Do not mix insurance and investment

A while back a reader informed us why pure life insurance goes against his religious beliefs. According to him, it works like a betting game. Let's say you insure yourself for Rs 10 lakh at an annual premium of just Rs 2,000. What this means, according to our reader, is that you are willing to bet that you will die this year and so you willingly cough up Rs 2,000. The insurance company bets that you will not die and is willing to pay your family Rs 10 lakh if you do. If you survive - which we're sure you would really love to - you lose the bet and the insurance company walks away with Rs 2,000. If you win the bet, you know what happens.

This goes on over a period of 10, 15 or 20 years, whatever the term of the policy. And so, he concludes, that it goes against his faith to lay a wager on his life. This compelled him to arrive at the conclusion that a policy which gave him a return would be a good option because he could view it more as an investment.

An interesting way around his particular problem. But not a wise conclusion.

Insurance is not an investment
First things first - insurance is not an investment. When you invest your money somewhere, you expect something back. Not so with pure term insurance. If you die, your nominee gets something. If you live, no one gets anything. Now that may sound like a raw deal. But hey, that's what life insurance is all about! Ironically, life insurance is not about life, but about death.

In their bid to get something out of the money given to the insurance company, investors opt for insurance policies that give them 'something back' even if they do live. And in the bargain, they give pure term insurance policies the cold shoulder. While everyone is entitled to their own personal views, we are of the opinion that term insurance is the purest, cheapest and best form of life insurance.

The math behind it
Let's assume the profile of a 30-year old male with a life cover of Rs 1 crore; a tenure of 20 years; and a premium payment term of 10 years.

Now let's look at HDFC's Classic Assure Plus Plan, which is a participating endowment insurance plan. Here, in the event of death, the beneficiary gets the sum assured of Rs 1 crore. Also, if the insured person outlives the policy, he gets the sum assured plus bonuses at the end of the policy term. The company pays a simple reversionary bonus which is guaranteed at a minimum of 3 per cent. However, the person will have to pay an annual premium of Rs 12,13,977 for the initial 10 years to get a Rs 1 crore cover for 20 years.

If he had taken a basic term policy from the same company with an annual premium of Rs 14,007, he could have invested the balance amount of Rs 11,99,970 (Rs 12,13,977 minus Rs 14,007) in an investment of his choice.

Let's say he invested Rs 99,998 (11,99,970/12) every month for the first 10 years via a Systematic Investment Plan (SIP) in Aditya Birla Sun Life Flexi Cap Fund, a flexicap fund. At the end of 20 years, he would have made more than Rs 18 crore. Yes, the fund has given an annual return of over 19 per cent in the last 20 years. Even at an annual return of 12 per cent, he would have made Rs 6.95 crore after 20 years. An endowment plan like Classic Assure Plus would pay him only Rs 3.14 crore (sum assured of Rs 1 crore plus a guaranteed bonus of Rs 30 lakh and an assumed bonus of Rs 1.84 crore). As you can see, it is far lower than what he would have got had he separated his insurance and investment needs.

Let's look at another type of term insurance policy which is not an investment option, but one that only returns premiums. A basic term insurance policy from SBI Life known as e-Shield, will have an annual premium of Rs 8,272. But Smart Swadhan Plus, a term insurance policy with a guaranteed refund of the premium paid on survival at the end of the policy term, has a premium of Rs 72,924 (including taxes) for the same cover.

So at the end of 20 years, the premium would be returned to him. This will amount to Rs 12.36 lakhs. Once again, let's look at the difference in the two premiums which amounts to Rs 64,652 (Rs 72,924 minus Rs 8,272). If he had invested Rs 5,388 (Rs 64,652/12) every month via an SIP in an equity mutual fund scheme, he would have got Rs 53.83 lakh on maturity, assuming a conservative 12% return. So instead of getting Rs 12.36 lakhs at the end of 20 years, he could have still had an insurance cover and beaten the return on life insurance policy by investing the balance.

How insurance companies operate
The entire amount you pay to the insurance company is not what is invested. The premium you pay has three components.

• Expenses (including commissions earned by the agents as well as expenses and distribution costs)
• Mortality premium
• Investment amount

And, to top it all, the amount permitted to be invested in equity may be just around 8 to 10 per cent of the total investment. So you cannot really expect a great return from their insurance product.

Moreover, the money may sound good now, but will be worth far less when you finally get it. Let's say you are promised Rs 2 crore 20 years down the road. Accounting for inflation at 6 per cent per annum, that would be worth around Rs 62.36 lakhs in today's prices.

Getting underinsured
The problem with money-back policies is that while the premium is much higher, one may still end up underinsured.

Say, you are a 25-year-old male looking for a life cover of Rs 1 crore for 30 years. If you took the e-Shield cover, the premium would be Rs 7,934 per annum. But, not comfortable with the premiums being 'lost,' you opt for Smart Swadhan plus. Now, the premium goes up to Rs 42,600 for the same cover. If you cannot afford Rs 42,600, you might be tempted to go for a policy of only Rs 50 lakh that would cost Rs 21,300 a year. So in one stroke, you have halved your life's financial worth!

Where commissions come in
Each insurance product has its own commission specifications. But the trend is that in the first year, the agent's commission is the highest. It decreases for the next three years and after that, drops even more. In the very first year, your agent may get around 15 to 35 per cent of your premium as commission. In the following three years, it will drop to between 5 and 15 per cent. After that, it will be between 2.5 and 7.5 per cent.

Generally, the upfront commission (amount paid in the first year) is the highest, and then the trailing commissions are much lower. So the higher the premium you pay, the more the agent benefits.

For starters, don't expect an agent to even mention term insurance. He will always try to push the fancier alternatives. Commissions are his bread and butter and he will try and sell you one that benefits him.

Secondly, don't blindly trust your agent. He has his own interest in mind. He will do his best to convince you that you need a particular product. As one of our colleagues here at Value Research always says, life insurance is never bought, but always sold. So make sure you are not being sold a policy, but are smartly buying one.

Finally, now that you know how much an agent earns, maybe you should consider becoming one!

- All quotes for life insurance are taken from the life insurance company websites.

This article first appeared in the October 2006 Issue of Mutual Fund Insight.