Personal Finance

It pays to separate insurance and investment

B. VENKATESH | Updated on November 15, 2017 Published on February 04, 2012

This week, we address two important questions relating to insurance. One, when is it important to buy insurance? And two, what kind of insurance contract should you buy? You will also appreciate why it is sub-optimal to buy investment-linked insurance products.

Why insure?

You do not need a life insurance contract if your passive income is more than sufficient to take care of your family's lifestyle expenses.

Consider two people, Kathy and Sam. Kathy earns Rs 1.5 lakh a month from salary. This is what we call active income. Sam also earns Rs 1.5 lakh but through a combination of rental income and investments. This is called passive income.

What happens if Kathy and Sam die? Kathy's family loses an income of Rs 1.5 lakh while Sam's family will continue to generate income, despite his death. It is, hence, necessary for Kathy to take an insurance policy to protect her family from loss of income in the event of her death. Sam can choose not to buy an insurance contract. From this argument, it is clear that only individuals whose family is dependent on active income need to buy insurance contracts.

Your objective while buying an insurance contract would be to protect your family's standard of living, despite loss of income.

You should, hence, ensure that your insurance amount covers, besides your active income, all existing loans including residential mortgages and large future liabilities such as child's college education. But what kind of insurance contracts should you buy?

Insure, not invest

A plain-vanilla insurance contract (called term insurance) pays only if the insured dies within the coverage period. Suppose a person buys a term insurance contract that covers till age 70. The contract pays sum-assured to the beneficiary if the person dies at or before 70.

But if the person survives past 70, the insurance company is not obligated to pay the beneficiary!

Most individuals consider paying premium without receiving any benefit as an economic loss. There is, hence, a demand for investment-linked insurance contracts.

Such contracts charge higher premium, but pay a survival benefit. That is, such contracts are essentially an insurance product wrapped with an investment component.

If the insured dies within the contract period, the beneficiary gets the sum-assured and the investment component. If the insured survives, the beneficiary receives only the investment component.

If you are one of those who are averse to buying term insurance, we ask you to consider this:

Life insurance is to indemnify loss of income to the family. The premium you pay is a cost, not an economic loss, to protect the family's standard of living. You do not insist on having with-profit motor vehicle insurance, do you?

We urge you to do the following five steps to appreciate why it pays to buy term insurance. First, calculate the premium on any investment-linked insurance product for a sum-assured of Rs one lakh for, say, 30 years. You can use the calculator available on the insurance company's Web site.

Second, calculate the premium on a term insurance contract with a sum-assured of Rs one lakh for a period of 30 years.

Third, calculate the difference in premium between the investment-linked insurance and pure insurance products.

Fourth, assuming the difference can be invested for 30 years at 10 per cent a year, calculate the total investment amount.

Fifth, compare the amount in step four with benefits illustration provided on the insurance company's Web site for the product selected in step one.

In essence, we are asking you to leverage professional expertise- buy pure insurance products from insurance companies and investment products from mutual funds! Why?

For one, costs (charges and agent commission) you incur to buy an investment-linked insurance product are higher compared to that of a mutual fund. For another, mutual funds can offer you a width of investment products. So, we urge you not to combine your insurance and investment needs into a single product.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com)

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