Tuesday, November 9, 2010

Insurance as an investment vehicle

After a break of one month, I would like to restart and share details on Insurance products available in India and what products you must use in your quest to create wealth. My presentation of this session can be downloaded from http://www.slideshare.net/sgrajasekharan/insurance-session
Insurance is designed to protect the financial well-being of an individual, company or other entity in the case of unexpected loss. Agreeing to the terms of an insurance policy creates a contract between the insured and the insurer. In exchange for payments from the insured (called premiums), the insurer agrees to pay the policy holder a sum of money upon the occurrence of a specific event.
In other words, 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.
There are three broad categories of insurance –
1.       Non life or General insurance - that insures against the loss of assets like house, car, factory etc.
2.       Health insurance – that insures against loss of health.
3.       Life insurance – that insures against the loss of life.
As we discuss wealth management, the only area where insurance is relevant is
·         When we are insuring the assets that we have created; or
·         When we are insuring our family against loss of life or health; or
·         When we have a liability like a home loan or a car loan, then we need to insure against the risk of loss of life of the primary wage earner for the amount of loan taken.
·         Another relevant area where risk mitigation is necessary is when one lives longer than normal and needs to fund the old age.
However, no discussion in wealth management goes without discussing insurance as a wealth management tool – this is because there are various offerings by insurance companies that mix this risk mitigation strategy with investment strategy. As customers, we are not able to differentiate between the cost of risk mitigation and the investment returns that these insurance companies are committing. 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. The annual premium for someone aged 25 years for a sum assured of Rs 100 lacs for 20 years term is only around Rs 10,000. This means, if you take this policy, you will need to pay Rs 10,000 per year for the next 20 years and during this period, 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.
2.       Whole life insurance – this policy runs as long as the policy holder is alive. The policy holder pays a premium every year for a period of 15 to 20 years and that will assure the nominee the insured amount plus bonuses on the death of the policy holder. In some cases, if the policy holder lives up to 85th year, then the company would pay the insured amount plus bonus to the policy holder itself.  The premiums here are high and part of the premium is invested and another part goes towards risk mitigation from death. For example a well known insurance company offers for 25 year olds, a premium of 2.66 lacs per year to be paid for 20 years for a sum assured of Rs 100 lacs – which will be paid along with bonuses either on death of the policy holder or on his/her 85th birthday. As you can see, 60 years is a long time and the returns are not good enough for a payment of 2.66 lacs per year for 20 years. Hence such policies are not recommended - instead take a pure term policy (which costs Rs 10000 per annum) and invest the remaining 2.56 lacs yourself – the returns will be better.
3.       Endowment policies – 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 marriage of daughter or college education of kids or retirement time. Plus there is a benefit in case of death. For example a well known insurance company offers for 25 year olds, for a premium of Rs. 10.94 lacs per year, to be paid for 5 years, a sum assured of Rs 100 lacs for 30 years – this 100 lacs will be paid along with bonuses either on death of the policy holder or on his/her 55th birthday (pre-retirement amount). As you can see, the policy holder is paying almost 55 lacs for the first 5 years and gets a term policy that he can get by paying 10,000 per year plus Rs 100 lacs plus bonuses after 30 years – it does not take too long to understand that this too is not an optimum investment strategy and we could do better by taking a term insurance and then investing the remaining amount directly. The endowment policies come in various forms and all of them have an investment /returns angle and an added death benefit. Unit linked insurance plans go further where they declare the value of units just like NAV’s in Mutual funds. Also in these policies, there are quite a few charges that the insurance companies charge – premium allocation charge, mortality charge, fund management fee, administration charge, surrender charge and fund switching charge. These charges are much more than what one would be charged by fund managers for managing your funds in wealth management companies. Hence it is far better to manage your own funds than use these endowment policies.
4.       Pension plans or Annuities – these policies cover the risk of living too long (unlike the risk of dying too early) – 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). For example, a well known insurance company offers for people in their 50th year, for a one time premium of 1000, a pension of Rs 42.79 per year for as long as he/she lives. As you can see, it comes to an ROI of 4.27%. We 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 good wealth creation vehicle – not for you – but for the insurance company– hence it is better just to take pure term insurance and manage your investments directly or through a wealth manager.