Before you buy insurance...

One of the major myths I deal with in the business of financial planning is that insurance is often misconstrued as an investment product.

The insurance industry is ever ready to oblige with fancy illustrations and creative selling techniques to add to this myth.

Were you aware that 65% to 80% of insurance policies are sold in the months of February and March? Whatever the exact figure is, the reason is not hard to find. People need to do their last-minute tax planning and opt for an insurance policy to take care of it.

Insurance companies, too, go berserk at this time with their advertisements, promotions and contests.

So, you have an essentially potent combination of a buyer wanting to save tax and running out of time and an insurance agent eager to meet his targets.

The agent/ insurance advisor/ company pays no attention to providing an insurance solution tailored to the family's needs. Instead, the focus is mostly on the product (to choose the one where the insurance agent will get maximum commission) and the premium paying capacity of the client.

Here are some costly mistakes you can avoid.

Do you need insurance?

You don't need insurance if you are sufficiently wealthy. Let me explain.

I have a client whose net worth is around Rs 20 crore (Rs 200 million). He was sold an insurance policy by his friend and has been paying a premium of Rs 15 lakh (Rs 1.5 million) every year for a cover of Rs 60 lakh (Rs 6 million).

In reality, this individual does not need any insurance. He has sufficient wealth to take care of his family for the next generation or two.

Insurance is just a cost effective mechanism to transfer risk from yourself to the insurance company. This man did not need to transfer any risk since he has the money to provide for his family.

Alright, you may not be wealthy but you may be young with no dependents either. So why would you buy insurance?

The sales pitch is that when you are young the premiums are low. Age does come into play, but there is not much difference in premiums if you buy a policy at 21 years and if you buy one at 28 years (when you are married and might have a dependent).

Premium for a 21-year-old for a Rs 10 lakh (Rs 1 million) term policy of 20 years is Rs 2,860. If you buy this policy at age 28, the premium is Rs 2,910. The difference is just Rs 50 per year, so it just does not make sense to go for it earlier.

If you invested the same amount, you would accumulate a tidy sum by the time you turned 28-30 years old, by which time there may be a need for insurance.

Don't fall for the sales spiel

I recently got a call from a private insurer. They wanted to sell my father, aged 65, a Unit Linked Insurance Plan. This is an insurance policy that also offers an investment like a mutual fund where you buy units. 

When I questioned the agent why a 65-year-old man to have such a policy, she told me that, instead, his son could go for it. All I would have to do was pay a premium for just three years and the returns have been 40% per annum till date.

When I asked her about costs, she either didn't know it or kept saying it's low and it will give you great returns.

One of my clients who had bought such a policy three years ago was surprised to see that, after considering his cost, his return was nearing zero. Over three years, he had paid Rs 60,000 to the insurance company. His return was just Rs 64,000 despite a fantastic bull market.

Insurance companies do not deduct the charges from the Net Asset Value. Instead, they just reduce the number of units. So, it may feel great to see the NAV of Rs 10 shoot up to Rs 20, but the units would have declined due to the costs.

Be objective

Insure yourself based on the needs of your family. Do not view your premium as an expense.

When you buy auto insurance, you do not do so with the assumption that, if no damage is caused to your car, you will get some money back. The same applies to life insurance.

You are at more risk than your car is. Insure yourself sufficiently by having a high cover and paying a low premium, like a term insurance.

Remember, insurance is all about providing for your family if you are not around. It is a risk cover, not an investment option.

A sales agent once wanted to convince me to buy a ULIP. When I asked her about a term plan, she told me 90% of the policies sold are ULIPs and no one goes for term plan.

I had to remind her I was not looking for bestsellers but for something that might be relevant to me.

Always question your agent

A 57-year-old acquaintance was sold a policy on the pretext that he needed to pay the premium for only three years; after that, he could cancel the policy.

When I looked at the policy, the premium paying term was for 12 years. He could cancel it after three but would lose a lot.

Besides, the costs were high. The upfront cost was 20%; this did not include administration and mortality charges. He would need at least three to four years to break even.

In some of the policies, which had high upfront costs of 76%, it would take at least 9-12 years to break even. This 76% would be levied on the first premium and the balance would just earn a 12% return.

Over the years, the upfront costs drop so you need to stay in to break even.

Having said all this, I am convinced the only insurance that a majority of people need to buy, and should buy, is a pure risk plan also known as a Term Plan. This is a basic and cheap life cover. Should you die, your nominees get the money you are insured for. Look at insurance as a risk cover and invest the balance savings elsewhere.

Amar Pandit is a certified financial planner and runs the Mumbai-based firm My Financial Advisor.