Adding Up: How Inflation Affects Your Insurance Policy

Suparna / 25 Jan 2012

Inflation matters as much to the health of your insurance policy as it does to trade and the markets. If the devaluation of money across smaller periods can cause a flutter, imagine the relative devaluation of the policy maturity sum you are counting upon, cautions Jay Sampat.
Inflation is at an all-time high these days. As a result, the cost of living has soared and the prices of essential commodities too have peaked. One element that few people tend to think about while considering inflation is the impact rising inflation has on one’s insurance needs. While the rule of thumb states that you should look at a life cover of around 10 times your annual income (after deducting your investment assets plus any liabilities), it is also important to consider the impact of increasing inflation on your insurance portfolio.

Inflation refers to the general rise in prices measured against a standard level of purchasing power. The most well-known measures of inflation are the Consumer Price Index (CPI), which measures consumer prices, and the GDP deflator, which measures inflation in the domestic economy. From 1969 to 2010, the average inflation rate in India was 7.99%. So, for instance, anything that could be purchased for Rs 10 lakh in 2011 would cost approximately Rs 45 lakh in 2031 at 8% inflation rate.

With respect to insurance, though inflation also causes premium rates to rise, the most significant factor for consumers is the reduction in value of the benefit amount. For example, a person who buys a life insurance policy of Rs 10 lakh may find that this coverage does not serve the purpose when s/he needs it. Though Rs 10 lakh may have been a sufficient amount at the time of purchase, s/he may not use the coverage for 20 years. Finally, when the insurance sum is claimed, the Rs 10 lakh insurance benefit may not be enough.

With the passage of time, your family’s needs are bound to increase. Unforeseen events do occur, and all individuals wish that their family can sustain the same lifestyle even when they are not around to provide for them. Unless you are purchasing a term life insurance policy for a 3-5 year period, inflation is sure to catch up. It is for this reason that the future value of money should figure in your calculations, and hence arises the need to continuously evaluate your life insurance needs, especially for periods of 10 years or more.

A term life policy is generally paid over a long period of 10-30 years. Policyholders pay a fixed rate for term life insurance over this span of time. As the rate of inflation is commonly in the range of about 7%-9% annually, the value of the rupee decreases by this percentage each year. Hence, one is not able to acquire the same amount of coverage benefit as in the previous year; the premium you pay per month for life insurance today will in rupee terms be the same, but will have lesser value 10 years from now due to inflation.

An increasing term insurance policy may provide the flexibility to increase the sum assured by 5%-10% each year to reflect the rate of inflation. Thus, it will hedge against the rising cost of living with the option of increasing the sum assured. Such policies ensure adequate financial protection at an affordable cost. Most companies provide this enhanced insurance with appropriate rider options at a nominal extra cost, as well as rewards for healthy lifestyle habits like non-smoking etc. If you are concerned about rising inflation and are buying a policy relatively young in life, for example just after having a child, this may be a suitable option for you. However, it is worth noting that the cost of your insurance premium is also likely to rise to reflect the increased sum assured. So, you will need to be certain that you would be able to afford the increased premiums.

While many people fear inflation wreaking havoc on the financial markets and causing a decline in the economy in general, many overlook how inflation affects insurance. As inflation causes a loss of the rupee’s buying power, it also reduces the value of an insurance policy. Of course, certain types of insurance coverage are more seriously affected than others. Health coverage and auto insurance premiums change yearly, and hence, are less affected. Insurance policies held for many years before use are those that inflation has the most significant effect on. Whole life insurance is a form of insurance that inflation often affects, as a consumer is likely to pay premiums for decades without using the insurance. By understanding how inflation impacts insurance policies, policyholders can take considered steps to ensure that the sum assured remains adequate at the time when it is required.

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