Why you must avoid mixing insurance with investment

Last Updated: Fri, Apr 13, 2018 18:13 hrs

There is a certain set pattern that most life insurance policy advertisements follow; the husband looks dubiously at his wife prior to signing on the dotted line of a life insurance policy, while the wife is convinced that the insurance cover is necessary and is the only way to secure their future.

The husband then, turns to his wife and asks, "Mere bina jee paogi?", and the wife responds in the negative. Upon being asked what she would do with the money once he passed, she replies that the insurance money would secure their child's future and the family's retirement. She explains how when everything is guaranteed, there is no tension; no tension results in a longer life. Thus, it is essentially for their long lives that he sign on the dotted line. The ad ends with the husband signing the papers and joking about having to endure the same wife for his entire life.

It was one such advertisement that had my friend's wife nervous and coaxing him to purchase insurance policies for their daughter's future and their own retirement. For the same, they got in touch with a couple of insurance companies, who pitched a multitude of products, ranging from children's plans to pension plans. But instead of giving them some peace of mind, all these meetings led to excessive confusion on their part. When they approached me for some advice, their main question was, "What exactly is life insurance?".

Well, primarily, life insurance is a risk transfer tool which can be used to transfer the financial risk of the family, in case of the holder's untimely demise, to the insurance company. The first step is to understand what risk means. Every individual faces two types of risks.

Pure risk is present in situations where there can only be a loss. This includes risk to life from death or illness and risk to property as a result of theft or any natural or man-made calamity. It also includes professional risk such as the personal liability of doctors and accountants.

Speculative risk (the kind that arises from making choices) is present in situations where there can be a loss or a gain, like investing in a business. If this decision leads to a gain, then it's the reward for taking the risk. Other examples of this type of risk include gambling and investing in equities, commodities, real estate and gold.

The key issue is understanding how one can manage these risks. As the breadwinner of a family, the main question to ask while trying to understand the financial risk in case of loss of life is- If something were to happen to me today, will my family have the financial resources to maintain their lifestyle and achieve their financial goals, such as children's education, marriage, etc.? The answer can be found only through detailed introspection and analysis.

Keeping the emotional loss aside, the death of the breadwinner is likely to result in financial loss for the family. This financial loss could either be because there isn't enough money, or because of mismanagement of money. In case of multiple claimants, poor planning might lead to tough times and litigation.

One's current financial risk can be seen as the gap between their family's finances (monthly income, as well as one-time needs for the next several years) and what they have accumulated today.

Managing risk can be done in three ways: by avoiding, retaining or transferring. As far as risk related to death is concerned, there is no way to avoid the risk because human beings are mortal. Retaining the risk of death is an option that is available only to a small set people who currently have the means to address their family's needs in the future with the assets and wealth they've accumulated in the present. This however, isn't an option for a majority of the population and so, the next best way to address the risk is to transfer it to an insurance company. The insurance company generally accepts this risk (subject to medical and financial underwriting) at a cost, which is the premium one pays.

But, for people, is insurance or are insurance companies simply a means to transfer risks? For them, is life insurance just as important as their car insurance? What I've generally found is that the same people who don't bat an eye while shelling out Rs. 40,000 for their cars, immediately balk at the thought of paying the same amount for a life insurance cover of Rs. 1 Crore. (This example applies to a 35 year old male purchasing a pure term plan with only risk cover, and no returns). The surprising aspect of this entire situation is how willing, rather how eager, people are to pay for a car that is valued at Rs. 20 lakhs, but which depreciates each year, as opposed to insuring their own life.

By confusing insurance with investment, most people end up looking for returns and make imprudent choices.

Amar Pandit, CFA, is the Founder and Chief Happiness Officer of HappynessFactory.in

More from Sify: