example - I An outstanding liability of ₹50,000 without any security offered through hypothecation of an existing asset. This we can call an unsecured loan raised for business. The hypothesis is that after assessing the individual's potential capacity, it is presumed that he will be able to repay the loan out of his future earnings. The creditor will be more relaxed and comfortable about extending if the source of future earnings is protected through a life insurance policy. This can be offered as collateral security. In terms of asset portfolio management, this hypothecated life policy will be a semi current asset being offered as a security which will protect the total present capital. There will not be any need to liquidate some assets to repay the loan in case the future earnings are discontinued on account of life assured's death, disability or unemployment. Example - 2 A young engineer raises a loan of ₹1,000,000 from a government agency under a scheme to support unemployed graduate engineers. The loan is being offered to set up his own business enterprise. This young graduate does not have any asset to mortgage with the government agency or the sponsor- bank, offering the loan. For capital redemption, a life policy (preferably term assurance) can be taken, which can be hypothecated against the loan liability. If during the repayment term the loanee dies, the refund of capital is made through the policy proceeds and the life assured's legal heir or family can keep the business intact. Thus a HLV policy helps to enhance the credit worthiness of the life assured. In contrast to this there are mortgage redemption policies, which can be taken to offer a pledge against the unsecured loan, raised on the basis of individual's earning potential. To sum up 1. Human life concept helps us to arrive at a fair estimate of insurance cover required as on date to protect the income earners' economic value to his family unit including his capitalized potential earning capacity. The HLV principle can also be applied to corporates with the purchase of Key-Man Insurance. 199

2. Through HLV, a contingent notional asset can be created for the purpose of capital redemption with easy liquidity being offered. 200

QUESTIONS Q1. The client's _________ stage is an important determinant of his needs (a) opinion (b) lifecycle (c) financial need Q2. To calculate the life insurance needs Suppose a client's dependants immediately require a real income of ₹5,00,000 per year and assuming that the rate of return is 9% and the rate of inflation are 2%, the principalsum required to generate interest amounting to the required amount will be: (a) ₹56,32,658.15 (b) ₹77,85,762 (c) ₹64,85,752.18 Q3. How the family is considered in HLV pattern? (a) Social Unit (b) Dependency unit (c) Economic unit (d) None of the above Q4. Life Insurance can be treated as (a) Total loss cover (b) Indemnity cover (c) Substitute for loss of income (d) All the above Q5. An individual's economic value is meant for (a) Self (b) Self + dependents (c) Family (economic unit) (d) Only dependents 201

Q6. HLV explains in general (a) Total income of an individual (b) Total wealth of an individual (c) Earning capacity Q7. Total HLV is equal to (a) Total savings (b) Total investment (c) Present value of all future income of an individual (d) Past income Q8. The economic value to an individual's family is represented by (a) Total earnings (b) Total expenditure (c) Surplus generated out of income. Q9. Corporate HLV can be a base for (a) Capital redemption insurance (b) Key-man insurance (c) Employee group insurance (d) None of the above Q10. The concept of HLV provides a guideline to arrive at (a) Affordable insurance (b) Adequate insurance cover (c) Cover to satisfy specific needs (d) All the above Q11. The paramedical hierarchy of human needs is presented by (a) Edward D'bono (b) Maslow (c) Napolean Hill (d) S.S. Huebener 202

Q12. Need analysis basically involves (a) Need sequencing (b) Needs explaining (c) Needs prioritization (d) None of the above Q13. Calculate HLV to recommend adequate insurance cover: Mr. Ritesh, age 30 retirement age 60. Hisis Asst. Vice President (Tech.) with Global Cosmetic Limited Present monthly salary ₹55,000 approximately. He pays Professional tax of ₹3000 and income tax subject to allowable deductions i.e. tax paid ₹1,32,000. Reasonable self maintenance expenditure estimated ₹45,000 p.a.; Life Insurance premium for self ₹18,000 with total sum assured ₹12,00,000. For wife and child he pays insurance premium of ₹10,500 and 6,500 respectively. Real rate of interest assumed for capitalisation of future income is at 8%. dequate additional insurance recommended will be (a) ₹56 lakhs (b) ₹44 lakhs (c) ₹55 lakhs (d) ₹lCrore Q14. Calculate the HLV to recommend total insurance cover Mr. Apte, Managing Director, Hindustan Tyres Limited. His present age 45. As per board resolution his retirement age is fixed at age 70. He has total annual income of ₹21,00,000. He has paid following taxes : Corporate professional tax 5,000; Income tax 4,10,000 as per his individual tax return filed. He pays total life insurance premium of ₹55,000 (self insurance cover S.A. 22,00,000); Reasonable maintenance charge for a person of his stature is assumed as ₹1,00,000 p.a. applied rate of interest to arrive at a present value of his future income is at 5% (a) ₹2.26 Crores (b) ₹2.04Crores (c) ₹1.80 Crores (d) ₹12 Crores Q15. Mr. Rajeev an electronics engineer applies for a bank loan to launch his own venture budgeted of ₹1 crore. The bank approves the loan with a conditional hypothecation margin of +25% and directs Mr. Rajeev to hypothecate the life policy as a collateral security for mortgage redemption what will be the sum assured of the policy. 203

(a) ₹75 lakhs (b) ₹80 lakhs (c) ₹1.25 crore (d) ₹2 Crores Q16. The first step in review of the insurance program of a client by a planner is (a) To find out the insurance needs of the client (b) To ascertain the liabilities of the client (c) To establish the frequency with which a review will be made of the client's program (d) To contact the client to ascertain the changes in his needs Q17. The review of the client's program should end with (a) Setting of a time for future review meeting with the client (b) Implementing of the revised program (c) Arriving at a revised program after consulting with the client (d) Discussing with the client the need for review of the program Q18. While conducting the review of the insurance program of the client, the planner should (a) Indicate to the client in the insurer has introduced any new product which will meet the client's needs better than the existing one (b) Bring to the notice of the client the need for additional cover to be purchased for the changed needs or circumstances (c) Keep the client informed of the risks faced by him which are not covered by the insurance program (d) All of the above Q19. Mr. and Mrs. Srinivas' have Mr. Srinivas's mother staying with them, who is entirely dependent on them. As an insurance advisor, you would estimate the life expectancy of (a) Mr. Srinivas because he rims the household (a) Mrs. Srinivas because in her absence, who would look after the mother (b) Mr. Srinivas's mother because Mr. and Mrs. Srinivas have to support her for life (c) None of the above Q20. Mr. Sharma is an Advocate having a roaring practice consisting of highly valued intricate 204

cases of Company Law. Clients are corporates. He has 3 young juniors. Cash transactions do not take place in the office that he maintains with modest furnishing. Which of the following covers is most necessary for him: (a) Fidelity Guarantee (b) Professional Indemnity (c) Public liability (d) Burglary Q21. In quantifying cost of personal risk of death, proper priority amongst the following will be: (a) Repayment of Debts (b) Funeral and other expenses (c) Establishment of an emergency fund (d) Final Medical expenses. Q22. What is the correct priority sequence in steps of Review: (A) Establish a frequency (B) Establish change in clients' circumstances (C) Develop revised program (D) Take approval of the client to revised programme, (a) ABCD (b) ACDB (c) ACBD (d) ADBC Q23. One item in the following list is not considered a short term liability (a) Credit-card debt (b) Education loan (c) Hire purchase (d) Personal loan Q24. One of the following statements does not apply to the Human Life Value approach in determining how much insurance one needs: (a) HLV is the source of all income and wealth. 205

(b) HLV is the connecting link between generations. (c) HLV accounts for the additional income stream flow arising from the individual's career progress. (d) Family is an economic partnership organization woven around the HLV of its members. Q25. One of the factors listed below does not enter the HLV calculations:- (a) Premium paid on spouse's life. (b) Self maintenance charges. (c) Taxes Payable (d) Gross Total Income Q26. The \"financial gap in funds required\" is the focus of one of the following methods of ascertaining how much insurance is needed. (a) Human Life Value approach (b) Capital Redemption approach (c) Multiple approach (d) Need based approach Q27. A family's insurance needs are the most where: a) A family is just founded. (b) Where chief earner is retiring. (c) Where the children are very young. (d) None of the above. Q28. Mr. Joshi is the sole income earner in the family. Mrs. Rao is a homemaker. They are aged 40 and 36 respectively. Life expectancy for both of them is another 40 years. They have no children. Other information you have is: Current investment portfolio - ₹20 lakh.; Estimated final Expenses - ₹1 lakh.; Present annual expenses-₹4 lakh (including a lakh of Mr. Rao's personal expenses); Mr. Rao's post-tax income in hand-₹3.5 lakh.; Assume a post tax, post inflation return/discounting factor of 3%.. Calculate the insurance requirement under the Needs Based method. (a) ₹51.42 lakhs (b) ₹72.42 lakhs (c) ₹52.42 lakhs 206

(d) ₹71.42 lakhs Q29. HLV = Human Life Value = (E - M) an where E is the total earnings p.a. and Mis the maintenance expenses of an individual & n is the period. The above present value is calculated taking (E - M) at (a) End of each year (b) Middle of each year (c) Beginning of each year (d) Immaterial what point of time is taken ANSWERS 1 B 11 B 21 B 2 B 12 C 22 A 3 C 13 B 23 B 4 C 14 A 24 C 5 C 15 C 25 A 6 B 16 C 26 D 7 C 17 A 27 C 8 C 18 D 28 C 9 B 19 C 29 C 10 B 20 B Explanation: Q2. (Annuity required/rrr)*(1+rrr) = (500000/1.068627) * 1.068627 = 7785762 Q13. Begin, n=30, I = 8, pmt = 55000*12-3000-132000-45000-18000 Pv=solve =5617183 Additional cover = 5617183-1200000 Q14. As in this question total insurance cover is required not additional insurance cover. 207

3.3 TYPES OF LIFE INSURANCE POLICIES 3.3.1 Term Insurance By definition, all term insurance products provide coverage for a specified period of time, called the policy term. The policy benefit is payable only if (1) the insured dies during the specified term and (2) the policy is in force when the insured dies. If the insured lives until the end of the specified term, the policyowner may have the right to continue the coverage provided by the policy. If coverage is not continued, then the policy expires and the insurer has no liability to provide further insurance coverage. The length of the term varies considerably from policy to policy. The term may be as short as the time required to complete an airplane trip or as long as 30,40, or more years. In general, though, insurers seldom sell term life insurance to cover periods of less than 1 year, 1 year, 5 years, 10 years, 20 years or it may be defined by specifying the age of the insured at the end of the term For example, a term insurance policy that covers an insured until age 65, and the policy's coverage expires on the policy anniversary that falls either closest to, or immediately after, the insured person's 65 birthday. The policy anniversary is the 208

anniversary of the date on which the policy was issued. For example, if a company issues a policy of December 2 of a given year, then every succeeding December 2 is the policy anniversary. Both the expiration date and the policy anniversary date are usually stated on the face page of the policy. Term life insurance protection is usually provided by an insurance policy,but it can also be provided by a rider added to a policy. A policy rider, which is also called an endorsement, is an amendment to an insurance policy that becomes a part of the insurance contract and that either expands or limits the benefits payable under the contract. A policy rider is as legally effective as any other part of the insurance contract. Riders are commonly used to provide some type of supplementary benefit or to increase the amount of the death benefit provided by a policy, although riders may also be used to limit or modify a policy's coverage. Some of the supplementary benefits - including some term insurance benefits - that are commonly provided through riders attached to life insurance policies are described in further Chapter. Plans of Term Life Insurance Coverage The amount of the benefit payable under a term life insurance policy or rider usually remains level throughout the term of the policy. Term life insurance, however, may also be purchased to provide either a benefit that decreases over the policy's term or a benefit that increases over the policy's term. Level Term Life Insurance By far, the most common plan of term insurance is level term life insurance. A level term life insurance policy provides a death benefit that remains the same over the term of the policy. For example, under a five-year level term policy that provides ₹100,000 of coverage, the insurer agrees to pay ₹100,000 if the insured dies at any time during the five-year period that the policy is in force. The amount of each renewal premium payable for a level term life insurance policy usually remains the same throughout the stated term of coverage. Decreasing Term Life Insurance The amount of the policy benefit payable under a decreasing term life insurance policy decreases over the term of coverage. The policy's death benefit begins as a set face amount and then decreases over the term of coverage according to some stated method that is described in the policy. For example, assume that the benefit during the first year of coverage of a five-year decreasing term policy is ₹50,000 and then decreases by ₹10,000 on each policy anniversary. The coverage is ₹40,000 for the second policy year, ₹30,000 for the third year ₹20,000, for the fourth year, and ₹10,000 for the last year. At the end of the fifth policy year, the coverage expires. The amount of each renewal premium payable for a 209

decreasing term insurance policy usually remains level throughout the term of coverage. Insurance companies offer several plans of decreasing term insurance, including (1) mortgage redemption insurance, (2) credit life insurance, and (3) family income insurance. Each of these plans provides benefits to meet a specific need for insurance, and we describe in this section how these plans operate to meet those specific needs. Mortgage Redemption Insurance Mortgage Redemption Insurance is a plan of decreasing term insurance designed to provide a death benefit amount that corresponds to the decreasing amount owed on a mortgage. If you have ever bought a home, you are probably aware that each payment a borrower makes on a mortgage loan consists of both principal and interest on the loan. The amount of the outstanding principal balance owed on the mortgage loan gradually decreases over the term of the mortgage, although initially the decrease is fairly slow. (See figure for a graphic illustration of mortgage redemption insurance.) If the borrower purchases mortgage redemption insurance, the amount of the policy benefit payable at any given time generally equals the amount the borrower then owes on the mortgage loan. The term of a mortgage redemption policy is based on the length of the mortgage, which is usually 10,15,20, or 30 years. Renewal premiums payable for mortgage redemption insurance are generally level throughout the term. Often, the beneficiary of a mortgage redemption policy uses the policy benefit to pay off the mortgage. The beneficiary, however, typically is not required to do that. In most instances, the life insurance policy is independent of the mortgage - the institution granting the mortgage is not a party to the insurance contract - and the beneficiary is not required to use the proceeds of the policy to repay the mortgage. The following example describes this situation. Example: Balraj Mhatre and his wife, Anjali, purchased a new home and obtained a 30-year mortgage from the New Home Mortgage Company. Balraj decided to purchase a mortgage redemption life insurance policy from the Insurance Company. He wanted to ensure that Anjali could afford to stay in the home if she should outlive him. So, he named Anjali as the beneficiary. Three years later, Balraj died in an accident, and Insurance company paid Anjali a death benefit of ₹72,150 - the loan amount remaining on the mortgage. Anjali invested the policy proceeds in a mutual fund and continued to make monthly mortgage payments. 210

Analysis: Because the contract for insurance was between Insurance company and Balraj Mhatre, Anjali was under no obligation to use the proceeds to pay the balance due on the mortgage. Note that the beneficiary decided not to pay off the mortgage. She apparently had sufficient income after investing the policy proceeds to make the monthly mortgage payments. If she did not think she had enough income to make those monthly payments, she could have used the policy proceeds to pay off the mortgage. In either case, the availability of the policy death benefit fulfilled Balraj‘s need to provide Anjali with sufficient financial resources to allow her to continue to live in the house if she outlived him. Increasing Term Life Insurance Increasing term life insurance provides a death benefit that starts at one amount and increases by some specified amount or percentage at stated intervals over the policy term. For example, an insurance company may offer coverage that starts at ₹100,000 and then increases by 5 percent on each policy anniversary date throughout the term of the policy. Alternatively, the face amount may increase according to increases in the cost of living, as measured by a standard index such as the Consumer Price Index (CPI). The premium for increasing term insurance generally increases as the amount of coverage increases. The policyowner is usually granted the option of freezing at any time the amount of coverage provided by the increasing term life insurance. This coverage may be provided by an increasing term life insurance policy or, more commonly, as a rider to a policy. Renewable Term Life Insurance Renewable term life insurance policies include a renewal provision that gives policyowner the right to renew the insurance coverage at the end of the specified term without submitting evidence of insurability - proof that the insured person continues to be an insurable risk. In other words, the insured is not required to undergo a medical examination or to provide the insurer with an updated health history. Regardless of the insured's health 211

at the end of the term of the coverage, the insurance company must renew the coverage if the policyowner requests a renewal. The following is a sample renewal provision contained in a yearly renewable term life insurance policy. Renewal: You may renew this policy for one year by continuing to pay premiums when due. You need not give proof of insurability. You may renew this policy on (1) the policy anniversary date; (2) each later policy anniversary before the policy anniversary nearest the insured's 75th birthday. When a term life insurance policy is renewed, however, the policy's premium rate increases. The renewal premium rate is based on the insured person's attained age (the age the insured has reached) on the renewal date. As we described in an earlier chapter, mortality rates generally increases as people grow older. Because the insured's mortality risk has increased over the initial term of coverage, the renewal premium rate must also be increased. The renewal premium rate remains level throughout the new term of coverage. Convertible Term Life Insurance Convertible term insurance policies contain a conversion privilege that allows the policyowner to change – convertthe term insurance policy to a permanent plan of insurance without providing evidence that the insured is an insurable risk. Even if the health of the person insured by a convertible term policy has deteriorated to the point that she would otherwise be uninsurable, the policyowner can obtain permanent insurance coverage on the insured because evidence of insurability is not required at the time of conversion. The premium that the policyowner is charged for the permanent coverage cannot be based on any increase in the insured's mortality risk, except with regard to an increase in the insured's age. 3.3.2 Whole Life Policy Two primary characteristics distinguish permanent life insurance products from term life insurance products.  Permanent life insurance products offer lifetime coverage.Term life insurance provides protection for a certain period of time and provides no benefits after that period ends. In contrast, permanent life insurance provides protection for the entire lifetime of the insured/ so long as premiums are paid as required.  Permanent life insurance products provide insurance coverage and contain a savings element.Term life insurance usually provides only insurance protection. In 212

contrast, permanent life insurance not only provides insurance protection, it also builds cash value that functions as a savings element. Some plans of permanent insurance have been sold for a hundred years; others have been introduced in more recent years. Although both traditional whole life insurance products and the newer plans of permanent insurance share characteristics that distinguish them from term life insurance products, the features and benefits of the various plans of permanent life insurance differ widely. Traditional Whole Life Insurance Whole Life Insurance provides lifetime insurance coverage at a level premium rate that does not increase as the insured ages. Insurers use the level premium system to price life insurance so that the premium rate does not increase as the insured's mortality rate increases. The insurance company invests the excess premium dollars it collects in the early years under the level premium system and accumulates assets that are at least equal to the amount of the policy reserve liability the insurer has established for those policies. As we have described, a permanent life insurance policy contains a savings element that is known as the policy's cash value. A policy that provides a cash value will include a chart that illustrates how the cash value will grow over time. If for some reason the policy does not remain in force until the insured's death, the insurer agrees to refund the cash value to the policyowner - less any surrender charges and outstanding policy loans. Because the policyowner generally has the right to surrender a permanent life insurance policy for its cash value during the insured's lifetime, the cash value is sometimes referred to as the surrender value or the cash surrender value. We describe the cash surrender value in more detail. Premium Payment Periods Whole life policies can be classified on the basis of the length of the policy's premium payment period. Most whole life policies are classified as either (1) continuous-premium policies or (2) limited-payment policies. Continuous - Premium Policies:- Under a continuous-premium whole life policy (sometimes referred to as a straight life insurance policy), premiums are payable until the death of the insured. Because premiums are payable over the life of the policy, the amount of each premium payment required for a continuous-premium whole life policy is lower than the premium amount required under any other premium payment schedule. 213

Limited - Payment Policies:- A limited-payment whole life policy is a whole life policy for which premiums are payable only until some stated period expires or until the insured's death, whichever occurs first. The policy may describe the stated period over which premiums are payable in one of two ways. 1. The policy may state a specific number of years during which premiums are payable. For example, a 20-payment whole life insurance policy is a policy for which premiums for 20 years. 2. The policy may state an age after which premiums are no longer payable. For example, a paid-up-at- age-65 whole life insurance policy provides that premiums are payable until the insured reaches the policy anniversary closest to or immediately following her 65th birthday, at which time the premium payments cease but the coverage continues. In either case, if the insured dies before the end of the specified premium payment period, the insurer will pay the death benefit to the named beneficiary and no further premiums are payable. Limited-payment policies are designed to meet a policyowner's need for permanent life insurance protection that is funded over a limited time period. The policyowner, for example, may expect that her income will drop considerably when she retires, and yet she anticipates that she will still need life insurance coverage after retirement. Example: Amrita Saxena who has just turned 42, plans to retire at age 62, at which time her income will be reduced considerably. Amrita wishes to obtain permanent life insurance, but she is concerned that she will not be able to pay the premiums from her retirement income. She has, therefore, purchased a 20-payment whole life policy. Analysis: Amrita will make her last premium payment at age 61, at which time she will have a paid-up policy that will require no further premium payments but will provide life insurance coverage for the rest of her life. The insurer establishes the premium amounts required for a limited payment policy so that, at the end of the premium payment period, it has received sufficient premiums to keep the policy in force for the rest of the insured's lifetime. A policy that requires no further premium payments is said to be a paid-up policy. Because fewer annual premium payments are expected to be made for a limited-payment policy than for a comparable continuous- premium policy, the annual premium for the limited-payment policy is larger than the annual premium for an equivalent continuous-premium policy. 214

3.3.3 Endowment Policy Endowment insurance provides a specified benefit amount whether the insured lives to the end of the term of coverage or dies during that term. Each endowment policy specifies a maturity date, which is the date on which the policy's face amount will be paid to the policyowner if the insured is still living. The maturity date is reached either (1) at the end of a stated term or (2) when the insured reaches a specified age. For example, the maturity date of a 20-year endowment policy is 20years following the policy's effective date; the maturity date of an endowment at age 65 policy is when the insured reaches age 65. If the insured dies before the maturity date, then the policy‘s face amount is paid to the designated beneficiary. Thus, an endowment insurance policy pays a fixed benefit whether the insured survives to the policy's maturity date or dies before that maturity date. Endowment policies share many of the features of permanent life insurance policies. For example, premiums usually are level throughout the term of an endowment policy, although an endowment can be purchased with a single premium or with a series of premiums over a limited period of time. Example : Sum assured = 1 lacs, term of the policy = 20 years, premium = Rs.5000 p.a. Guaranteed simple reversionary bonus = Rs.60 per thousand sum assured The maturity of this policy will be = 1 lac + 60/1000 * 100000 * 20 = 220000 Modified Products Money Back Policies These are endowment type plans and are also called Anticipated Endowment Policies. Under such products a certain percentage of the sum assured is paid to the proposer at regular interval, generally after every 4 or 5 years. The balance of the sum assured is payable on the date of maturity along with the bonus. However, the risk remains covered for the full sum assured throughout the policy term subject to the policy being in force. Illustration: for a policy with a term of 12 years, l/5th of the sum assured becomes payable on the life assured surviving 4 years, a further 1 /5th of the sum assured becomes payable on his surviving 8 years and the balance 3/5th of the sum assured on his surviving to the 215

end of the term of 12 years Generally such policies are with profit policies and, therefore, the bonus amount will also be paid along with the balance sum assured. Hence under a policy of rupees 1 Lac sum assured, rupees 20,000/- will be paid on insured surviving for 4 tears, another 20,000/ - will be paid on his surviving 8 years and balance 60,000/- along with bonus will be paid on surviving the term of 12 years i.e. on the date of maturity. In case of earlier death at any time during the term, rupees 1 Lac along with bonus is payable. The bonus will always be calculated on basic sum assured. The death risk also remains constant for rupees 1 Lac subject to policy being in force at the time of death. If the insurer so desires he can frame a money back policy where 25% is payable after every four years and balance 50% may be paid on maturity. The money back policies on the above pattern are available for 15/ 20/ 25 years term where survival benefits ranging from 15% to 25% are paid after every 5 years interval as per terms of the policy. However, in a 20 years policy the first survival benefit may be paid after 10 years and in a 25 years policy after 15 years. Above products although costly yet are very popular in the market. In temptation to buy such policies one should not forget to cover death risk adequately. Joint Life Endowment Insurance Plan Normally husband and wife are covered under a single policy in such a plan. Death risk is covered for both the partners. On maturity sum assured is paid along with bonus. In case of death of any partner during the term of the policy, the basic sum assured is paid to the surviving partner and further premiums are waived and the policy remain in force. On maturity basic sum assured is paid with bonus to the surviving partner. Such policies can be issued for business partners as well with some modification. Children Insurance Plans Marriage Endowment Policies These are endowment type of policies where the sum assured is payable only on the expiry of the policy term. Such policies are bought to save money for the marriage of the children. In case the proroser dies during the term of the policy, the premium payment ceases (if policy is with premium waiver benefit) and policy continues and the sum assured is paid on the expiry of the policy term along with the bonus, if the policy is with profit, to serve the specific purpose for which it was purchased. Some insurer pay basic sum assured on death during the term and another sum assured along with bonus on maturity. 216

Children Deferred Plans/Children Anticipated Plans These are also endowment type plans taken on the lives of minors. A parent signs the contract on behalf of the child. The risk of child is not covered immediately and is deferred for sometime as per age of the child and policy provisions. On attaining majority, the child becomes the owner of the policy. The benefit of taking such a plan is that a father/ mother can buy this policy at a lower premium because of young age of the insured and it also inculcates a habit of saving in children. The amount received on maturity can help the child to establish himself / herself in life. Such plans are also issued in the form of money back policy where periodical payments are received before the final payment on maturity. The policies are called Children Anticipated Plans. Children Education Plan/Annuities These policies are also on the pattern of marriage endowment policies except the payment of the sum assured is spread over in 4 to 5 yearly instalments. The parents generally take such policies for the term when the child attains age 21 or so for meeting his/her higher educational expenses. Most of the educational plans are with profits. It will be observed that though above two plans are for the benefit of the children but coverage of risk is on the life of the parent, the proposer. Some insurers call these plans as children protection plans. 3.3.4 Investment Linked Insurance A New Generation of Permanent Products During the decades of the 1970s and 1980s, the North American economy changed to such a degree that insurers, like many other financial institutions, were forced to take a long look at the products they offered. Inflation hit record highs; interest rates on savings accounts and consumer loans soared. Consumers realized that the cash values of their whole life policies 217

were earning investment returns at rates that were much lower than the rates that savings accounts and other investment vehicles could earn. Insurers realized that much of their invested assets were earning a lower return than could be obtained through newer investments. To address the need for insurance products that were more responsive to the changing economy, insurers began marketing a new generation of insurance products. These plans are characterized by their ability to reflect current conditions in the financial marketplace. These new generation products include universal life, adjustable life, variable life, variable universal life, interest-sensitive whole life, and indeterminate premium products. Universal Life Insurance Universal life insurance is a form of permanent life insurance that is characterized by its flexible premiums, its flexible face amounts, and its unbundling of the pricing factors. All of the policies that we have described until now - both term insurance policies and whole life insurance policies - state the gross premium that the policyowner must pay in order to keep the policy in force. However, some policies - most notably universal life insurance policies - list each of the three pricing factors (mortality, interest, and expenses) separately. In addition, the policyowner is given the flexibility to determine, within certain limits, the amount of the premium she wants to pay for the coverage. The larger the premium that the policyowner pays, the greater will be the policy's cash value. In the following sections, we describe the distinguishing characteristics of universal life policies. In particular, we describe its flexibility - both in terms of face amounts and premium amounts - and how its unbundled pricingworks. We also show how a typical universal life policy operates and describe some other unusual characteristics of the policy. Because the unbundling of the pricing structure is at the core of the operation of a universal life policy, we begin with that aspect of the policy. Unbundled Pricing Factors Each of the three factors that the insurer will apply to price a universal life policy is listed separately in the policy. Thus, each universal life policy specifies (1) the mortality charges that will be applied periodically, (2) the interest rate that will be credited periodically to the policy's cash value, and (3) the expense charges that will be applied. 218

Mortality Charges The insurer periodically deducts a mortality charge from the universal life policy's cash value. This mortality charge is the amount the insurer needs to collect to cover the mortality risk it has assumed by issuing the universal life policy. In other words, the mortality charge pays the cost of the life insurance coverage. Each universal life policy states the mortality charge that the insurer will periodically apply. The amount of this charge is based on the insured's risk classification, and the charge typically increases each year as the insured ages. Universal life policies guarantee that the mortality charge will never exceed a stated maximum amount. In addition, however, these policies usually provide that the mortality charge will be less than the specified maximum if the insurance company's mortality experience is more favorable than expected. The mortality charge is expressed as a charge per thousand dollars of net amount at risk. Although policies define net amount at risk in various ways, in general, a policy's net amount at risk at any given time is equal to the difference between (1) the death benefit provided by the policy and (2) the amount of the policy's cash value. We describe the net amount at risk in more detail later in this section. Interest A universal life insurance policy guarantees that the insurer will pay at least a stated minimum interest rate on the policy's cash value each year. The policy also provides that the insurer will pay a higher interest rate if economic and competitive conditions warrant. For example, some policies state that the interest rate paid will reflect current interest rates in the economy. Some policies state that the interest rate to be paid on the cash value will be tied to the rate paid on a standard investment, such as some category of United States Government Treasury Bills. According to the terms of some universal life policies, the guaranteed interest rate is paid on cash value amounts up to a stated amount, such as ₹1,000; any amounts over the stated amount are credited with the higher current interest rate. Finally, most universal life policies provide that any portion of the cash value that is being used as security for a policy loan will earn interest at a rate that is lower than the current rate. This reduced rate, however, will not fall below the guaranteed minimum rate of interest. 219

Expenses Each universal life insurance policy lists the expense charges that the insurance company will impose to cover the costs it incurs to administer the policy. These expense charges can include  A flat charge the first policy year to cover sales and policy issue costs;  A percentage of each annual premium (such as 5 percent) to cover expenses;  A monthly administration fee; and  Specific service charges for coverage changes, cash withdrawals, and policy surrenders. Flexibility Features A universal life insurance policy gives the policyowner a great deal of flexibility, both when he purchases the policy and over the life of the policy. When he purchases the policy, the policyowner decides, within certain limits,what the policy's face amount will be and the amount of premiums he'll pay for that coverage. Both of these choices can be changed during the life of the policy, but some changes must first be approved by the insurance company. Face Amounts At the time he purchases the policy, the policyowner specifies the policy's face amount and decides whether the death benefit amount will be level or will vary with changes in the policy's cash value. Under an Option A plan (Option 1 plan), the amount of the death benefit is level; the death benefit payable is equal to the policy's face amount. Under an Option B Plan (Option 2 plan), the amount of the death benefit at any given time is equal to the policy's face amount plus the amount of the policy's cash value. Note that the net amount at risk for an Option A plan decreases as the amount of the cash value increases. The net amount at risk for an Option B plan, however, is always equal to the policy's face amount. Option - A plan: (Death Benefit) = (Face Amount) Option - B plan: (Net Amount at Risk) = (Death Benefit - Cash Value) (Death Benefit) = (Face Amount + Cash Value) (Net Amount at Risk) - (Face Amount) 220

After the policy has been in force for a specified minimum time - often one year - the policyowner can request an increase or decrease in the policy's face amount. The policyowner is typically required to provide evidence of the insured's continued insurability in order to increase the policy's face amount. Before approving a decrease in a policy's face amount, the insurer must ensure that the decrease would not cause the policy to lose its status as an insurance contract and instead be classified as an investment contract. Later in this section, we describe the regulatory requirements that policies must meet in order to be classified as an insurance contract rather than an investment contract. Flexible Premiums The owner of a universal life policy is permitted to determine, within certain limits, how much to pay both for theinitial premium and for each subsequent renewal premium. The insurance company imposes maximum limits on the amounts of the initial and renewal premiums in order to ensure that the policy will maintain its status as an insurance policy. In addition, the insurance company requires that at least a stated minimum initial premium be paid. As long as the policy's cash value is large enough to pay the periodic charges imposed by the insurer, the policy will remain in force even if no renewal premiums are paid. If, however, the policy's cash value is insufficient to cover the periodic charges, the policy will lapse unless the policyowner pays an adequate renewal premium. The operation of a universal life insurance policy Unit linked Insurance Plans These are market-linked insurance products also called Unit-Linked Insurance Plans (ULIP). Unit-Linked plans are fundamentally different from the conventional life insurance policies. Unit Linked Insurance offers the benefits of: 221

a) Risk Cover (which can be a life cover or life cover with accident benefit or life cover and critical illness cover and accident benefit) b) Investment of savings in the capital market to ensure market linked returns to the insured c) Tax Benefits: income tax relief is available like in any other life insurance policy. It is a flexible saving Plan with transparency as to what portion of the premium is being invested in the market and how much of the premium is being earmarked for various expenses and charges. The investment of savings portion is made in the manner desired by the insured. Such Plans are normally for a fixed term but some insurers are offering such plans for whole life. Sometime there is an option to extend the term as per policy provision. The Plans carry a sum assured to cover the risk of death. Insurer collects contribution (Premium)) from the policyholders. A small portion of the premium is used to provide life cover, called mortality charges. After deducting the administrative and fund management charges, which are made known to the insured, the balance amount is used to purchase units in the investment Fund chosen by the insured. The units will be purchased on behalf of the insured as per the prevalent market price called offer price. Some Examples of the Funds are: Equity Fund Major portion of savings is invested in Stock Market. Some of these funds are Diversified Fund, Mid Cap Fund, Low Cap Fund, and Sector Fund. Debt Fund Major portion of savings is invested in Debt Market like investment in Government Securities, AAA/AA Rated PSU Bond/ Corporate Bonds/ or mix of them. Balanced Fund Savings are partly invested in Stock Market and partly in Debt Market. The proportion of equity and debt may be in the range of 40 to 60 or vice versa. The insurance company may offer more types of funds to satisfy some specific investment need of the insured. 222

The policyholder should select the funds for investment after careful consideration and looking to his profile and financial position. For instance, selecting equity fund may also bring the risk of fluctuation in the market that can deplete his capital. Hence, the policyholder should park the fund after consulting an investment consultant. Other Salient Features of Unit Linked Insurance are: In conventional type of policies, sum assured is a guaranteed amount payable on death and/ or maturity but in ULIPs the situation is quite different as discussed below: Death Benefit The value of the plan (the amount paid on death or maturity) is directly linked to the value of the fund. Upon death prior to expiry of the term the amount paid out is the sum insured or the value of the units whichever is greater. In other words, if the insured dies during the term of the policy, sum assured or the value of the units whichever is higher is payable to the nominee/ legal heirs. Maturity Benefit On the date of maturity only the market value of the units is payable. Hence there is no guaranteed amount payable on maturity. The value of the units depends upon the net value of the investment in the fund. The Net Asset Value (NAV) of a Unit is declared periodically. There is liquidity in such plans as the insured can withdraw / partially withdraw by selling units to the insurance company at prevalent NAV subject to the policy provisions. IRDA has taken some restrictive steps to reduce the liquidity so that the plans are not used only as an investment tool. Flexibility in Payment of Premium A unit-linked policy can be structured with flexibility in the payment of premiums. If the insured does not pay some premium, the risk of death remains covered by deducting the mortality charges by canceling the appropriate number of units from his account. This depletes the number of units in ones account. There is also an option to make lump sum payment in addition to the regular premium to enhance the saving content as per the policy conditions. This additional remittance is called Top-Up. There are also options to switch from one fund to another fund. This way one can park his 223

money in the fund of his choice looking to the prevalent market conditions at any time during the currency of the policy. A separate unit amount maintained for each insured person. Periodical statement is sent to the policyholder informing him the number of units accumulated in his account, NAV of the units and total value of his investment. He is also informed about the various charges and expenses deducted from his account. Some of the Important guidelines Issued by IRDA on Unit Linked Insurance Products: Cir. No. IRDA/ACT/CIR/ULIP/102/06/2010 June 28, 2010 Sub: Unit Linked Insurance Products (ULIPs) In order to meet the emerging needs of prospective insurance policyholders, this circular specifies certain elements which shall be incorporated in all ULIPs which may be offered for sale to the public commencing from September 1, 2010. 1. The three year lock-in period for all Unit Linked Products will be increased to a period of five years, including top-up premiums. During this period, no residuary payments on policies which are lapsed/surrendered/ discontinued will be made. The residuary payments for policies arising out of policies which stand lapsed/ surrendered/discontinued during the lock-in period shall be payable on the expiry of the lock in period and in accordance with the relevant Regulations of IRDA. 2. All regular premium/limited premium ULIPs shall have uniform/level paying premiums. Any additional payments shall be treated as single premium for the purpose of insurance cover. 3. All limited premium unit linked insurance products, other than single premium products, shall have premium paying term of at least 5 years. 4. The insurers shall distribute the overall charges, in ULIPs in an even fashion during the lock-in period. 5. All unit linked products, other than pension and annuity products shall provide a minimum mortality cover or a health cover, as indicated below: (i) Minimum mortality cover should be as follows: Minimum Sum assured for age at Minimum Sum assured for age at entry of below 45 years entry of 45 years and above Single Premium (SP) contracts: Single Premium (SP) contracts: 224

125 percent of single premium. 110 percent of single premium Regular Premium (RP) including Regular Premium (RP) including limited premium paying (LPP) limited premium paying (LPP) contracts: contracts: 10 times the annualized premiums 7 times the annualized premiums or (0.5 x T x annualized premium) or (0.25 X T X annualized whichever is higher. At no time premium) whichever is higher. At the death benefit shall be less than no time the death benefit shall be 105 per cent of the total premiums less than 105 percent of the total (including top-ups) paid. premiums (including top-ups) paid. (In case of whole life contracts, term (T) shall be taken as 70 minus age at entry) (ii) The minimum health cover per annum should be as follows: Minimum annual health cover for Minimum annual health cover age at entry of below 45 years for age at entry of 45 years and above Regular Premium (RP) contracts:5 Regular Premium (RP) times the annualized premiums or ₹100,000 per annum whichever is contracts:5times the annualized higher. premiums or ₹75,000 per annum whichever is higher. At no time the annual health cover At no time the annual health shall be less than 105 percent of the cover shall be less than 105 total premiums paid. percent of the total premiums paid. 6. All top-up premiums made during the currency of the contract, except for pension/annuity products, must have insurance cover treating them as single premium, as per above table. 7. The accumulated fund value of unit linked pension/annuity products is the fund value as on the maturity date. All ULIP pension/annuity products shall offer a minimum guaranteed return of 4.5 per cent per annum or as specified by IRDA from time to time, on the maturity date. This guaranteed return is applicable on the maturity date, for policies where all due premiums are paid. Mortality and/or health cover could be offered along with the pension/annuity products as riders, giving enough flexibility for the policyholders to select covers of their choice. 225

8. In the case of unit linked pension/annuity products, no partial withdrawal shall be allowed during the accumulation phase and the insurer shall convert the accumulated fund value into an annuity at the vesting date. However, the insured will have an option to commute up to a maximum of one-third of the accumulated value as lump sum at the time of vesting. In the case of surrender, only a maximum of one-third of the surrender value can be commuted after the lock-in period. The remaining amount must be used to purchase an annuity, subject to the provisions of Section 4 of Insurance Act, 1938. 9. Caps on charges were fixed on Unit Linked contracts with a tenor of 10 years or less and for those with tenor above 10 years. However, taking into account the discontinuance/lapsation/surrender behavior and with a view to smoothen the cap on charges, the following limits are prescribed starting from the 5th policy anniversary: Annualized Premiums Paid (Difference Maximum reduction in between Gross and Net Yield (% pa)) yield 5 4.00% 6 3.75% 7 3.50% 8 3.30% 9 3.15% 10 3.00% 11 and 12 2.75 % 13 and 14 2.50 % 15 and thereafter 2.25 % 10. The net reduction in yield for policies with term less than or equal to 10 years shall not be more than 3.00% at maturity. For policies with term above 10 years, the net reduction in yield at maturity shall not be more than 2.25%. 11. The maximum loan amount that can be sanctioned under any ULIP policy shall not exceed 40% of the net asset value in those products where equity accounts for more than 60% of the total share and shall not exceed 50% of the net asset value of those products where debt instruments accounts for more than 60% of the total share. 226

3.3.5 Insurance Linked Annuities Difference between Annuity and Life Insurance Annuity Life Insurance 1. It is not an Insurance. So no Risk 1. Covers the risk of life - death and cover. disability. 2. Receive the interest on the fixed 2. Accumulated bonus on the sum investment as promised. insured can be withdrawn during the policy period or at maturity. 3. Interest and last receipts are taxable. 3. No receipts are taxable. An annuity is a contract/ which provides a series of periodic payments. An annuity contracts is an insurance policy, under which the annuity provider (insurer) agrees to pay the purchaser of annuity (annuitant) a series of regular periodical payments for a fixed period or over someone's lifetime. Types of Annuities Annuities can be classified on the basis of  The number of lives covered  Single 227

 Joint  The beginning of the payment of annuity  Immediate annuity  Deferred annuity  Method of premium payment  Single premium  Regular installment  Period of payment of annuity  Annuity Certain  Life Annuity  Life Annuity with guarantee  Quantum of annuity installments  Fixed  Variable  Index linked Single life annuities provide for payment of the periodical installments during the lifetime of the single annuities under the contract. Joint life annuities provide for payments during the lifetime of 2 annuitants. Here again it can beJoint life last survivor annuity' where annuity is payable as long as either one of them is alive. A joint life annuity provides for payments, which stop on the first death among the covered lives. Immediate annuity: Annuity payments begin immediately on purchase, with the purchase price being paid in a single installment of premium. The first installment of annuity will become due at the end of one payment interval (month, quarter, half year or year). Under deferred annuity the annuity installments begin at the end of a selected term of years (or on the annuitant's reaching a chosen age). Here the purchase premium can be paid in a single installments or the annuitant can choose to pay the premiums in regular installments spread through the deferment period. Annuities which are payable as long as the annuitant is alive is alife annuity' and the one which is payable for a definite number of years irrespective of whether the annuitant is alive or not is called anannuity certain'. A combination of these two is also prevalent, where the annuity payments are guaranteed for a definite period of years and thereafter for the life of the annuitant. Similarly, the annuity installments can be guaranteed to be paid during the 228

lifetime of the annuitant and upon his death, a lump sum installment bearing a certain relationship to the face value (or purchase price) of the policy shall become due for payment. On the basis of the quantum of annuity installment payable, they can be classified as fixed annuity or variable annuity. A fixed annuity, as the name suggests, provides for a fixed sum of money to be paid periodically. Whereas a variable annuity is an annuity contract whose cash values and benefit payments vary directly with the experience of the assets allocated to the contracts. Every contract will have a separate account, to which the premium paid by the annuitant will be credited. The amount in the account will be utilized to purchase financial assets and the annuity that the contract will fetch will directly depend upon the value of the assets in the account backing the contract. Taxation of Individual Annuities Unlike what we have seen in the case of life insurance policies, the money received by the annuitant as per the annuity contract are treated as income and taxed at his hands. The premium paid by the annuitant for the annuity contract or the annuity policy is eligible for deduction under section 80C within the overall limit prescribed, provided such a policy does not provide an option to avail of a cash option in lump sum in lieu of the annuity payments. Classification of Annuities We can classify every annuity according to various criteria. In order to understand how a given annuity operates, we have to know:  How the annuity was purchased?  How often periodic annuity benefits are to be paid?  When annuity benefit payments are scheduled to begin?  The number of annuitants covered by the annuity policy? and  Whether annuity values are guaranteed or variable? Let's look at each of these criteria to get a better idea of the various ways that annuity policies may be structured. How Annuities are Purchased Most annuities today are purchased as single-premium annuities. A single-premium annuity is an annuity that is purchased by the payment of a single, lump-sum premium. 229

Benefit payments under a single-premium annuity may begin shortly after the premium is paid or may begin many years after the premium is paid. An annuity also can be purchased by paying periodic premiums over a period of years. Periodic premiums can be paid by two methods: (1) on a level-premium basis or (2) on a flexible-premium basis. Under a periodic level- premium annuity, the contractholder pays equal premiums for the annuity at regularly scheduled intervals, such as monthly or annually, until some predetermined future date. Premiums might, for example, be payable annually for a stated number of years. Under a flexible-premium annuity, the contractholder pays premiums on a periodic basis over a stated period of time; the amount of each premium payment, however, can vary between a set minimum amount and a set maximum amount. For example, the policy might allow the contractholder to pay any premium amount between ₹250 and ₹10,000 each year. The contractholder can also choose not to pay any premium in a given year; the only requirement is that any premium amount paid each year must fall within the stated minimum and maximum. Hexible-premium annuities are sold far more often today than are periodic level-premium annuities. (See Appendix C for a sample flexible-premium annuity policy.) The operation of an annuity is basically the same regardless of whether the premium is paid in one sum or in a series of payments. The premium payment method, however, affects the length of time that the insurer holds the principal at interest. And the longer the insurer holds a given premium, the larger will be the investment earnings generated by that principal. How Often Benefits are Paid The frequency of periodic annuity benefit payments depends on the length of the annuity period. An annuity period is the time span between each of the payments in the series of periodic annuity benefit payments. The annuity period is typically either one month or one year, but other options, such as quarterly or semiannual, are also available. For example, an annuity policy that provides for a series of annual benefit payments has an annuity periodof one year and is referred to as an annual annuity. An annuity policy that provides for an annuity period of one month is referred to as a monthly annuity. 230

When Benefit Payments Begin The date on which the insurer begins to make the annuity benefit payments is known as the annuity's maturity date or the annuity date. An annuity can be classified as either an immediate annuity or a deferred annuity, depending on when the insurer is to begin making periodic annuity benefit payments. Immediate Annuities An immediate annuity is an annuity under which benefit payments are scheduled to begin one annuity period after the annuity is purchased. Remember, an annuity period is typically one month or one year. Thus, if an immediate annuity contains an annuity period of one year, then the maturity date on which periodic annuity benefit payments will begin is one year after the annuity was purchased. Because benefit payments begin soon after an immediate annuity is purchased, an immediate annuity is generally purchased with a single premium; such a policy is known as a single-premium immediate annuity(SPIA). Deferred Annuities A deferred annuity is an annuity under which periodic benefits are scheduled to begin more than one annuity period after the date on which the annuity was purchased. Although a deferred annuity typically specifies the date on which benefit payments are scheduled to begin, the contractholder usually can change this date at any time before those benefit payments begin. People often purchase deferred annuities during their working years in anticipation of the need for retirement income later in their lives. The period during which annuity benefit payments are made is known as the payout period or the liquidation period.The period between the contractholder‘s purchase of a deferred annuity and the onset of the payout period is known as the accumulate period. Because a deferred annuity has an accumulation period, the contract holder generally can choose to pay for the annuity either in a single premium or in a series of periodic premiums. Although most deferred annuities are purchased as single-premium deferredannuities (SPDAs), insurers also sell flexible- premium deferred annuities(FPDAs). Note that every annuity purchased with the payment of periodic premiums is by definition a deferred annuity. Example: When she was 48 years old, Jaya Ingle received a lump sum of ₹50,000. She used that amount to purchase a deferred annuity that will provide her with a benefit each month during her retirement years, beginning when she reaches age 65. Analysis: The information given in this example tells us that Jaya purchased a single- premium deferred annuity. The annuity has an accumulation period of 17 years - the time 231

between Jaya's purchase of the annuity at age 48 and the time she begins receiving benefits at age 65. The annuity period is one month; therefore, the annuity is a monthly annuity. The insurer's obligations and the rights of the contract holder differ depending on whether a deferred annuity is in its accumulation period or its payout period. Let‘s look at how a deferred annuity operates during these two periods. Accumulation period: During a deferred annuity's accumulation period, the insurer invests the premiums paid by the contract holder. Thus, during the accumulation period, the deferred annuity builds an accumulated value. An annuity's accumulated value is equal to the net amount paid for the annuity, plus interest earned, less the amount of any withdrawals. The manner in which the policy provides for investment earnings on the accumulated value depends on whether the deferred annuity is a fixed-benefit annuity or a variable annuity. We describe these distinctions later in the chapter. Accumulated Value of a Deferred Annuity = Net Amount Paid for Annuity + Interest – With drawls The contract holder typically can make withdrawals from a deferred annuity's accumulated value in accordance with the policy's withdrawal provision. The withdrawal provision grants the contract holder the right to withdraw all or a portion of the annuity's accumulated value during the accumulation period. Most annuity policies allow the contract holder to withdraw a stated percentage of the annuity's accumulated value each year without charge. If the contract holder withdraws more than that stated percentage in one year, then the insurer generally imposes a withdrawal charge. Withdrawals of less than a stated minimum amount are typically not permitted. Throughout the accumulation period, the contract holder also has the right to surrender the policy for its cash surrender value - the accumulated value less any surrender charges included in the policy. A surrender charge is typically imposed if the policy is surrendered within a stated number of years after it was purchased. The amount of any surrender charge that is imposed usually declines over time. An insurer usually imposes these surrender charges during the early years of an annuity policy in order to recoup the costs it incurred in issuing the policy. Cash Surrender Value of a Deferred Annuity = Accumulated Value – Surrender Charges Deferred annuity policies usually provide a survivor benefit; if the annuitant or contract holder dies before annuity benefit payments begin, the annuity's accumulated value is paid to a beneficiary designated by the contract holder. No surrender charges are incurred when 232

the accumulated value is paid as a survivor benefit. Payout Period. When an annuity matures, the insurer uses the annuity's accumulated value to fund the periodic annuity benefit payments. Thereafter, all provisions relating to the policy's accumulated value - including the withdrawal provision and the survivor benefit provision - become inoperable, and the terms of the payout option provision govern the parties' rights and obligations under the policy. The payout option provision in an annuity policy lists and describes each of the payout options from which the contract holder may select. In the next section, we describe some of the payout options typically available under an annuity policy. When Benefit Payments End The length of the payout period depends on the payout option that the contract holder selects. Under the three general types of payout options available, the annuity benefits will be paid as either (1) a life annuity, (2) an annuity certain, or (3) a temporary life annuity. Life Annuity A life annuity is an annuity that provides periodic benefit payments for at least the lifetime of a named individual. Some life annuities also provide further payments guarantees. The various forms of life annuities and commonly available payment guarantees are described later in this chapter. The terminology used to describe the people connected with an annuity varies widely throughout the insurance industry. The named individual whose lifetime is used as the measuring life in a life annuity typically is called the annuitant. Note that the annuitant is not always the owner of the annuity, although in most situations the annuity contract holder and the annuitant are the same person. Just as we distinguish between the insured and the policy owner of a life insurance policy, we also need to distinguish between the annuitant and the contract holder. Additional confusion over annuity terminology results from the use of the term beneficiary in an annuity. An annuity beneficiary is the individual the contract holder names to receive any survivor benefits that the payable during the accumulation period of a deferred annuity. Once the payout period begins, the person who receives the annuity benefit payments is often known as the payee. Generally, the payee is also the contract holder. Example: Padma Chaturvedi is 53 years old and has just received an early retirement package from her employer. Part of that package was a ₹50,000 lump-sum payment. Padma has accepted a position with another employer and has used the ₹50,000 to purchase a 233

deferred annuity that will make payments to her beginning when she retires at age 65. She named her daughter, Kavita, to receive the policy's survivor benefit. Analysis: Padma purchased the annuity, and, thus, she is the contract holder. Because annuity benefits will be paid to Padma throughout her lifetime, she is also the annuitant and the payee. Finally, because Kavita will receive any survivor benefits payable if her mother dies before the annuity benefit payments begin, Kavita is the annuity beneficiary. We will come back to the topic of life annuities later in the chapter. For now, let's return to our discussion of how annuities are classified. Annuity Certain An annuity can be purchased to provide periodic payments over a period of time that is unrelated to the lifetime of an annuitant. An annuity certain is an annuity that is payable for a stated period of time, regardless of whether an individual person lives or dies. The stated period over which the insurer will make benefit payments is called the period certain. At the end of the period certain, annuity payments cease. The annuity certain is useful when a person needs an income for a specified period of time. An annuity certain also might be purchased to provide income during a specified period until some other source of income, such as a pension, becomes payable. Example:MadhuriHegde is a 50-year-old office manager who plans to retire at age 60. She will not begin receiving pension benefits from her employer-sponsered pension plan until she reaches age 65. Thus, she wants to purchase an annuity that will provide her with periodic benefit payments during the five-year period following her retirement before she begins receiving her pension benefits. Analysis: Madhuri wants to begin receiving annuity benefit payments in ten years, when she retires at age 60. Thus, she should purchase a ten-year deferred annuity. Madhuri wants to receive annuity benefit payments only until she will begin to receive her pension benefits. Thus, she should elect a payout option under which annuity benefits are paid as a five-year annuity certain. Temporary Life Annuity A temporary life annuity provides periodic benefit payments until the end of a specified number of years or until the death of the annuitant, whichever occurs first. Once the stated period expires or the annuitant dies, the annuity benefits cease. For example, under the terms of a five-year temporary life annuity, five years is the maximum length of time during which annuity benefits will be payable. If the annuitant dies before the end of that five-year 234

period, no further annuity benefits will be payable. Although the temporary life annuity is not sold very often, it is sometimes purchased to fill a gap between the end of an earning period and the time some other anticipated income, such as a pension, begins. Number of Annuitants The examples we have looked at so far have all involved situations in which a life annuity was based on the life of one annuitant and benefits were paid to a named individual. It is possible, however, to purchase a life annuity that provides an income to more than one individual. When a couple purchases a life annuity, they usually want the annuity to provide benefit payments throughout both of their lives. A joint and survivor annuity, which is also known as a joint and last survivorship annuity, provides a series of payments to two or more individuals, and those payments continue until both or all of the individuals die. The terms of a joint and survivor annuity policy determine whether the amount of each periodic benefit payment remains the same after the death of one of the annuitants. For example, the annuity might provide that the amount of the periodic benefit payment will remain the same until the last annuitant dies, or the annuity might provide that the amount of the periodic benefit will be reduced by a stated amount, such as 50 percent, following the death of the first annuitant. Of course, the premium amount required to fund the annuity will vary, depending on the amount of benefits that are to be paid out - the larger the expected amount of benefit payments, the larger the premium required to pay for the annuity. Whether Annuity Values are Guaranteed or Variable People who purchase annuities have different purposes in mind for the funds they place in an annuity. Annuity contract holders also have different capacities for assuming a financial risk when they place money in their annuities. Thus, many insurers offer two general options to annuity purchasers: (1) the insurer will guarantee to pay at least a stated interest rate on the annuity funds it holds or (2) the insurer will pay interest at a rate that is not guaranteed; instead, the interest rate will vary according to the earnings of certain investments held by the insurer. Fixed-Benefit Annuities A fixed-benefit annuity is an annuity under which the insurer guarantees that at least a defined amount of monthly annuity benefit will be provided for each dollar applied to purchasing the annuity. Most fixed-benefit annuities specify that once the insurer begins paying annuity benefits, the amount of each benefit payment will not change. A new fixed- benefit annuities, however, specify that benefit payments may increase if the insurer's 235

investment earnings exceed those the insurer expected when it calculated the benefit amount. If the fixed-benefit annuity is an immediate annuity, then the amount of the annuity benefit payments is known when the insurer issues the annuity policy. The purchaser pays a single premium amount, and the insurer calculates the annuity benefit amount that will be provided by that premium amount. If the fixed-benefit annuity is a deferred annuity, then the annuity policy includes a chart of annuity values. This chart lists the amount of annuity benefit that is guaranteed for each ₹1,000 of accumulated value on the maturity date is ₹20,000 and the annuitant is ages 40, then the insurer will pay the annuitant ₹82.60 per month (20 x ₹4.13 = ₹82.60) for the remainder of the annuitant's life. Note, however, that the amounts listed in the policy are the minimum guaranteed benefit amounts. These are the benefits amounts that the insurer is comfortable guaranteeing when it issues a fixed-benefit annuity. If the insurer's investment experience is more favorable than expected, then the insurer will pay a larger benefit than the guaranteed amount. When an insurer provides interest rate guarantees in an annuity policy, the insurer agrees to assume the investment risk of the policy. The insurer places the funds in relatively secure investments, such as bonds and real estate, as part of its general investment account. If the general investment accounts performs well, the insurer can pay interest rates that the higher than the rates guaranteed in its policies while still achieving profits from the investment account. The insurer, however, takes the risk that if its investments perform poorly and its investment returns are less than the minimums guaranteed in its policies, then the insurer will lose money. Variable Annuities A variable annuity is an annuity under which the amount of the policy's accumulated value and the amount of the annuity benefit payment will fluctuate in accordance with the performance of a separate account. The individual who purchases a variable annuity assumes the investment risk of the policy. Because the insurer makes no guarantees regarding the investment earnings or the amount of a variable annuity's benefit payments, the insurer retains no risk under the policy. Instead, the purchaser realizes all gains from profitable investments and incurs all losses from unprofitable investments. Variable annuities are considered to be securities contracts because of this investment risk transfer and, thus, are subject to federal regulations in the United States. 236

Guaranteed Annuity A guaranteed annuity is a life annuity which is guaranteed to be payable for a minimum period regardless of when the annuitant dies. Thus, an annuity guaranteed for ten years will be payable for life or ten years, whichever is longer. If the annuitant dies during the guaranteed period then the balance of the guaranteed instilments will be payable to the nominee of the legal heirs as the case be. This type of arrangement is also called Annuity certain for 5/10/15 years and thereafter for life'. Annuity with Return of Purchase Price Some annuitants want that the capital or the purchase price of the annuity should be returned to the legal heirs after his death. Hence, there are annuities which pay life annuity and return the purchase price or the capital to the legal heirs or nominee as the case be on the death of the annuitant. There are also guaranteed annuities as discussed above where the purchase price is also returned on the death of the annuitant. The financial planner is duty bound to advise his client as to what type of annuity will suit him the most. Life Insurance Policy Analysis: Practice Sums Q1. A money back policy for 12 years with a sum assured of ₹5,00,000 pays 20% of the sum assured at the end of every three years and the balance at maturity. The premium per year is ₹80 per thousand sum assured. Calculate the rate of return at maturity assuming an annual bonus rate of ₹50 per thousand sum assured. Ans. Annual premium = (80/1000) X 500000 = 40000 Money back received = 500000 X (20/100) = 100000 at the end of 3rd, 6th & 9th years Sum assured payable at maturity = 500000 - (100000 X 3) = 200000 Bonus at Maturity = (50/1000) X 500000 X 12 = 300000 Rate of return for the money back policy: We use cash function of calculator in this question. 237

Cash flow CASH CASH INFLOW NET CASH entries OUTFLOW FLOW 0 1 -40000 0 -40000 2 -40000 0 -40000 3 -40000 100000 -40000 4 -40000 0 60000 5 -40000 0 -40000 6 -40000 100000 -40000 7 -40000 0 60000 8 -40000 0 -40000 9 -40000 100000 -40000 10 -40000 0 60000 11 -40000 0 -40000 12 -40000 500000 -40000 13 500000 0 12.85% IRR Q2. The annual premium for a 20 year pure term policy of ₹12,00,000 sum assured is ₹4,920. A similar participating endowment policy charges an additional premium of ₹30 per thousand sum assured compared to the pure term policy. You client has being paying premiums regularly for the last sixteen years towards the participating endowment policy. The annual bonuses declared under the participating endowment policy were ₹50 per thousand sum assured. What is the rate of return under this participating endowment policy assuming that the client dies today? Ans. Annual premium for the participating endowment policy: 4920 + ((30/1000) X 1200000) = 40920 -40920; FV = Rate of return under the participating endowment policy: SET = Begin; N = 16; I = 13; PV = X; PMT = 1200000+((50/1000)X1200000X16) 238