Are you mixing insurance and investments? Here’s what you need to know

Keanu Reeves, a Canadian actor and the lead actor in the movie ‘The Matrix,’ was once asked in an interview, “What do you think happens when we die?”

His response touched everyone emotionally for a moment – he said, “I know that the ones who love us will miss us.”

Now, imagine if that person is the breadwinner of the family. While emotional loss can never be replaced, having life insurance will at least provide the family with financial security when that person is no longer around.

Life insurance serves as a safety net for the family in unforeseen situations. By paying a fixed amount (known as a premium) to the insurance company every year, the family will receive a lump sum from the insurance company if the policyholder passes away.

Insurance functions by collecting small contributions from many individuals and then redistributing that pooled amount to others in need. The insurance company will take a small cut, for providing the service.

Fortunately, the number of people taking life insurance policies in India has increased. In fact, we are getting better than the global average, as highlighted by the economic survey (2023) of the government of India.

But.., most life insurance products sold in India are savings-linked, with just a tiny protection component, pointed out the survey.

Confused? Let me explain.

Many find it difficult to fully understand or appreciate the importance of insurance. They think paying for insurance is like just throwing money away. Where does this mindset come from, you ask? Well, it is rooted in the notion that nothing bad will ever happen to them.

Insurance companies figured out this hesitation. So, they designed savings-linked insurance plans. These plans, such as endowment plans, money-back policies, or ULIPs (Unit Linked Insurance Plans), offer a safety net if something unfortunate were to happen; while also promising to give back your money, even if nothing happens.

It totally worked! Those who had reservations about buying insurance policies found their match in savings-linked insurance policies.

But if you understand a bit of economics – there’s no such thing as a free lunch, right? So, how do these savings-linked policies manage to return the premium?

Let me give you a simple example.

Imagine you are in the market to buy 1 kg of apples. There are two sellers – Rani and Ramu.

Rani said, “Give me Rs 100. I will give you 1 kg of apples.”

Then, there is street-smart Ramu. He stood up confidently and said, “Listen, give me Rs 200. I will give you 1 kg of apples now. After ten years, I will give your Rs 200 back too. I am not charging anything for apples.”

Does Ramu’s deal sound intriguing?

Now, before you think he is doing charity by giving free apples, let’s break it down. Out of Rs 200, Ramu takes Rs 100 for the apples you buy. For the remaining Rs 100, he has got plans. He invests that amount in a fixed deposit, earning 8% annually.

After ten years, that investment becomes Rs 216. Ramu keeps Rs 16 for himself and hands you back Rs 200, grinning from ear to ear.

Had you invested that extra Rs 100, you could keep the entire Rs 216 to yourself.

To understand endowment/money-back insurance policies, replace apples sold by Ramu with an insurance cover. The amount you pay as a premium under these policies has two components – 1. insurance cover; 2. Savings.

Insurance companies invest that savings component. By using the returns earned from it, all the premium paid by the customer will be returned.

Of course, this is just a simplistic explanation of how savings-linked insurance plans work. Things can get complicated with a bunch of insurance jargon and fine print. But this is how it basically operates.

The problem is that most of these savings insurance policies lean heavily on the savings side and not so much on insurance coverage. This ends up giving you a cover that’s inadequate (think, fewer apples in our example) compared to what you actually need.

If you want a good cover, the cheapest way is to buy a simple term plan. This doesn’t guarantee any money back, just pure coverage; no bells and whistles.

To dig even deeper, let’s compare an endowment policy with a term plan.

Endowment plan Vs. term plan

The following analysis is based on insurance policies offered by one of the top private life insurers in India.

Let’s take an example. Imagine a person named Sam, a healthy 30-year-old individual with no smoking habits has one lakh rupees annually that can be used for insurance and investments.

Sam stumbled upon an endowment plan that offers the dual benefits of insurance and investment. The annual insurance premium is Rs 1 lakh, and the policy spans 20 years, with a premium payment period of 10 years. In case of an unfortunate death of Sam, the insurance company pays a sum assured of up to Rs 27 lakh. The plan also promises to return Rs 24.5 lakh, if Sam outlives the policy term of 20 years.

On the flip side, by paying just Rs 9,100 annually for a term plan for ten years, Sam secures a life cover of Rs 50 lakh for 20 years. But if Sam outlives the policy term, no money is given back.

So, what’s the better option between these two? Let’s dig in –

Take the first scenario, where Sam outlives the policy term of 20 years:

For paying Rs 10 lakh premium (Rs 1 lakh* 10 years), the endowment plan pays a lumpsum of Rs 24.5 lakh at the end. This is called maturity benefit.

In a term plan, there is no payout after 20 years. However, if Sam invests the difference of Rs 90,900 (Rs 1 lakh – Rs 9,100) every year in a humble post office scheme PPF (public provident fund) for ten years, the corpus earns a decent return.

Assuming PPF gives 7.1% p.a yearly (current rate as of September 2023), the accumulated balance after 20 years would be Rs 26.8 lakh. This is almost Rs 2.3 lakh more than Sam would get as a maturity benefit from an endowment plan.

PPF and endowment plans have similar tax benefits. Also, both are long term plans.

Check the table below to see how much Sam would accumulate if the balance were invested in a FD (fixed deposit) or an equity mutual fund, instead of PPF. Note, equity comes with higher risk, but 10% CAGR is a decent return expectation from the asset class in the long run.

Generally, returns from life insurance policies are lower because they invest significantly in low-risk, low-return yielding G-sec (except ULIP plans). Additionally, commissions paid to agents – directly or indirectly from your premium – tend to be higher in the insurance industry.

While FD offers lower post-tax returns, remember that it is much more liquid than an endowment plan. You can’t access your money from the savings-linked insurance plan before maturity unless canceled or surrendered earlier. The surrender chargers are steep, sometimes even exceeding 50% (of the total premium paid) in some scenarios. Plus, the insurance coverage won’t continue.

Keeping your insurance and investment separate gives you more flexibility. With bundled insurance products, you can’t withdraw investments without affecting your insurance cover, but with separate plans, you can.

As there are better alternatives, Sam would be better off not investing in an endowment plan for savings.

According to a tax rule notified in August 2023, when annual premium paid for a single policy or aggregate premium paid for life insurance policies (except ULIP and term plan) is more than Rs 5 lakh, the maturity benefits are not completely tax-exempt. This is for policies issued on or after April 1, 2023. In such cases, the yield from savings-linked insurance policies will be much lower.

Now, let’s consider the second scenario, where Sam passes away before 20 years:

As shown in the table above, in an endowment plan, the sum assured ranges between Rs 12.8 lakh to Rs 27.1 lakh, depending on the number of years the premium is paid.

For example, if Sam unfortunately passes away within the first seven years of taking the policy, the sum assured is just Rs 12.87 lakh. The death benefit increases with every passing year. If the demise happens between 15th to 20th year, the death benefit will be Rs 21.6 lakh to Rs 27.1 lakh. When the sum assured is paid by the insurance company, the contract ends. No maturity benefits come into picture.

On the other hand, the term plan has no frills attached. Even if the premium is paid for one year, the sum assured is Rs 50 lakh.

Also, Sam’s family members get to keep the PPF/investment amount accumulated until then.

So, even on the savings front, going for a term plan gets a better score. Look at the above image for more details.

The critical point here, though, is to invest the extra amount (Rs 90,900, in our example) after purchasing the term cover.

Do your math

Returns from most of the savings-linked insurance policies are said to be in the range of just 5-6 percent. Some savings-linked insurance policies available in the market might promise attractive returns. For instance, with higher taxation on debt mutual funds (taxed at the slab rate), returns from savings policies could appear appealing to those in the higher tax slab. However, don’t allow this factor to sway your decision.

In most instances, these savings policies come with inadequate insurance coverage and/or lower liquidity and transparency.

I am not saying that these products are bad; many of them just seem to be less efficient. They could come handy to those who are hesitant about paying insurance and have no knowledge about investing.

If you’re still with me and want to evaluate a savings-linked insurance policy that someone offers you in the future, here’s what you can do:

1. For a saving-linked policy, check the policy benefits illustration. This document contains details about how premiums are invested, how your money will grow, the charges involved, and what you’ll receive in return.
2. Insurance products can offer both guaranteed and non-guaranteed returns. The returns on non-guaranteed policies depend on how the investments perform. Benefits from such plans are calculated based on assumed returns of 4% and 8% in the illustration.
3. Understand your returns after deducting costs. The net yield on savings-linked insurance policies is calculated by subtracting costs from the gross yield.
4. Under various scenarios, compare what you would receive from a savings plan versus a term plan combined with investments.
5. When maturity benefits are guaranteed, you can easily calculate the return using the IRR (internal rate of return) formula in Excel, as demonstrated below:

Steps:

• Prepare the cash flow data for the initial investment and future benefits
• In Excel, create two columns for years and cash flows.
• Display premiums paid as negative cash flows and benefits received from the insurance company as positive cash flows.
• Use the IRR formula for the cash flow range, as shown in the screenshot provided below.

Remember you cannot calculate IRR for death benefit/sum assured, as death is an uncertain event.

In conclusion, be aware of what you are entering into when you are asked to buy a saving-linked insurance policy. Remember that insurance is meant to cover the future of our family financially in the face of unforeseen events. It is not for savings where we get our money back. If a policy promises both, it’s likely tailored to be sold. Prioritize assessing the product’s suitability for your needs before making a decision.

PS: We’ve also put together a video to break down the concept in an easy-to-understand way. Click the link below to check it out.