Insuring is not Investing

At a glance

  • Most of us own atleast one cash-back life insurance policy bought early in our careers for the 80C tax deduction
  • Insurance is a means of managing risk, meant to compensate your dependents in the event of a catastrophic event while an investment is meant to help grow your savings at an acceptable rate. Confusing insurance with investment is one of the most wide-spread mistakes
  • The most prevalent insurance product, Cash-back policies that offer a lumpsum on maturity are the worst of both insurance and investing since they offer low death benefit to premiums paid and also sub-optimal returns on maturity
  • The Calm Investor recognizes this difference and chooses term insurance which allows for “adequate” coverage. Meanwhile, his investment decisions are completely separate from universe of insurance

Almost everyone in India has interacted with at least one LIC agent early in their professional lives. The pitch is fairly straightforward, “Here’s a great investment vehicle that saves you tax and gives you a lump sum of money at some point in the future”. At a time in our lives where we’re more focused on managing money for the next few weeks. Thinking 15-20 years down seems a waste of time but the promise of immediate tax benefits usually means anyone born before the late 90s has at least one LIC life insurance policy document stashed away somewhere. So do I, but that’s from a time where my financial decisions ran on autopilot. Confusing insurance with investment is one of the most fundamental and widespread mistakes we make.

Buying an insurance product for the ‘promised’ returns is like wearing the thinner bullet proof vest because it can double as a t-shirt

Here’s how:

When unsullied, insurance is a sensible and an essential concept. Simply put, it is a mode of distributing financial risk of an event that has low probability but high impact.

Life insurance, when done right, manages the financial impact of the death of a person, by paying out a one-time sum that replaces at least 7-10 years of future earnings of the insured person. For this lump-sum payment to be possible, the insurer collects annual premium payments from a large number of people out of which they expect a small percentage to die (called mortality rate). The premium is what one pays for this protection, which means, if the event being insured against does not occur, you don’t get any money. This is insurance in its purest form and is referred to as “term insurance”. The hallmark of such a product is the high ratio of death benefit to premium paid, for e.g. a reasonably healthy 30 year old looking for Rs 1 Crore coverage would pay annual premiums of around Rs 10,000 to 12,000, i.e. coverage of over 900 times the premium amount.

The problem in India has been the proliferation of “cash-back policies” which incent buyers by offering them an amount at the end of the coverage period if the insured does not die. There are two problems with such products:

Underinsurance

The death benefit to premium ratio is much lower, because now the insurer has to account for returning a lumpsum in 10-15-20 years. For example, LIC’s Jeevan Anand requires Rs 3,165 of premium1 for a sum assured of Rs 1 Lakh. So it would require premium payments of Rs 3 Lakhs annually to have the same cover of Rs 1 Crore (A term policy premium for the same amount would be approximately Rs 11,000). The very purpose of “life insurance” is undermined by introducing the cash-back element because the death benefit amount that can be afforded using this calculation is typically nowhere near sufficient to support a family

Inferior returns

Most such products do not have to commit to a required rate of return and do not produce favourable returns compared to other investment avenues like equities. The Jeevan Anand illustration shows two possible scenarios 4% and 8% annual returns, a huge range of uncertainty! Thus they underperform as investment vehicles.

The reason for this mis-selling is a combination of lack of understanding or interest from customers and agent incentives. Insurance agents get paid on commission, up to 25% of the 1st year premium is paid for long-term policies. This percentage progressively reduces as the policy ages but settles at 5% after the 4th year. Let that sink in for a moment.

Now think about why an agent would recommend a term policy with a premium of Rs 11,000 when he can sell a far more inferior “cash-back” policy, but with a premium that is 4 times the term policy?

Life Insurance is an essential product.  The course of action for any professional is to buy a TERM policy with a death benefit amount of at least 7 to 10 times their annual incomes, preferably online, from one of the many providers in the market

My dad’s insurance agent is who sold me my first policy. I call him “uncle” out of respect, but now, when he calls every year to “advise” me to increase coverage with “products offering excellent returns”, I politely deflect saying I’ll think about it and go back to focusing on my equity portfolio for my investments knowing I have a term policy that takes care of my need for life insurance.

References (external links):

1 Illustration of one of LIC’s “typical” products – Jeevan Anand (LIC Website)

2 What’s wrong with using insurance as an investment? (CNN Money)

3 5 ways to spot insurance mis-selling (LiveMint)

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