Life Insurance: Meaning, Importance, and Real-World Applications

 

Definition of Life Insurance

Life insurance is a financial contract between an individual (policyholder) and an insurance company, where the insurer promises to pay a specified sum (called the death benefit) to the beneficiary upon the death of the insured, in exchange for regular premium payments. It acts as a risk management tool, offering financial security and peace of mind to families and dependents.

Meaning of Life Insurance

At its core, life insurance is about financial protection. When the primary earner of a family passes away, dependents may face financial hardship due to the loss of income. Life insurance provides a safety net by ensuring that the family continues to receive financial support, helping cover expenses such as household costs, education, medical bills, and outstanding debts.

From an economic perspective, life insurance reduces financial vulnerability and enhances overall stability within households and businesses. In the business context, it is also used to protect companies against the financial loss caused by the death of key employees or partners.

Sub-Sections for Clarity

Nature of Life Insurance

• It is a contractual agreement governed by law.

• The policyholder pays premiums regularly.

• The insurer provides a lump sum payout (death benefit) or sometimes survival benefits.

Types of Life Insurance Policies

• Term Life Insurance: Provides coverage for a fixed period (e.g., 10, 20, or 30 years).

• Whole Life Insurance: Offers lifetime coverage along with a savings element.

• Endowment Plans: Combines insurance with savings, paying benefits either on death or policy maturity.

• Unit-Linked Insurance Plans (ULIPs): Life cover with investment opportunities in equity and debt funds.

• Keyman Insurance: A business-focused policy for safeguarding against the loss of key employees.

Formula / Calculation in Life Insurance

The Life Insurance Premium is calculated using the following formula:

$$\text{Premium} = \frac{\text{Probability of Death} \times \text{Sum Assured}}{1 - (1 + i)^{-n}}$$

Where:

• Probability of Death = Mortality rate of the insured.

• Sum Assured = Amount payable on death.

• i = Rate of interest (discount rate).

• n = Term of policy (in years).

Example Calculation

Suppose:

• Sum Assured = ₹10,00,000

• Annual Probability of Death = 0.001 (0.1%)

• Term = 20 years

• Interest rate = 5%

Premium ≈ $\frac{0.001 \times 10,00,000}{1 - (1.05)^{-20}}$

Premium ≈ ₹526 (approx annual premium, excluding expenses & profit loading).

Journal Entry (Accounting for Life Insurance Premium)

When an individual or business pays the premium:

Journal Entry:

Insurance Premium A/c    Dr  
   To Bank A/c  
(Being life insurance premium paid)  

If it is business-related (Keyman Insurance Premium):

Keyman Insurance Premium A/c   Dr  
   To Bank A/c  
(Being keyman insurance premium paid)  

Detailed Illustration (Business Context)

A company buys Keyman Insurance for its CEO with:

• Premium = ₹1,00,000 per year

• Sum Assured = ₹50,00,000

Accounting treatment:

• Premium treated as a business expense in P&L.

• On claim (death of insured CEO), ₹50,00,000 is received and shown as business income.

Key Features / Components of Life Insurance

• Premiums: Regular payments by policyholder.

• Sum Assured: Guaranteed payout on death or maturity.

• Nominee/Beneficiary: Person who receives payout.

• Policy Term: Duration of coverage.

• Riders: Additional benefits like accidental cover, disability cover, etc.

Importance / Role in Business

• Provides financial security for employees and dependents.

• Enhances employee loyalty when offered as a corporate benefit.

• Businesses use Keyman Insurance to cover risks related to valuable employees.

• Acts as collateral in loan agreements.

Advantages and Disadvantages

Advantages:

• Financial security for dependents.

• Encourages savings and financial discipline.

• Tax benefits under Income Tax Act (Section 80C & 10(10D) in India).

• Helps in wealth creation through investment-linked plans.

Disadvantages:

• Premium burden if not planned properly.

• Complexity in choosing the right plan.

• Early termination may lead to financial loss.

• Not an immediate-return investment.

Usage of Life Insurance

• Personal protection (family security).

• Estate planning and wealth transfer.

• Business succession planning.

• Tax-saving instrument.

• Loan collateral in banks.

Case Studies

• LIC of India: One of the world’s largest life insurers, offering protection to millions. Families rely on its payouts for long-term financial security.

• Keyman Insurance in Startups: Indian startups often insure co-founders to ensure business continuity in case of untimely death.

Practical Example

A 35-year-old buys a term life policy with:

• Premium = ₹10,000 per year

• Coverage = ₹1 crore
  If he passes away during the policy term, his family receives ₹1 crore. If he survives till maturity, no payout is made (unless maturity benefit is included).

Common Mistakes or Misunderstandings

• Believing life insurance is only for death, ignoring living benefits.

• Assuming employer-provided insurance is enough.

• Not updating nominees.

• Choosing inadequate coverage (rule: minimum 10–15 times annual income).

Real-Life Applications and Legal Implications

• Life insurance is legally binding under Insurance Act, 1938 in India.

• Widely used in financial planning for retirement, child education, and debt repayment.

• Businesses use life insurance for buy-sell agreements in partnerships.

• Courts often consider insurance payout in family inheritance disputes.

FAQs

Q1. What is the ideal age to buy life insurance?
Earlier is better—premiums are lower when you are young and healthy.

Q2. Is life insurance taxable?
Premiums qualify for tax deduction under Section 80C; payouts are usually tax-free under Section 10(10D) (subject to conditions).

Q3. Can I have multiple life insurance policies?
Yes, you can own multiple policies for higher coverage.

Q4. What happens if I stop paying premiums?
Policy may lapse; some plans convert to paid-up policies with reduced benefits.

Q5. Is life insurance necessary if I am single?
Yes, especially if you have debts, dependent parents, or future financial goals.

Expert Tip from Learn with Manika

Always calculate your Human Life Value (HLV) before choosing a policy. HLV ensures you buy adequate coverage based on income, expenses, liabilities, and long-term goals.

Related Terms

• Term Insurance
• Whole Life Policy
• Premium Loading
• Keyman Insurance
• Endowment Policy
• Annuity Plans