Insurance is not investment

Insurance is a key part of every individual's financial planning but far too many people are thinking of it as an investment

'I invested Rs 2 lakh last year, out of which Rs 80,000 was in insurance.' The genesis of the article you are reading was this one single sentence in an e-mail. There was nothing unique about this e-mail--we get many every day asking us for investment advice. The fact that the writer, without any hesitation, considered insurance to be investment was also not unique. What has really caught our eye is that we are seeing more and more of this attitude.

An ever-increasing number of people are 'investing' in insurance, driven, no doubt, by the sharply higher amount of insurance advertising and marketing that they are exposed to. Over the years, we have been bombarded by insurance pitches at a rate that is far higher than used to earlier. This is a natural by-product of the competition in the insurance industry and by itself there is nothing wrong with this.

Whereas earlier, insurance marketing was driven solely by competition between insurance agents and agents' own drive to make more money, today the marketing hype is driven by insurance companies competing with each other. Insurance advertising in the mass media, which was almost non-existent once, has grown hugely. By some measures, mass media advertising of insurance products is around eight times what it used to be three years ago. On the face of it, there's nothing wrong with this. After all, it's an uncertain world and most people sleep better at night knowing that they're well insured. Actually, there is something deeply wrong about the way the whole activity of insurance is evolving.

Here's the problem: a bulk of the money that flows into the insurance companies' coffers is not payment for insurance but for what are essentially investment products. Generations of Indian have been brainwashed into thinking that buying term insurance is a stupid thing to do.

Here's how it works.

An insurance agent never mentions term insurance on his own and if you bring up the topic, he immediately warns you that you will not get anything back. 'No benefit' is the phrase he normally uses. Since you certainly don't want to do anything that carries no benefit, your thinking veers towards policies that supposedly carry a benefit.

They do carry a benefit of course, but this benefit is largely for the agent and the insurance company. The reason for this is a secret of the psychology of insurance-buying that every agent understands but few insurance buyers (or 'life', as they are called in the insurance business) do. 

Here's the secret:

The 'life' thinks in terms of the cover he or she gets, while the agent and the insurer make money in terms of the premiums that the life pays. The 'life' will come to a purchase decision that is something like, 'If I die, Rs 20 lakh ought to be adequate for my family'. Once such a number has been put to what the life's life is worth, it's in the agent's interest to steer the life's thoughts away from the cheaper term insurance policies and towards more expensive policies.

This combination of factors--the business model of insurance selling plus the insurance buyers' hunger for 'benefit' has resulted in a situation where too many otherwise money-savvy Indians are not thinking clearly about what insurance is, how it is different from investment and how they should best go about insuring themselves.

To be sure, there are many superficial similarities between insurance and investment, and this is what causes the confusion. Loosely speaking, both involve giving money to a financial service provider in exchange for a future benefit but there the similarity ends.

Let's take a systematic, back-to-the-basics look at 

what insurance is and how it should be bought and compare this to investment.

The purpose of insurance is to cover the financial aspect of risk. The risk can be of property, life, health, legal liability and of many other kinds. The only logical kind of life insurance that makes sense is term insurance because only in that case are you are insuring against a risk that is insurable. The moment you buy any other kind of insurance, you are actually making an investment that is disguised as insurance.

The problem with buying investment disguised as insurance is that there are many characteristics of insurance that are most undesirable in investments. Here are some major problems.

Illiquid: Investments ought to be liquid. After all, it's your money and if you really need it, you should be able to get your hands on it. However, the investment part of your insurance policy is locked in for enormous periods of time. Sure, there are investments like public provident fund and other tax-saving investments which we recommend. However, those offer a far better deal in some other way, either in tax exemptions, or in sovereign guarantees or in the relatively short period of lock-in and often a combination of these. The investment part of insurance offers moderate returns and decades-long lock-in. This just doesn't make sense.

Lack of transparency: We believe that transparency should be followed like a religion in every kind of financial service, most of all in insurance on which people depend so totally. Malpractices, inefficiency and poor performance in any kind of financial service are almost always rooted in lack of transparency.

In this regard, the insurance industry in India just doesn't measure up to the standards that are followed by the mutual fund industry. There is absolutely no valid reason why you, as an investor, should have less knowledge about what your insurer is doing with your money than you have about what your mutual fund is doing with it. Daily NAVs, change in personnel, procedural rules about justifying investment decisions and the myriad other rules that funds follow need to be imposed on insurance companies as well.

Cost: Compared to what agents selling mutual funds, Reserve Bank of India and other bonds and Post Office deposits get, the commissions received by insurance agents are a scandal. The commissions are enormous, generally around 15 per cent of first year premiums and 7.5 per cent in the second and 5 per cent from the third year onwards. For a financial product that is supposed to be an investment, this is a shocking level.

At the end of the day, these commissions are probably the strongest argument against investing with an insurance company. Given what safe investment earns these days, this commission alone ensures that this 'investment' is an incredibly bad deal.

Sure, insurance is necessary, but at these commission levels, it is a necessary evil. The only way to go about it is to calculate how much cover you need and then find a good, low-cost, term insurance.

Investment and insurance just don't mix.