Basic primer on insurance policies and which ones to take

This is a long post. My data tells me that 95% of people who buy insurance in India buy it for the wrong reasons. So, there is a 95% chance that you (my reader) too have bought insurance for the wrong reasons. Hence please bear with me and read this post till the end. Undoing this mistake could save you a decent amount every year.
Insurance is a promise made by the insurance company to pay a certain sum of money at some future date or on the happening of an unfortunate event.

The concept behind insurance is that a group of people exposed to similar risk come together and make contributions towards formation of a pool of funds. In case a person actually suffers a loss on account of such risk, he is compensated out of the same pool of funds. Contribution to the pool is made by a group of people sharing common risks and collected by the insurance companies in the form of premiums.

The areas where insurance needs to be taken is:

• Insuring your assets like house or car

• Insuring our family against loss of life (called term policy)

• Insuring your health (through health policies)

• Insuring for the scenario that one ends up living a long life and need funds for old age ( called Pension plans)

Insurance is primarily a risk mitigation tool. However, insurance is positioned as a wealth management tool by insurance companies -the industry mixes risk mitigation strategy with investment strategy. As customers, we end up buying the wrong policies – wrong for our financial health – but very profitable for the insurance company and the agent who sells it.

So let me describe the basic four types of insurance and share my views:

1. Term insurance –in this type of policy, the policy holder pays a premium and get insured against death for a particular term – in case of the unfortunate event of his/her demise during that term, the insurance company would pay to his/her nominee the amount insured. If there is no demise, the policy holder does not get any returns. An example of this would be HDFC Click2Protect policy. Here is a listing of the amount you would need to pay for a RS 1 crore policy – here . As you can see, the annual premium for someone aged 30 years for a sum assured of Rs1 crore term around Rs 10,000. This means, if you take this policy, you will need to pay around of Rs 10,000 per year and if you lose your life, your nominee would get Rs 100 lacs . This is a pure risk mitigation policy that I recommend that each one of you take –the earlier the better.There is more detailed note on term policy here

2. Whole life insurance –Here is an example of a whole life policy . This policy runs as long as the policy holder is alive. The policy holder pays a premium every year for a specific period (normally 15 to 20 years )and that will assure the nominee the insured amount plus bonuses on the death of the policy holder. The premiums here are high as part of the premium is invested and another part goes towards risk mitigation from death. For example, a well known insurance company offers for 30 year olds an insurance cover of Rs1 crore for life (up to 85th year of age) for a premium of Rs. 2.66 lacs per year to be paid for 20 years. Such policies are not good for your financial health – instead of taking such policies, take a pure term policy (which costs much lesser as seen above) and invest the remaining in FD and the your dependants will be richer.

3. Endowment policies – Here is an example of an endowment policy –https://www.hdfclife.com/children-insurance-plans . These policies are designed to provide a benefit to the policy holder at a stage of life when a lumpsum of money is required – like college education of kids, marriage of daughter or retirement time. It also covers these expenses in the event of untimely death of the policy holder. For example, a well known insurance company offers for 30 year olds an insurance cover of Rs 1 crore as retirement amount at 55th year of age, for an annual premium of Rs. 10.94 lacs to be paid for 5 years. As you can see, the policy holder is paying almost 55 lacs for the first 5 years and gets Rs1 crore after 25 years. These policies are toxic for your financial health – by taking these policies, your get a return of less than 5% per annum – it would be far better to take a term policy and invest the remaining amount yourself

4. Unit linked insurance are almost pure investment plans with a risk mitigation added to it. These plans are closer to mutual funds as they declare the value of units regularly and you can see the current value of your investments. However, unlike mutual funds, these policies add quite few charges. Typically you would pay things like – premium allocation charge, mortality charge, fund management fee, administration charge, surrender charge and fund switching charge. These charges are much more than what the mutual funds charge. Hence it is far better to manage invest through mutual funds and take a term insurance for risk mitigation than take a ULIP policy.
5. Pension plans or Annuities – these policies cover the risk of living too long (unlike the risk of dying too early) – here is an example for such a plan . Here you pay one single lumpsum or pay a premium for a few years now and in return get an assured pension after a particular age (normally retirement age). These plans also come with a ROI of just around 5-6%. You can do better than this simply by investing in a bank FD. Hence this too is not recommended.

As you can see, Insurance is a not good wealth creation vehicle – it is a risk mitigation vehicle– hence it is better just to take pure term insurance (for covering the risk of untimely demise). Beyond term policy, you must insure your health through a health policy as the cost of hospitalisation is increasing every year and you must take policies to safe guard your aseets like house and car.

If you want any help – please do send me a mail  with the details of the policies that you have taken and I will be happy to help.