What makes insurance different from an investment?
The term “personal finance” is often used interchangeably with “investment planning,” but the two are not mutually exclusive. From maximising revenue and minimising expenditures, to setting up a budget, to keeping track of debt and assets, to managing credit, and, of course, to making investments and purchasing insurance.
Financial management would be incomplete without insurance and investments, both of which are critical, but they serve quite distinct reasons.
What exactly is insurance, and how does it work?
Expenses are incurred when you pay for something, in this case, a service, in exchange for your money. Your family’s financial well-being is protected when you acquire insurance to cover the costs of unanticipated calamities. In spite of the fact that human life cannot be valued, life insurance plans are designed to alleviate financial worry for your loved ones if the unthinkable happens.
To ensure that your family or a designated beneficiary receives a sum assured (SA) if you die, you must pay a predetermined premium over a set period of time.
A variety of criteria go into calculating the SA, including your age, current and projected wages, current and projected expenses/liabilities, and overall inflation levels. Another method of estimating the SA is to use the Human Life Value (HLV). The premium cost is then computed based on the SA and other parameters such as age, health condition, plan specifications, riders, and so on and so forth.
You must continue to pay the premium in order to benefit from the insurance’s risk coverage. Insurance benefits expire if premiums are not paid, just like with any other fee-based service.
Term life insurance is not a sound financial decision.
When making an investment in a financial product, the investor’s financial goals, risk tolerance, and return expectation are all taken into consideration. If the investment is a fixed-income one, it is possible to keep it and receive periodic returns. Another option is to sell it at a later date for a one-time gain to meet your financial objectives, such as a down payment on a home, tuition for a child, or a fund for your needs after retirement.
The policyholder receives no benefits from a pure term insurance plan while the policy is active or if the policy is still in force at the end of the term. In the event of an untimely death, however, the nominees receive the death benefit. If your primary goal is to save your loved ones from becoming poor after you are no longer around, then insurance isn’t necessary for you.
What’s the big deal?
Several factors contribute to the haziness of the distinction between insurance and investing. Insurance commissions are higher than commissions on pure investment goods like mutual funds, which is why so many people choose it over pure investment products like mutual funds.
Hybrid insurance-cumulative investment schemes, such as endowment plans, money-back insurance policies, and unit-linked insurance plans (ULIPs), have also played a significant role. It’s been common practise in the past for many of these products to fail on both fronts – neither offering appropriate insurance nor considerable returns.
As an illustration, consider a ULIP. In terms of financial protection, a ULIP can provide a maximum SA of 10 times the amount of premiums paid. So if a policyholder is able to pay an annual premium of Rs 50,000, they can acquire up to Rs 5 lakh in life insurance. Car loan payments alone would not be enough to cover the family’s long-term financial demands.
In contrast, for as little as Rs 7,000 to 10,000 a year in premiums, a healthy 30-year-old can acquire up to Rs 50 lakh in coverage with a simple pure term policy!
Invested funds are frequently depleted as a result of additional expenses. Your premium is worth less than what you paid for it at first. A portion of the premium is used to pay for the actual insurance coverage (mortality charges), while another 5% to 7% is used for premium allocation charges, fund management charges, and other administrative charges. This indicates that throughout the course of a ten-year period, only roughly Rs 4.65 lakh of the Rs 5 lakh you paid as premium will actually be invested. The amount invested is also subject to a lock-in period.
As ULIPs are market-linked, the actual fund value at maturity is influenced by equities exposure and the market. When things go wrong, you could lose a lot of your starting capital, which would leave you with nothing. However, ULIPs have recently provided good returns. However, it is always best to separate your insurance needs from your financial goals.
What can we do to help?
Investing in a hybrid insurance package has a significant opportunity cost.
Invest in a life insurance policy that will cover your loved ones’ financial obligations in the event of your untimely death. Your insurance can be upgraded at any time for a little fee in order to provide you with more protection. Because premiums can be paid quarterly or semi-annually, you can spread out the cost of insurance over the course of the year without disrupting your financial plan.
Additionally, take into account your time horizon, risk tolerance, portfolio allocation, and projected return on investment while making investment decisions. Monitor your assets on a regular basis to ensure they are aligned with your goals, and take remedial action if necessary.
The road ahead will be easier if you keep to the foundations of solid financial planning.