Insurance is not Investment. Don’t Mix the Two!

Is life insurance a good investment?

If you want a one-word answer, then its NO.

insurance vs investment

Life insurance is not an investment. Period.

Comparing insurance and investments and trying to pick either of two (or combining them) – is one of the biggest reasons why most people are unable to:

  1. Save enough
  2. Invest properly (and become rich)
  3. Have an adequate insurance coverage

I assume that most of you know that you need to keep insurance and investments separate – i.e. its always about Insurance Vs Investment 🙂

But if you have your doubts, then read on.

Any well thought out financial plan should include the following:

  • Insurance
  • Savings
  • Investments

And one should not try to mix the three.

But unfortunately, the lines that differentiate between insurance, savings and investments are often blurred.

Insurance Vs Investment

In India, insurance plans that double up as investments are extremely popular. So apart from the life cover that is available during the policy tenure, there are endowment policies that return a lump sum at maturity. Then there are Money-back policies that offer regular payouts at fixed policy intervals and one final payout at maturity. And there are hundreds of variants of these two popular insurance products.

But people buying an endowment plan or a moneyback policy don’t understand that they are not getting the best of both worlds by buying a hybrid product (that combines insurance with investments).

Instead, they are getting a product that is neither a good investment nor a good insurance.

Ofcourse, it is convenient to have just one product that takes care of everything.

But convenience should not result in sacrifice of the very reason why the product is being purchased – returns (for investment) and cover (for insurance).

Isn’t it?

So to put it bluntly, life insurance as an investment tool – is a flawed concept.

Why do people think that insurance and investment are same?

This is the biggest problem.

And the root cause of this problem is the status of tax-saving instrument – which is given to insurance plans.

Ask people about their investments and they will tell you that they invest in insurance!

Common tax treatment is the main reason why people compare insurance with investments and end up buying insurance-based investment products. This is also the reason why people think that once they are done with their tax planning, their financial planning is over too (which is wrong again)

Then there has never been a shortage of our family friend(ly) insurance agents, who have always been over-optimistic about the reason one should purchase insurance – to earn returns 🙂 and not as protection for dependents.

They will tell you everything about what an insurance policy can do for you – like death benefits, maturity benefits, bonuses, accident riders, etc. But they will never tell you about what would happen, had you simply purchased a term plan and invested rest of the money elsewhere.

(If you don’t understand what I am trying to hint here, don’t worry. I will come to the comparison in a bit. Then it will become crystal clear.)

Don’t mix Investment & Insurance. Why?

Let us take them one by one

When you invest, your main aim is to earn high returns. But when you mix investment with insurance, i.e. you ‘invest’ in insurance products 🙂 like endowment or moneyback plans, your returns are limited – around 4-6%.

Good equity funds can easily give you 12% kind of returns in the long run. So there is an opportunity cost of not investing in high-return products.

When you buy insurance, your main aim to have a life cover that is big enough to take care of everything (family’s regular expenses for years, major life goals like children’s education & marriage, etc.). But when you mix insurance with investment (like in endowment or moneyback plans), your life cover will be low unless you are ready to pay a hefty premium.

In contrast, pure life insurance policies (term plans) give big covers for very nominal premium.

A small personal example…

When I started earning, I was ‘forced’ to purchase an endowment plan as investment.

And if my memory serves me correctly, it was giving me a cover of Rs 5 lac for an annual premium of around Rs 30,000.

I later dumped that policy. I now have a term plan (one of many), which gives Rs 50 lac cover for about Rs 5000.

To summarize,

Earlier: Rs 5 lac cover – premium Rs 30,000 (traditional insurance policy)

Now: Rs 50 lac cover – premium Rs 5000 (pure insurance policy)

See the difference?

Infact, the ‘family friend’ who forced me to purchase the traditional plan was trying to convince me to create a life insurance based investment strategy! Thank God I realized what it meant – after just few years! 🙂

Many people ignore pure insurance plans because it gives no returns if they survive (on maturity).

But we must not forget that life insurance is not there to make us rich when we are alive. It’s to ensure that our dependents don’t become poor when we are not there.

Lets now see exactly why buying a pure insurance product is better than buying a traditional insurance product…

Traditional Life Insurance Policy Vs. Term Plans 

For the purpose of illustration, I am taking a popular endowment (+ whole life insurance) plan by LIC named New Jeevan Anand. For more details about this policy read this.

Suppose that a person aged 30 years, wishes to purchase an insurance policy with sum Assured of Rs 25 lac for a period of 20 years.

He has the option of either going in for a traditional insurance policy (like endowment plan) or a simple term plan.

The premiums for both policies will ofcourse be different. Lets see ‘how’ big the difference is:

Premium (Endowment Plan) – Rs 1,44,858/-

Premium (Term Plan*) – Rs 3996/-

(Premium data source – LIC’s own premium calculator)

* LIC eTerm Plan

Surprising. Isn’t it?

The difference in premiums is huge!

Agreed that term plans don’t give back anything in case you survive the policy term. But don’t you think that every year, the term plan leaves you with an additional amount (surplus that you save by not buying endowment plan) that can be invested elsewhere for better returns?

You might argue that endowment plans too offer returns if held till maturity. But returns given by traditional insurance plans are abysmally low – around 4-6%.

Simply speaking, for Rs 1.4 lac that you pay annually as premium, the insurance cover you are getting (Rs 25 lac) is shit inadequate! A simple term can give you same coverage for just Rs 4000.

Whether Rs 25 lac cover is enough for you or not is another question (check this article on how much cover to buy).

But what I am trying to highlight here is the huge difference in premiums.

Infact a cover that is four times larger (than Rs 25 lac cover), i.e. Rs 1 crore can be purchased using term plan at just about Rs 16,000. And this is the premium of term plan offered by LIC (plan name – eTerm). The private life insurers will offer the same cover at even lesser premiums!

Now lets put nail in the coffin of traditional insurance plans 😉

_____

Endowment plan (Rs 25 lac cover) – Rs 1.44 lac annual premium

Term plan (Rs 1 crore cover) – Rs 16,000 annual premium

Annual premium difference – Rs 1.28 lac

Also note that term plan is giving a 4-times larger cover than endowment plan.

Lets see what happens at maturity…

Endowment Plan (at maturity)

Insurance Cover – Rs 25 lacs

Total Premium Paid – Rs 29 lacs (20 years x Rs 1.44 lacs)

Maturity Amount – Rs 50-60 lacs or maybe 70 lacs.

Let us compare this with a combination of Term Plan + Equity Funds (giving 12% annual returns)

Term Plan (at maturity)

Insurance Cover – Rs 1 crore (four times that of endowment plan)

Total Premium Paid – Rs 3.2 lac (20 years x Rs 16,000)

Maturity Amount (from term plan) – Rs 0

Maturity Amount (from equity funds – investing Rs 1.28 lacs annually) – Rs 90+ lacs

So the clear winner in case of maturity amount here is a combination of term plan + equity funds. The amount you get is more than what you would have got had you bought an endowment plan.

Also, you get a life cover that is 4 times larger than that given by the endowment plan. That too at 1/9th the premium.

What else is there to think of now?

Read the above example again (to really understand it)

Now lets come to the case of policyholder dying during the policy term.

Depending on when exactly the death happens, the amount paid to nominee will be equal to sum assured (1.25 times of SA in case of New Jeevan Anand) + accrued bonuses. This would be anywhere between Rs 31 and 60 lacs.

Compare this with term plan – death during policy term will lead to term plan paying out Rs 1 crore to the nominee. In addition, the amount that is already invested in equity funds (in previous years) will also be available for the nominee.

Again, a combination of term plan + equity funds seems to be a better choice than endowment plan.

What if we don’t invest in Equity Funds and instead choose low-risk PPF?

The benefits of term plan + PPF combination will be lower (than Term+Equity Funds) but still better than endowment plans. This is because historically, returns given by PPF are lower than those given by equity funds.

So depending on your risk profile and asset allocation requirements, you can club a term plan with either PPF or equity funds or even both!

As for tax benefits, all instruments discussed – endowment, term plan, PPF, ELSS mutual funds offer tax deductions. So not much to compare here.

But do note that the money invested in equity funds is available to you as and when you want (after 3 years in case of ELSS). But bonus accrued in endowment plans are paid only at the time of maturity (though you can take a loan against it).

What Should You Do?

  • If you have recently bought the policy (less than 3 years old), then stop paying the premiums and forget about the policy. Bear the losses. Switch to Term Plan + Equity MF / PPF mode. It will work out better in the long term.
  • If your traditional policy has completed 3 or more years, make them paid up or surrender them. Take the surrender money and invest it elsewhere. Buy a large term plan.
  • If your policy is close to maturity, then there is not much you can do. Better stick with it. And if you think that your current insurance cover (death benefits + bonus) is not adequate, then purchase additional term plans to enhance your life cover.

There will always be people who will not get convinced about the superiority of term insurance plans over traditional plans. Such people will eventually end up getting mediocre returns and inadequate life covers.

Then there are many people who do realize the mistake in having bought traditional insurance policies. But by the time they realize it, it’s already too late.

But if you are smart enough 🙂 and do understand that insurance is not an investment and its best to keep the two separate, you will know why term plans are the best option for your insurance needs.

They are cheaper, give bigger life cover, the amount invested elsewhere earns better returns and can be withdrawn in times of need (unlike the accrued bonuses of traditional endowment plans which is only available at maturity).

So is term insurance the best form of life insurance?

I think it is.

Though insurance is no alternative to investments, it must be kept separate from investments (and savings) and that is what a term insurance helps you do.

insurance investment savings

Don’t try to take sides on investment vs insurance debate. Both life insurance, as well as investments, are necessary. Just make sure you keep them separate.

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How much Life Insurance to Buy & How To Calculate the Right Amount?

How Much Insurance To Buy

A reader had a very specific question in Personal Financial Concerns Survey 1.0. It was about calculations related to life insurance amounts.

This is what he had to say:

In past, I have bought insurance policies for saving taxes and investments. But now I understand that these should not be the main reasons for buying insurance. Hence, I want to buy the right insurance cover to secure my family. How much cover is enough for me? People say buying Rs 50 lacs or Rs 1 Crore coverage works. Is it correct?

Now that’s a question that many people have.

I have seen people earning in 7-figures and having insurance cover of 6-figures! 🙂 They believe that a 6-figure amount will be sufficient to take care of their family in case of their death. And these people don’t even have a lot of money saved up.

Tells of risks that people take with their family’s future.

Insurance is bought simply to ensure that insured person’s family does not have to make sacrifices with their standard of living, are able to achieve their future financial goals and close all outstanding loans. That’s it. Nothing more. Nothing less.

But I am not writing this post just to prove that buying life insurance is a must. I am rather concerned about addressing the reader query, which is:

How much Life Insurance to Buy?

It is not that difficult to calculate.

You life cover should be sufficient enough to take care of the following 3 parts:

  • Provide enough money to foreclose all outstanding loans
  • Provide enough money to help meet regular day-to-day expenses of your family for years to come.
  • Provide enough money for your children’s education and marriage.

Lets take them up, one by one…

Part 1: Provide enough money to foreclose all outstanding loans.

This is pretty simple to understand. Just make sure to add any foreclosure charges that have to be paid in case of loan closure.

Lets call this as Amount-Loan-Closures.

Part 2: Provide enough money to help meet regular day-to-day expenses of your family for XX number of years to come.

(Caution – You need to be really sure about what XX is here – as it is the number of years, you think your family needs to be financially supported).

If you think your working spouse will take care of this part on her own, then that’s debatable. Just remember, that in a dual-income family, life style costs and regular expenses generally increase to use a larger part of the combined incomes.

So if suddenly one income stops, it can become a big problem to maintain the existing lifestyle.

Hence, it’s better and safer to make a provision for this as well.

Now how to calculate this amount?

Step 1: Estimate regular annual family expenses (exclude your individual expenses).

Step 2: Subtract the amount you think your spouse can manage on their own (better keep this as minimum)

Step 3: Understand that multiplying the above amount with the number of years (XX above) you wish to support your family won’t work. Why? Inflation. Inflation will increase these expenses every year. So take a safe inflation assumption (say around 8%).

Step 4: Understand that the amount your family gets from insurance company, will be invested and used to generate income. Don’t expect very high rates of returns from the investment. Lower your expectation are, better it is.

Step 5: Use this information to calculate the required insurance amount. This amount will provide enough money for your family to meet regular day-to-day expenses for the XX number of years.

Lets call this as Amount-Family-Expenses.

Part 3: Provide enough money for your children’s education and marriage.

Now it’s a personal choice here – Do you want to provide for your children’s education or marriage needs or not?

Assuming you want to, lets see how to arrive at this figure.

Step 1: Estimate the amount required for your children’s education and marriage, if it were to happen today.

Step 2: Since you children need funds in future, understand that inflation will increase the amount required. So if a MBA from good college costs Rs 15 lacs today, it might cost Rs 35-40 lacs after say 10-12 years. Calculate the amount in future using inflation numbers.

Step 3: You might have already saved some money for these goals. Calculate the future value of these savings and subtract the figure from amount calculated in above step.

Lets call this as Amount-Child-Goals.

 

Now we have calculated 3 figures for each part.

Add these three figures:

= Amount-Loan-Closures + Amount-Family-Expenses + Amount-Child-Goals

This is you current insurance requirement.

But you don’t stop here.

I am sure that you have been careful in your calculations.

But you see, in all calculations above, we had to make certain assumptions. Assumptions that require us to make predictions regarding rate of inflation, rate of return, etc. Now you know that even experts have trouble predicting the future. So at best, our predictions are mere educated guesses and not future realities.

We can always be wrong in our assumptions.

So in order to provide a buffer for mistakes in our assumptions, increase the amount you calculated above by atleast 10%.

Higher you bump it up, better it is.

I personally take it at 25%. (Even if it means that you family ends up with more money than they actually require, it is a good problem to be in. Isn’t it?)

This is the Gross Insurance Requirement for you.

Once you have calculated the figure, you need to subtract a few things from it. You might already have some other insurance policies,  employer-provided insurance covers, existing savings and investments earmarked for some of these child_goals . Subtract these amounts from above figure.

This will give you the additional insurance cover you need to purchase.

You can use the following grid as a guide:

Life Insurance Calculations

I am sure that once you are done with your calculations, a huge amount will be staring at you from your calculation sheet. Many of you who have endowment plans, moneyback plans, etc. as insurance covers, will even fear asking about the premiums for such large covers.

But don’t worry. Solution is there. And it is to buy plain term insurance cover. Its cheap and can provide coverage of almost Rs 1 crore for around Rs 10,000 – Rs 12,000. But remember one thing – term insurance has no survival benefits. You won’t get any money in case you don’t die within the insured period.

 

Important points:

  • Buying a term insurance does not mean that you don’t need to save for your future goals(retirement, kids education). It is only a backup plan in case you don’t survive that long. Insurance is not investment.
  • You are smart enough to purchase the right insurance cover for your family. But are your family members smart enough to deploy the huge insurance amount correctly (which they get when you die)? Don’t bet on it. Make sure that you sit with them and educate them what insurance is. And more importantly, what to do when they get the big amount. Tell them where to put the money and when to withdraw it. One wrong decision on their part and they will lose the money (a part or whole, who knows). And worst is that this is inspite of you having taken care of everything. So make sure you educate them.

There is a way to reduce your insurance requirements. Suppose you want to provide for your family’s expenses for 25 years (Part 2 of the above discussion). But your child’s education goal is just 10 years away (Part 3). So if you follow the approach discussed in article above, it will mean that you are paying for providing risk cover for the child’s education goal, even after its completion (i.e. 25 – 10 years = 15 years).

Effectively, you might find yourself paying a premium for sum assured that is higher than what is actually required. But that is not completely wrong. As I said, being over-insured is any day better than being under-insured. In any case, your insurance requirements keep changing every year.

The problem (though wrong to call it that), is solvable through an approach known as laddering of insurances. Its an approach where one buys term insurance plans of different durations that correspond to major goals like kids education, marriage, etc. Once the period of shorter-term plan is over, it frees up cash that can be invested elsewhere. Its an interesting topic – Laddering. I will write about it in another post soon.