|Buy insurance only if you want life cover, not as a savings device or to save tax, says Sanjay Matai.|
Insurance is a form of risk management primarily used to hedge against the risk of a potential financial loss. It is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in exchange for a premium and the duty of care. In India it is also one of the least understood financial instruments, commonly bought or sold for all the wrong reasons.
Though the insurance sector was opened to private players and placed under a regulator a few years back, it is unfortunate that increased competition has not dispelled the misconceptions. In fact, they may even have increased, as large numbers of wrong policies continue to be sold, something that can cause serious financial damage to policy buyers.
Let us look at some common myths and point out the most frequent mistakes people make when buying insurance.
Is insurance an investment?
Most of us feel satisfied paying our insurance premiums. We feel we are doing a great job saving for the long term while getting a deduction on income tax at the same time.
But have you ever worked out how much return you are actually getting from this so-called 'investment'? If you do, you will quickly realise that the returns from an insurance policy are pathetic except certain policies like ULIPs, where one takes an equity risk. The problem with the latter is that on the one hand, the insurance component is often so small that one is getting very little coverage. On the other, if the stock market goes down like it did recently, one could end up losing on all fronts.
Insurance is a very poor investment option because:
- A part of the premium is first deducted towards providing you risk cover.
- A large part is deducted to meet sales commissions, which are very high (40 per cent of first year's premiums and 6 to 10 per cent of subsequent premiums) when compared to other investment products.
- Only the balance remaining premium gets invested; this can sometimes be as low as 30 per cent of the premium you pay.
- Most of these investments are in extremely safe instruments like government securities, in which the returns are very low.
Overall, the net return on the total premium paid works out to a pittance. There are a lot of investment products like PPF, NSC, and even fixed deposit bank accounts that offer superior returns without compromising on safety. About the risk cover, the next point provides the right answer.
Endowment / moneyback versus a term policy
Essentially speaking we have two kinds of insurance policies:
- Pure life cover policies (term policies).
- Life cover-cum-investment policies (endowment, moneyback).
Term policies provide adequate life cover and the premiums are very low. But they are hardly ever sold, because agents don't tell us about such policies (they get very low commissions for them). We also tend to ignore them, as there are no 'returns' in such policies; we don't get anything back if we survive the policy term.
Life cover-cum-investment policies provide both cover and 'returns'. But for a given amount of sum assured, the premiums are very high when compared to term policies, so we buy policies based on the premium we can afford. The end result is a nominal insurance cover, which will not be sufficient when the need really arises. And the 'returns', as we have already seen, are very poor.
For a concrete comparison, let us say a 30-year-old professional wants to get a Rs 10-lakh life insurance policy for a 15-year-period. The premiums would be more or less as follows:
- Pure risk term policy (no 'returns'): Rs4,091 per year - Rs341 per month
- Endowment policy (returns after 15 years): Rs65,582 per year - Rs5,465 per month
- Cashback policy (returns every 5 years): Rs99,767 per year - Rs8,314 per month
For the same sum insured, an endowment policy costs 16 times as much and a cashback policy costs 24 times as much as a term policy! Of course, the term policy offers no return, but if the money you save on a term policy were invested in PPF or NSC, it would earn a better return than endowment or cashback policies.
In most cases, a term policy that provides pure life cover would be your best option.
Insurance is generally bought for tax saving
How many people in India buy insurance for life cover? Practically none.
How many people in India buy insurance to save income tax? Practically all.
Since the objective is to save tax, people often decide on a fixed amount they want to invest. The question is not how much cover they are getting or whether that cover is sufficient, but rather how tax they need to save and how much premium they can afford to pay.
The choice of the policy is also flawed - people go for ULIP, endowment or moneyback policies rather than pure life cover, which also provides tax saving.
The result is an insurance policy that is of no use, as it rarely provides the desired life cover. When you also consider the fact that they give extremely poor returns, the saving seems a total waste. Tax saving should be considered only as an add-on benefit, rather the primary reason for buying insurance.
Tax can be saved through a number of other options (including PPF, NSC and mutual funds), almost all of which offer much better returns, in addition to other benefits and features.
The agent is giving a rebate
Agents have lured many people into buying insurance policies by offering a rebate on a part of their commission. This is illegal and also highly unethical.
They profess to take care of your interest, but they sell you endowment or moneyback policies, which earn them huge commissions but are generally useless for you. As we have seen, they neither provide adequate cover nor give decent returns. If they really had your interest in mind, they would have sold you a term policy. But they won't, as their commissions on such policies are very low.
So don't fall for the rebate trap.
Everyone must be insured?
If you look at it objectively, insurance only provides a financial support to the dependents of the insured in case of his untimely demise. If the breadwinner in the family dies, the money received from the insurance policy will provide financial help to the family members.
But take the case of a wife who is a homemaker; or a child; or an extremely wealthy person. Their passing away may be a huge emotional loss. However, it usually does not plunge the family into a financial crisis. Therefore, insuring such persons does not stand to reason. It is a needless expense and is well avoided.
Buying an insurance policy requires careful analysis, as a wrong policy can cause financial harm for years to come. One can, in a short period, recover from a loss in equity investments. But with insurance, you are compromising on both the cover and the returns, and the damage could be long term.