One of the most important aspects of any individual’s financial plan is life insurance. However, there is a lot of misinformation about life insurance, owing to the way life insurance products have been sold in India over the years. We’ve talked about some common blunders that insurance buyers should avoid when purchasing policies.
1. Underestimating insurance needs: Many life insurance buyers choose their insurance covers or sum assured based on the plans their agents want to sell and the amount of premium they can afford. This is the wrong approach. Your insurance needs are determined by your financial situation and have nothing to do with the products that are available. Many insurance buyers base their coverage on rule of thumbs such as 10 times annual income. Some financial advisers believe that a cover of ten times your annual income is adequate because it provides your family with ten years of income if you die.
However, this is not always the case. Assume you have a 20-year mortgage or home loan. How will your family pay the EMIs after ten years, when the majority of the loan is still owed? Assume you have young children. Your family will run out of money at a time when your children require it the most, such as for college. Insurance buyers must consider a number of factors when determining how much insurance coverage is appropriate for them.
Repayment of the policyholder’s entire outstanding debt (e.g., home loan, car loan, etc.)
After debt repayment, the cover or sum assured should have enough funds to generate enough monthly income to cover all of the policyholder’s dependents’ living expenses, taking inflation into account.
After debt repayment and monthly income generation, the sum assured should be sufficient to meet the policyholder’s future obligations, such as children’s education, marriage, and so on.
2. Choosing the cheapest policy: Many insurance buyers prefer to purchase policies that are less expensive. This is yet another serious blunder. A low-cost policy is useless if the insurance company is unable to pay out the claim in the event of an untimely death for whatever reason. Even if the insurer pays the claim, it is not a desirable situation for the insured’s family to be in if it takes a long time to pay the claim.
To choose an insurer that will honor its obligation in fulfilling your claim in a timely manner, you should look at metrics such as Claims Settlement Ratio and Duration wise settlement of death claims of different life insurance companies. The IRDA annual report contains data on these metrics for all insurance companies in India (on the IRDA website). You should also look up claim settlement reviews online before deciding on a company with a good track record of settling claims.
3. Viewing life insurance as an investment and selecting the incorrect plan: The most common misconception about life insurance is that it can also be used as an investment or retirement planning tool. This is largely due to some insurance agents who prefer to sell expensive policies in order to earn high commissions. When compared to other investment options, life insurance simply does not make sense as an investment.
Equity is the best wealth creation instrument for a young investor with a long time horizon. Over a 20-year time horizon, investing in equity funds via SIP will result in a corpus that is at least three or four times the maturity amount of a 20-year term life insurance plan with the same investment. Life insurance should always be viewed as a way to protect your family in the event of your untimely death. Investment should be treated as a distinct consideration.
Even though insurance companies market Unit Linked Insurance Plans (ULIPs) as appealing investment products, you should separate the insurance and investment components for your own evaluation and pay close attention to what portion of your premium is allocated to investments. In the early years of a ULIP policy, only a small portion of the premium is used to purchase units.
A good financial planner will always recommend that you purchase term insurance. A term plan is the most basic type of insurance and is a simple protection policy. The premium for term insurance plans is much lower than for other types of insurance plans, and it leaves policyholders with a much larger investible surplus, which they can invest in investment products such as mutual funds, which provide much higher long-term returns than endowment or money back plans. If you have a term insurance policy, you may choose to add other types of insurance (e.g., ULIP, endowment, or money back plans) to your term policy to meet your specific financial needs.
4. Purchasing insurance for tax planning: For many years, agents have persuaded their clients to purchase insurance plans in order to save tax under Section 80C of the Income Tax Act. Investors should understand that insurance is most likely the worst tax-saving investment. Returns on insurance plans range from 5 to 6%, whereas Public Provident Fund, another 80C investment, provides close to 9% risk-free and tax-free returns. Another 80C investment is equity linked savings schemes, which provide much higher tax-free returns over time.
Furthermore, insurance plan returns may not be entirely tax-free. If the premiums exceed 20% of the sum assured, the maturity proceeds are taxable to that extent. As previously stated, the most important aspect of life insurance is that the goal is to provide life insurance, not to generate the highest investment return.
5. Surrendering or withdrawing from a life insurance policy before maturity: This is a serious mistake that jeopardizes your family’s financial security in the event of an unfortunate incident. Life insurance should not be touched until the insured’s unfortunate death occurs. Some policyholders surrender their policy to meet an immediate financial need, with the intention of purchasing a new policy once their financial situation improves.
Two things should be kept in mind by such policyholders. First and foremost, no one has control over their own mortality. This is why we purchase life insurance in the first place. Second, as the insurance buyer gets older, the cost of life insurance skyrockets. In the event of financial distress, your financial plan should include contingency funds to cover any unexpected urgent expenses or to provide liquidity for a period of time.
6. Insurance is a one-time purchase: I recall seeing an old motorcycle commercial on television with the punch line, “Fill it, shut it, forget it.” Some insurance buyers adhere to the same philosophy when it comes to life insurance. They believe that once they purchase adequate coverage in a good life insurance plan from a reputable company, their life insurance needs will be met indefinitely. This is a blunder.
The financial situation of insurance buyers shifts over time. Compare your current earnings to your earnings ten years ago. Isn’t it true that your income has increased several times? Your standard of living would have greatly improved as well. If you purchased a life insurance policy ten years ago based on your income at the time, the sum assured will be insufficient to meet your family’s current lifestyle and needs in the unfortunate event of your untimely death. As a result, you should purchase an additional term plan to cover that risk. Life insurance needs to be re-evaluated on a regular basis, and any additional sum assured, if needed, should be purchased.
When purchasing insurance policies, investors should avoid these common blunders. One of the most important aspects of any individual’s financial plan is life insurance. As a result, life insurance must be given careful consideration. Insurance buyers should be cautious of questionable selling practices in the life insurance industry. It is always beneficial to work with a financial planner who examines your entire portfolio of investments and insurance on a holistic basis, allowing you to make the best decisions for both life insurance and investments.