Personal finance in itself is a vast subject and relates to the end-to-end management of money at an individual or a household level. It deals with areas such as income, expenses, savings, and investment, and includes components such as credit, insurance, and so on.
Due to the vastness of the subject, folks tend to mistake one area of personal finance for another; for instance, savings for an investment. However, these are two different aspects that are whole in themselves. While savings means to simply set aside a portion of your income, investment is to park your savings in a scheme with an expectation to earn returns.
Similarly, financial experts across the world unanimously agree that most individuals mistake insurance as an investment and find themselves on the losing end. If you are one among them and are seeking clarity as to whether insurance is an investment or not, here’s some food for your thought.
What is an investment?
An investment is a financial product that generates returns. It is an asset you purchase, based on your return expectation, risk tolerance, and goals, with an intention to create wealth. You can either retain the investment and enjoy the returns as a regular income or sell it on a future date at a price higher than what you bought it for and gain a profit.
What is insurance?
Initially, insurance was sold as a financial product that offered monetary protection to the insured’s (policyholder) family/nominee in case of an eventuality where they passed. That said, a typical insurance policy necessarily has two components: premium (the cost that you pay to avail the monetary protection) and benefit (claim that your nominee gets on your demise).
What’s the confusion, then?
Down the years, in a bid to boost the sale of insurance, insurers mixed up insurance with investment and sold hybrid products that offered both monetary protection and returns. Now, insurers sell insurance as an investment product—thus, the confusion.
Insurance + Investment = A hybrid product
When one product is disguised and sold as another, there ought to be a catch. Here’s what it is.
Insurance is of various types, out of which here are two:
1. Term life insurance
2. Whole life insurance
Term life insurance
The name ‘term insurance’ comes from the fact that this policy only covers you as long as the term of the policy lasts. That is, your nominee gets the sum insured only in case you pass within the policy term is in force. In contrast, if you outlive the term of the policy, your nominee doesn’t get a single dime.
Sounds a bit too harsh? But that’s what it is. When you buy a term plan, you agree to pay a premium annually, and in turn, insure your life; if nothing happens to your life the policy doesn’t pay your nominee.
Things to know about a term plan:
- The premium amount increases annually considering that your chances of dying increase with growing age, which increases the insurer’s risk of compensating your death
- There is no return/bonus component other than the death benefit that your nominee receives on your demise
Whole life insurance
Just like a term insurance plan, a whole life insurance policy also compensates your nominee on your passing. However, a whole life plan only covers your life as long as you live, 100 years and beyond, so to say. In addition, it is life insurance with an investment component, which generates a fixed percentage as bonus/cash value.
Things to note about the whole life insurance plan:
- The premium of a whole life plan is significantly higher than that of a term policy and remains constant throughout the term
- A portion of your premium is invested in an underlying instrument and the return it generates accumulates as a guaranteed bonus
- You can either withdraw the bonus or choose to receive it when the policy matures
- On maturity, you/your nominee, as the case may be, can opt to receive the bonus either in a lump sum or as a regular income
- The insurer deducts the cost of insuring you and other associated fees from the cash value of your policy. This means you may get a lower percentage of bonus as against what was promised
Why not consider insurance as an investment?
Cutting to the core, understand the objective of buying both insurance and investment products. The former is to protect your loved ones from the uncertainty of your death and the latter is to accumulate wealth to meet goals or earn a regular income. When you mix these products with an objective to enjoy benefits that both bestow, this happens:
You would be underinsured
As mentioned before, a term life insurance plan only offers a death benefit and no bonus, which may discourage you from buying it. Or, you may not buy an adequate cover, because, of course, you don’t get any value for the premium you pay. But by doing this, you deprive your loved ones’ monetary protection, which can most certainly be vital for them in your absence.
Think of it this way. Suppose you are the breadwinner of your family and have availed a home loan to buy your dream cocoon. What happens if God forbid, you pass before repaying the entire loan? The repayment burden, of course, falls on your immediate family members. In addition to the grief of losing you, the absence of your regular income and the burden of repaying your home loan would make matters more for them. Thus, not buying adequate insurance simply because it doesn’t offer returns is foolishness.
You don’t accumulate enough wealth to meet goals
On the flip side, if you consider whole life insurance as an investment just because it offers a bonus, and so not invest elsewhere, then too you’re on the losing end. The reason is simple. You invest with an expectation of returns that you can use to meet a certain goal. But when you buy a whole plan with an investment approach, you are investing without a purpose, which is like driving without a direction. The drawbacks of this approach are:
- You rely on the bonus that the insurance offers, which may not be sufficient to meet your goal, say buy a car
- The promised bonus, which may seem generous now, may not stand the test of inflation and lose value
- You may not receive a bonus on time to meet your goals
Cost of insurance reduces your returns
You get a lower effective return on your whole life plan as the associated cost of insurance is deducted from your bonus. Firstly, the cost of insuring yourself increases every year as you go one step closer to death. The insurer makes up for this risk by deducting a larger amount from your returns every year, ultimately reducing your bonus. Second, insurance comes with the agent’s commission, which is a percentage of your premium. The commission is highest in the first year and reduces gradually in the following years. Both these deductions add to your cost and eat into your bonus. Therefore, it makes no sense to rely on insurance as an investment.
So, what should you do?
The answer is simple, keep insurance and investment separate. Here’s why:
- Buying adequate whole/term insurance with the only objective to insure your life gives monetary protection to your nominees after you pass
- Investing in instruments after a careful evaluation of your risk tolerance, return expectation, timeline, and then aligning them to your goals will help you achieve them on time without compromise
Final verdict: be your own judge
Hopefully, you now have enough information and reason at your disposal to decide whether to approach life insurance as an investment. For best results, returns, and security, assess your needs before investing and insuring. Enjoyed the read? Stick with us for more 🙂
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