Don’t buy insurance in the name of investments

During my recent interaction with people, I realised that many of us are still not very clear about investments and tend to buy insurance products as investments. I will try to explain the basics of insurance and investments and how we should go ahead planning with our investments.

Let’s first understand the basic concept of life insurance. It is an instrument that provides protection against those risk events that can destroy or diminish the value of human life as an asset. These risk events may include dying too early, living too long, or living with a disability.?

The Human Life Value (HLV) concept considers human life as a kind of property or asset that earns an income.

It thus measures the value of human life based on an individual’s expected net future earnings. Net earnings are the income a person expects to earn each year in the future, less the amount he or she would spend on themselves. Thus, it indicates the economic loss a family would suffer if the wage earner were to die prematurely, and accordingly, the quantum of insurance required would be calculated.

In general, we can say that the amount of insurance should be around 10 to 15 times one’s annual income. And to cover the risk of life, we need to pay the cost of risk (calculated based on mortality factor, termed a premium).

Now that we understand the concept and need for life insurance, let’s see what? options are available to us:

Term Insurance. Under term insurance, only the risk of life gets covered without any maturity benefits on survival. In the event of death during the policy period, the sum assured is given to the nominee. The premium paid towards the policy covers only the cost of life. So, for a small amount of premium, we can get a good sum insured as part of term insurance.?

All of us in the Armed Forces are covered by the group insurance with a sum insured of approx. one crore which is, by and large, sufficient to cover the risk of life.

Assuming that most of us retire in the age group of 54 - 56 years, there is actually no need to go for another term insurance policy post-retirement, as we are expected to have either fulfilled our financial liabilities or have planned for them.?

However, people taking PMR should definitely buy term insurance for at least six to twelve months before leaving the organisation. Pension is not treated as income for buying term insurance, and we won't be able to buy the term plan until we start getting another income.

Variants of life insurance policies cover the risk of life as well as provide investment options (e.g. endowment, money-back policies with conventional investment options, unit-linked insurance plans, etc). All such policies provide a sum assured in case of death during the policy period and a maturity amount on survival. The premium paid towards such policies has two components: firstly, the cost to cover the risk of life, and secondly, the investable portion called the cash value component. Now what you get as maturity value on survival is only the cash value component of the premium, with annualised returns of not more than 5 - 6%. An important point to note is that the premium consists largely of a cash value component and a small portion is devoted towards risk cover.

So, avoid taking any insurance policy offering a maturity amount on survival.

Investments. An investment involves putting capital to use today in order to increase its value over time. Broadly, we have the following options

Fixed income instruments. These are the financial instruments that give us a fixed amount of interest on our principal amount during the period of mutual engagement. A few of these instruments are SCSS, PO MIS, RBI taxable bonds, etc. The rate of interest is decided by the government of India on a quarterly basis in relation to the prevailing repo rate.?

• Advantages
• These schemes have a sovereign guarantee and, hence, no credit risk (timely payment of interest and repayment of principal as and when due).
• Disadvantages
• Interest is fully taxable as per our income slab.?
• Assuming an average rate of interest of 7.5% in today’s scenario and 30% taxation, effective RoI works out to be only 5.25% per annum. With lifestyle inflation hovering around 8 - 9%, we are actually losing the value of money by around 3% annually.
• The rate of interest is likely to go down in the future as the RBI starts reducing the repo rate.
• The lock-in period of 5 - 8 years

Direct investment in equity. Buying a stock for the short, medium, or long-term direct investment can be very rewarding provided one has done enough research on the company and can hold it with conviction for the long term if it so warrants. It requires regular monitoring and can not be left unattended for long. Portfolio risk and volatility can be nerve-wracking at times, and one should have the patience to go through that period of time. As they say, "Often there is no correlation between the success of a company's operations and the success of its stock price over a few months or even a few years. In the long run, there's a 100% correlation. It pays to be patient. It’s difficult to make money through direct investments in stocks. We can read more on this here

Investment in equity through mutual funds. Investment in equities through mutual funds is a better option, as we get good returns on investments without going through the rigmarole of monitoring direct investments in equities on a daily basis. Good-quality equity mutual fund schemes have given a CAGR in the range of 12-18% over a longer period of time in the past.

• Advantages
• Equity has been the best-performing asset class among all other asset classes over the last many decades and has provided an inflation-adjusted real RoI of 4-5%
• It’s tax efficient; there is no tax up to one lakh of long-term capital gains in a financial year. Beyond one lakh, flat taxation of 10% on long-term capital gains. Short-term capital gains (up to one year of holding period) get taxed at 15%.
• Disadvantages
• Can be volatile in the short term.

Investment in debt instruments through mutual funds. Debt mutual funds provide us with the option of investing in different classes of debt instruments, both government-owned and private, over different maturity periods under one umbrella. Investment in debt mutual funds is an important aspect of the overall portfolio design keeping in view the risk profile, the financial goals intended to be achieved, and the time available to achieve these goals. One has to be careful while selecting debt mutual funds to avoid credit and interest rate risks. The government has taken out long-term capital gains benefits from the debt mutual funds from the current FY onwards, and any gains would form part of the income and be taxed as per the marginal rates.

Investment in gold. We have the option to invest some of our investments in gold, as it’s considered a good hedge against inflation. We can invest in gold through a mutual fund, gold ETF, or SGB. Avoid buying physical gold as it attracts making charges and GST, and we are not sure of the quality of gold.

Conclusion

• Be clear about your investment objectives. Insurance is meant to cover the risk of loss of income due to untimely death and should not be used for investments.
• Invest in the financial instruments that you understand, not what is told to you by others.
• Do not run after the IPOs (most are overvalued) and other FADs in the market like crypto, PMS, private equity, etc. As they say, you are likely to make the most of your money with the simplest of ideas. Keep it simple and straight (KISS)
• Don’t try to copy others. What has worked for your friend may not work for you. Investments cannot be generalised.?
• Be aware of the risk involved in your investments. Known risks can be managed effectively in your favour.
• Even if you have a total aversion to equity, invest some parts of your corpus in equities, preferably through mutual funds. It will help you generate positive real returns (inflation-adjusted) on your overall investment portfolio.
• Last but not least, if you are not able to understand the intricacies of investments, take the help of a financial planner.

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