2 July 2022

Term insurance: Limited pay vs Regular pay

While comparing a 3 Crore term insurance cover for a 28 year old till the age of 85, I see that there is an option to pay a Rs 1,54,000 premium for 5 years (till the age 33) and another option to pay a Rs 39,000 premium every year till the age of 85. If I choose to pay for 5 years, the total premium works out to Rs 7.73 Lakhs while if I choose to pay life-long, the total premium works out to Rs 22.7 Lakhs. Either ways the buyer gets a 3 Crore term cover till the age of 85, so isn’t it better to pay 7.73 Lakhs versus 22.7 Lakhs? Well, numbers can be deceiving. In this post, we will not only see the numbers to identify the better opportunity but also other aspects to be checked.

Opportunity cost is the value of the next-best alternative when a decision is made.

In the above scenario, I can either pay Rs 1.54 Lakhs for 5 years or pay Rs 39,000 every year till age 85 and invest the Rs. 1.15 Lakhs that I save (1,54,000 minus 39,000) in the first 5 years. First, lets consider the non-quantifiable factors.

Why can someone consider paying off the premiums in limited pay vs regular pay?

  • Cash flow predictability - If you have a predictable flow of income now and you believe that this may not be the case 5-10 years down the line because you will want to take a sabbatical or startup your own venture, then you can consider paying off the premiums early
  • Retirement - If you don’t want to take the burden of paying premiums after retiring, you may consider taking a limited pay option spread over your working career (15-20 years, if available)

Why would someone consider paying through out the policy tenure rather than a limited pay?

  • Less chances of forgetting - If you are paying a premium every year, your family will be able to notice it in the bank statement, policy communications or simply you mentioning it to them. While it would be tough for the family to remember of a policy whose premium was paid off 20 years back
  • Option to surrender and buy a new policy - Lets say 10 years after buying a term insurance policy you feel that the coverage is less. You have the flexibility to surrender the existing policy before buying a new policy

Now lets see what the numbers say. To compare different streams of cashflows over different periods, we can use the Net Present Value. NPV is used to calculate the current total value of a future stream of payments. We will assume both a 6% rate and a 10% rate to discount the cash flows. 6% because that is what a conservative portfolio can earn on a post tax basis and 10% because that is what I expect to earn from index funds post tax in the long run.

NPV calculations paint a different picture

Clearly, the regular pay option is cheaper on an NPV basis assuming a discount rate of 6% and 10%. It means, the higher you expect to earn on your investments, the better a regular pay option is. In this example, the rate at which both options remain the same is ~5.73%. It means that if you expect to earn < 5.73% p.a., pay off the premiums in 5 years and if you expect to earn more than 5.73% p.a. then opt for the regular pay.

The insurance company would like you opt for the limited pay option as it gives them significant cash flows upfront and they can earn more than 6% p.a. on their investments. I personally believe that the regular pay option is a better value proposition both in terms of NPV and other factors mentioned above.

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