The reason why the lines between insurance and investments feel blurred can be attributed to a couple of factors. The most common ones are the lack of adequate financial knowledge as well as push by advisors/ agents on account of higher commissions offered on insurance products.
Many people tend to equate financial planning with investments, when in fact there are various aspects of money management that the subject of personal finance encompasses. From optimising income and expenses, budgeting, to managing loans and liabilities, credit management, and of course investments and insurance.
Insurance and investments are crucial pillars of financial management, but they serve very different purposes, and hence should not be considered interchangeably.
What is insurance?
Purchasing a product, or in this case a service in exchange for money is considered an expense. When you purchase insurance, you are effectively ‘buying’ protection against unforeseeable events that can have an adverse impact on your family’s financial future. Even though no value can be placed on human life, a life insurance plan aims to mitigate the financial uncertainty for your family in case of an eventuality.
You are expected to ‘pay’ a fixed premium (for a specified duration) to make available the monetary benefits known as a sum assured (SA) for your family/ nominee in case of your untimely demise.
The SA can be estimated in a lot of ways, one of which is calculated basis the Human Life Value or HLV, which factors in your age, present and potential future earnings, present and future expenses/ liabilities and general inflation levels. The premium cost is then calculated on the basis of SA and other factors such as age, health condition, plan specifics, riders, etc.
You have to continue paying the premium as per the terms of the insurance to enjoy the risk protection. If you stop paying the premiums, the insurance benefit ceases just as would happen with any other fee-based service.
Why term insurance is not an investment
Simply put, investment in a financial product is made with the intention of generating wealth after accounting for the investor’s financial goals, risk tolerance and return expectation. One can hold on to the investment and enjoy periodical returns, if applicable as with some fixed income investments. Alternatively, you can offload it at a future date for a lump sum profit to fulfil your financial goals such as making a down payment on a house, paying for a child’s education or as a corpus for your post-retirement needs.
A pure term insurance plan does not offer any kind of returns to the policyholder, either during the tenure or on surviving the policy term. In the event of an untimely demise, however, the death benefit is paid out to the nominees. The purpose of insurance is not to make you rich while you are alive, but rather ensure that your loved ones don’t become poor when you’re no longer there.
Why the confusion?
The reason why the lines between insurance and investments feel blurred can be attributed to a couple of factors. The most common ones are the lack of adequate financial knowledge as well as push by advisors/ agents on account of higher commissions offered on insurance products vis-à-vis pure investment products such as mutual funds.
The emergence of hybrid insurance-cum-investment products such as endowment plans, money back policies, ULIPs etc. has been another major contributing factor. Traditionally, in a bid to provide multiple benefits, many of these products have failed on both fronts – neither providing adequate insurance, nor delivering substantial returns.
Consider a ULIP for example. On the insurance front, the maximum SA a ULIP offers is 10x the premium paid. So if a policyholder has the capacity to pay an annual premium of Rs 50,000, the maximum life coverage they can get is Rs 5 lakh. This amount would not be adequate to pay off the car loan on a standard sedan, let alone take care of the family’s future needs.
On the other hand, with a simple pure term cover, a healthy 30 year old person can get up to a Rs 50 lakh coverage for an annual premium as low as Rs 7,000 to 10,000!
The costs often add up to reduce the invested amounts. To begin with, the investible value of your premium is lower than what you have paid. This is because a small portion of it goes towards the actual insurance cover (mortality charges) and another 5% to 7% is deducted as premium allocation charges, fund management charges and other administrative charges. Which means, over a 10-year period from the Rs 5 lakh that you have paid as premium, only about Rs 4.65 lakh is actually invested after deducting all the aforementioned costs and charges. There is also a lock-in for the sum invested.
As ULIPs are market-linked, the actual fund value on maturity is subject to equity exposure and market performance. In the event of poor performance, the base capital could also get eroded, leaving you with much less than you started off. That said, in recent times ULIPs have given good returns. However, it is always better to separate your insurance needs from the investment objectives.
What should be done?
The opportunity cost of investing in a hybrid insurance product is very high.
Buy a term cover that is large enough to meet your family’s future needs after you pass. Even if your insurance needs to be increased in the future, you can avail of a higher coverage at nominal additional charges. The flexibility to pay the premiums in quarterly/ half-yearly installments means that you can spread the expense over the year without throwing your budget out of order.
Additionally, make your investment choices carefully after considering your timelines, risk appetite, portfolio allocation and expected RoI. Align different investments with different goals, monitor them regularly to optimise risk, return, and take corrective measures as and when required.
As long as you stick with the fundamentals of sound financial planning, the road ahead will be easier.
(By Prateek Mehta, Co-Founder and CBO, Scripbox)