What is Insurance and why you need it

After you have solved your debt problem and set up automated transfer to pay your loans, the next important task for you is to take a life insurance. If you are the sole breadwinner in your family, then I would say life insurance is mandatory.

So lets see what insurance is and how it works. According to wikipedia “Insurance is the equitable transfer of the risk of a loss, from one entity to another in exchange for payment.” In simpler terms, if you lose something valuable (in the monetary sense), insurance is a way to get back the money (at least partially) which you lose.

Types of Insurances

There are various types of insurances. If you crash your car into a concrete pillar, your vehicle insurance would compensate for the repairs. If a thief robs your house while you are enjoying your vacation, your home insurance would compensate for your losses. If you are admitted in the hospital for a surgery, your mediclaim insurance would pay for most of the hospitalization costs.

All of the above examples are instances when you get the money when you claim for insurance. In case of life insurance (which is the most popular form of insurance) on the event of your death, your family would get the insured money. This is important because, when you are dead, your family’s source of income (sometime the only source) stops immediately. And your family now has to make ends meet somehow, without you to support them. This money from the insurance helps them in the time of need.

So how do insurance companies work?

The way insurance companies work is, they collect a small fee called a “premium” every month/quarter/year from you when you insure something. The insurance would have a sum assured value, which would be the maximum amount you would receive when you claim an insurance because of loss. This sum assured will be more than the premium you pay. For eg: For a sum assured of Rs. 1 Crore, you would pay a premium of Rs.10,000 every year. Of course your premium amount would vary depending upon your age and health condition.

But you ask “Is the insurance company nuts to give you 1 Crore? The math doesn’t add up!”. The math does add up if you understand that there are tens of thousands/lakhs of customers for these companies. Lets say there are 1 lakh customers who are healthy and in their early 20s and every year they all pay Rs.10,000. It adds up to Rs.100 Crores, every year.  Lets say on the first year 90 customers die (may be due to accidents or because their health was sooo bad). That means the company has to pay these 90 families, Rs. 1 Crore each. Even after paying this 90 crores, the insurance company still has Rs.10 crore as profit, and this is just for year 1. They would get premiums every year and every year few people would die and the sum assured would be paid to the families.

Of course, the calculation that I made was very crude and simple. But you get the idea. Insurance companies work because the probability of all of its customers dying (or claiming a loss) is very small. And that is the risk these companies are willing to take. So you have transferred the risk (of supporting your family or paying for the hospital bills or repairing your car) to some third party by paying the small premium for it.

Why you need to get a life insurance

Now lets say you are working in a company and get regular salary and decided to buy a nice apartment with a sea view. It costs about Rs.50 lakhs and you pay an EMI every month from your salary. Lets say you die before you could finish paying the EMIs, your family would now have to take over the loan repayment. Or they would have to give up the house and move to a rented house. In most households, it isn’t that easy for a spouse/parent to go to work and earn enough to pay the EMI.

What can you do to reduce this risk? Take a life insurance for yourself with one of your family member as the nominee who will receive the money if you die. You would pay a small yearly premium, which reduces the tension of the financial insecurity your family would be thrown into if you die.

Remember, life insurance isn’t going to save your life when your bike gets hit by a bus from behind. Instead life insurance will save your investments for your dependants after you die. It is going to protect your family by providing financial safety in your absence. That is why life insurance is very important to take once you started earning a good salary.

How much insurance to take?

In the examples above I used sum assured like Rs.1 crore and enough insurance for repaying Rs. 50 lakhs house, etc. You say “But the uncle next door who is a LIC agent showed me insurance plans for Rs. 2 lakhs or Rs. 3 lakhs. Also he is asking me to pay huge premiums every month/year. I asked for Rs.1 Crore coverage and I can’t pay such a heavy premium.”

Please stay away from these agents and ask them to STFU as politely as you can. You could do a much better job of insuring your life using something called as term insurance than these insurances plans these agents suggest. These term insurances allow you to insure yourself for crores by paying a very small premium every year. And the best part, it can be bought online by filling a form and it takes just minutes.

We will see the difference between these term insurances and the other insurance policies these agents try to sell and why term insurance is better, in tomorrow’s post.