I got the idea of this topic from the comments I received on my earlier post on “How To Start Financial Planning”. I thank Aditya for his comment.
Reasons for buying life insurance
Many a times, we get advice to buy life insurance at an early age. Many reasons are given to buy life insurance at a young age. Peace of mind and lower premiums amounts are the most common reasons.
I would not comment on “peace of mind” as the reason, because it is a person specific subjective factor. One should do everything, which gives him/her peace of mind provided it is legally and morally right. If buying life insurance early, gives you a comfort, you may consider buying it from your first paycheck and feel happy about it.
However, from a financial adviser’s perspective, I believe that life insurance should be bought only when you have dependents and/or have loans to repay.
A comparison of life insurance purchase at different ages
To illustrate the topic, I have compared three scenarios where a person who is currently 25 years of age has decided to buy life insurance at different ages. I have assumed that he needs life insurance till 55 years of age, when his children would be independent and he would have done sufficient savings to take care of retirement.
- Scenario 1: He buys life insurance at the age of 25 years and pays premium for 30 years to get insurance till the age of 55 years.
- Scenario 2: He waits and buys life insurance at the age of 30 years and then pays premium for 25 years.
- Scenario 3: He waits and buys life insurance at the age of 35 years and then pays premium for 20 years.
Please note that the absolute age numbers are of no significance here. They are only for illustrating different scenarios to show the impact of buying life insurance at different ages. You may take age of buying insurance as (20, 25 & 30 years) and life insurance requirement till 60 or 65 years. It would not have any impact on the conclusion.
I have utilized the pure insurance term plan of HDFC Life, Click2Protect, for analysis and used the premium amounts as per the premium calculator at HDFC Life website for Click2Protect assuming insurance cover (sum assured) of Rs. 30 lakh for a non-smoker man, staying at Mumbai, Maharashtra.
I have used a financial concept called Present Value (PV) to compare these 3 scenarios.
PV means today’s value of an amount of money to be received or paid in future. Friends, who are not from finance background, may understand it by building on knowledge of interest rates (also called as Discounting Rate). If interest rate is 10% per year then Rs. 100 today would be equal to Rs. 110 after 1 year. It is true vice versa also. If you need to pay me Rs. 110 after one year but instead offer me to pay Rs. 100 today, I would not have any problem in accepting Rs. 100 today as I can put it in the bank to get Rs. 110 after one year. Hence, Rs. 100 is present value (PV) of Rs. 110 to be paid after 1 year, if interest rate is 10% per year. This is an example of application of concept of PV to a single payment to be done after 1 year.
The concept of PV can be extended to multiple payments to be done over many future years. In case of life insurance, it applies to the premiums to be paid in future. Each of these payments at any future date would have a present value (PV or today’s value). Sum of PVs of all these future payment amounts would give you what those future payment would cost you in today’s value terms.
PV (Present Value) of different premium payment scenarios has been calculated using a simple formula in excel/spreadsheet. The finals PVs have been compared to conclude which scenario is financially preferable in terms of today’s value.
The schedule for premium payments for scenario 1, 2 and 3 is as given below:
*He needs to pay premium till the age of 54 to get insurance till the age of 55.
It is assumed that premium payments to be done while buying term life insurance 5 & 10 years later at age 30 years (Scenario 2) and 35 years (Scenario 3) respectively, would remain at today’s levels. It is a conservative assumption in light of the fact that premiums of term life insurance plans are decreasing since last decade and are expected to continue this declining trend in future. Please read about it here:
Life Insurance Premiums Are Declining! Will This Trend Continue?
I have calculated the PV (present value) of all future premium payments, at age 25 in this Google spreadsheet for all three scenarios. A discounting rate of 10% is used for calculations. You may analyze the spreadsheet to get a better understanding of calculations.
The calculated present value (PV) of all future premiums at age 25 in all three scenarios is as given below:
The Verdict:
The values in the above table mean that if you buy life insurance at the age of 25 years and pay premium of Rs. 3,990 for 30 years, the sum total of all future premiums, which you would pay over 30 years is Rs. 1,19,700. However, it would have a cost of Rs. 41,375 in today’s value (at age 25). Today’s cost value of premiums to be paid over 25 years when insurance is bought at age of 30 years, is Rs. 28,271. Similarly, today’s cost value (at age 25) of premiums to be paid over 20 years when insurance is bought at 35 years of age, is Rs. 20,255.
Thus, we can see that although the sum total of all future premiums in all three scenarios looks almost similar, the real cost in terms of present value (PV) differs by a huge margin. Scenario 1 is the costliest and scenario 3 is the cheapest.
Therefore, it becomes clear that even though you seem to be paying lower premium of Rs. 3,990 when you buy life insurance at the age of 25 years, your insurance effectively costs you more because you make premium payments even for years when you do not need insurance.
You should buy insurance only when you have dependents or have loans. Young or old age should never be a factor while buying life insurance. You should not buy life insurance due to fear of increase in premium amounts with increasing age.
Life insurance is a protective tool and you should buy it only when you have something to protect. If you have dependents, you must buy life insurance whether you are at the age of 25 or 60 years. If you do not have any dependents, you should never buy life insurance. The decision should be kept simple.
P.S.
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