At the outset, it should be very clear that insurance is not investment, then why is so much of investor money locked in to traditional life insurance products such as Endowment Plans and Money back policies? We all know the answer- it is misselling. I propose that the investors ask an even more fundamental question- What is the opportunity cost of putting their hard money in one type of asset class vs others? The rest of the article is dedicated to answering that question.
Let’s consider a typical case study, I see very often. An investor pays a premium of 6 Lakhs a year for traditional Life insurance policies from LIC with a sum assured of Rs 1.25 crores for a policy term of 20 years. There are guaranteed additions, more commonly refered to as a bonus given to policyholders along with the sum assured at the end of the term. The bonus is calculated at a particular rate, usually in the range of Rs 40 to Rs. 50/- per thousand of Sum Assured.
Based on the above scenario and calculations as per the table below, we find that total corpus accumulated through the LIC policy will be approximately Rs 2.5 crores, which includes the sum assured and the bonus paid at the end of the term. Alternatively, if the investor decides to invest the annual premium amount in equity mutual funds via SIPs, he or she can accumulate Rs 5 crores even with a nominal 12% return. The opportunity cost in absolute terms is Rs 2.5 crores which by any stretch of imagination, is not a small amount. It could easily contribute to the individual’s retirement corpus or other important financial goals.
Please note that the alternative of investing in equity via mutual funds, does not entail high risk as the mode of investment is SIP and the investment horizon in this case is really long, which reduces the volatility associated with markets considerably.
So, from a return’s perspective, it is clear that using traditional life insurance policies as an investment vehicle is a losing proposition, but there are other hidden costs too. Let’s explore them now.
In case of an insurance policy, there is a hefty premium commitment every year in a particular month (assuming yearly payments). This significantly reduces the cashflow for the particular month. In the above scenario, even if the investor is earning a decent Rs 60 Lakhs per year i.e. Rs 5 lakhs per month, the Rs 6 lakh outflow in the premium month, will be more than the total monthly take home income. On the other hand, if the investor spreads out the 6 lakhs of investment over 12 monthly SIP instalments of Rs 50,000 each, the monthly outflow as a percentage of inflow will not exceed 10% in any given month.
Another important consideration is flexibility, in case of mutual funds you can stop or redeem the investments via SIPs at any time if required, not so in case of insurance policies. Almost every traditional policy attains minimum surrender value after the policy has been in force for 3 yrs. For example, if you are paying Rs 6 Lakhs premium per year and choose to surrender after 3 years, then you would have paid Rs 18 lakhs but will get back only 30% of 2 premiums (as the 1st year premium is excluded), i.e. you get back Rs 3,60,000. Since the payback is negligible, investors usually continue with their premiums not calculating the opportunity loss in the future.
But the most important drawback is that the traditional life insurance policy will not even meet the goal it is designed to achieve i.e. replace the income stream of the individual to support the dependants through their working life. In the case study we have assumed an annual income of Rs 60 lakhs for the investor, the sum assured is Rs 1.25 crores which along with the accrued bonus will typically be around 2.5 crores. This will cover for only 4 years of income at best.
So, am I suggesting that one should not buy any kind of life insurance policy absolutely not, you can and should purchase a term insurance with an adequate amount that will support the dependants for a reasonable period of time. Also, the premium for a pure term insurance plan will be a fraction of those of traditional insurance policies.
The opportunity cost of continuing with the traditional policies over the long term is not worth it because it does not meet any meaningful objective in terms of life cover or give adequate returns, the latter is a prerequisite for any investment.