Individuals have conventionally bought life insurance plans mainly for investments, tax benefits and the life cover they offer. They have seldom tried to understand how their insurance plan works for them or for that mater, how their premium is structured.

Simply put, the main purpose of life insurance is to secure the financial future of the nominees in case of an eventuality to the insured. It does this by paying a 'sum assured' to the nominees. The sum assured is decided at the time the individual buys the insurance plan and the premium is paid accordingly. The premium consists of three important elements which individuals should know in order to opt for the right insurance plan.

Mortality charges
Mortality charges are incurred by the insurance company to cover the risk of an eventuality to the individual. The mortality expenses differ depending on the age of the individual and the sum assured- they are higher for a higher age and sum assured.

Sales and administration expenses
Insurance companies incurred sales and administration expenses for operation purposes and recovered from the premiums that the individual pays towards his policy. Agent commissions, sales and marketing expenses and the overhead costs incurred to run the insurance business on a daily basis are examples of such expenses.

Savings component
This part of the premium is invested by the life insurance company in various investment avenues such as government securities (G-secs), bonds, money market instruments and equities in varying proportions. The savings component is what helps generate the returns which insurance companies pay to the policyholder by way of bonuses and the maturity amount. Having understood the premium structure, it now becomes necessary for individuals to evaluate their own needs and buy insurance cover accordingly. For understanding this, individuals should understand the two basic types of life insurance plans i.e. term plans and endowment plans.

Term plans are basically pure risk cover plans. The premium for Term plan covers the mortality charges and sales and administration expenses. In this, there is no savings element in the premium; therefore no maturity amount accrues. It may be due to the reason that term plans are one of the cheapest forms of life cover available. As opposed to this, the premium towards an endowment type plan also includes a savings component. The savings component is what helps the insurance company in generating a corpus over the tenure of the policy. But it is also due to this reason that the premium paid for an endowment plan is a lot more than what an individual would have to pay for a comparable term plan.

For instance, an individual aged 30 years, wants to buy life insurance cover for a sum of Rs 1,000,000 for a 30-year tenure. If he wants to purchase a term plan for the said amount, he will have to pay a premium of approximately Rs 3,500 per annum. In case, he decides to opt for an endowment plan for the same amount, he will have to pay approximately Rs 26,500 per annum.  The main difference of the premium between the term plan and endowment plan is the savings component, which is invested by the insurance company to generate returns for the policyholder.

The premium of Term plan works out approximately 87% cheaper than the endowment plan premium every year. Or in other words, the individual has to pay 7.5 times more premium for an endowment plan for the same amount of cover. In our opinion, individuals should not mix their life insurance requirements and investment needs together. They should consider buying a term plan for the desired amount of life cover and devote the remaining 'investible surplus' to other investment avenues like mutual funds or NSCs or PPF.

Individuals should, therefore, ensure that they have understood life insurance products. For this, it will not only help them in making wiser decisions but it will also ensure the policyholders a better and a more secure financial future.