Many individuals consider insurance as an investment. Indeed, the insurance industry thrives on this belief and generously offers a suite of policies that offer ‘profits’ if you survive. Are such policies appropriate? Should you buy a life insurance policy? How do you insure your life?

Insure or not? If you do not have dependents, or if your wealth is enough to support your family after your death, you may not require a life insurance policy. You might as well invest the premiums and earn better returns elsewhere. So, who should buy life insurance contracts?

One, you should buy life insurance if you are a young working professional. Why? Your human capital — the present value of all your future income — is large at the beginning of your career. Now, life insurance contract is a hedge against your human capital. When you die, your human capital becomes zero. The sooner you die, the larger the loss to your family because it does not enjoy the benefits (cash flows) of your human capital.

Two, continuing from the above, you should buy life insurance policy if your income is stable. So, between two individuals of the same age, the one who works with the government should buy more life insurance than the one with a private-sector company in an industry which is highly cyclical. Why? If you have stable human capital, your family has a lot more to lose when you die.

Third, if you want to leave a large inheritance or bequest, you should buy life insurance. This is, indeed, a tax-efficient way to transfer wealth to your children. You can also request through your will to have the proceeds given to your favourite charity or place of worship.

You should separate your insurance and investment decisions. Why?

How to insure? One, based on LIC’s web site, a 30-year old has to pay ₹9,800 per year for sum insured of ₹50 lakh on a term insurance with policy-term of 25 years. Contrast this with an endowment policy — you have to pay ₹2.33 lakh for the same term and sum insured!

Two, higher premiums for with-profit plans may not always be worthwhile; returns through survival benefit can be lower than interest rate on bank fixed deposit. Three, insurance companies are good at managing mortality risk while mutual funds are better at managing investment risk. Use both their expertise by separating your insurance and investment decisions. Buy term insurance and invest the difference in a mutual fund.

You should consider the insurance and the mutual fund as a single entity. So, sell the fund if you survive the policy period. This will be your survival benefit and will be typically higher than what you will receive from with-profit insurance plans.

Finally, ladder your insurance purchases — first, buy a policy for basic protection and gradually enhance your risk cover by age 35. Insurance companies will not accept large risk cover during your early career. Besides, large premiums can stress your cash flows. Insurance companies continually change their product offerings and may offer risk cover for longer period as the industry matures.

Life insurance is not an investment. So, do not buy with-profit policies just because they pay you back a return. Also, do not buy life insurance to save on taxes. And do not buy insurance when you are closer to retirement; for your human capital will then be tending towards zero. Finally, remember this: Your aim is to protect your family’s standard of living even if you die. So, buy from an insurance company that is likely to outlive you.

(The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in)

Related Topics
comment COMMENT NOW