Why are Insurance products inefficient investment options?

Understanding the Divide Between Insurance and Investment

In the complex landscape of personal finance, many Indian investors grapple with the intricacies of insurance and its differentiation from investment. This discussion aims to shed light on the concept of insurance and offer a clear perspective on securing financial well-being while contrasting it with the world of investments.

At its core, insurance serves as a safety net against financial risks. Term insurance, in particular, emerges as the practical form of life insurance. It offers protection against insurable risks at an affordable cost, ensuring that the sum insured is disbursed to your family in the event of an unfortunate incident.

However, other types of insurance, excluding term insurance, often blur the lines between insurance and investment. These policies frequently present several challenges:

• Lack of Liquidity: Investments should always maintain liquidity, ensuring easy accessibility when required. Nonetheless, the investment component of life insurance policies often entails extended lock-in periods with moderate returns. Alternatives like the Public Provident Fund and various tax-saving investments tend to provide more attractive features, including tax exemptions, government guarantees, shorter lock-in periods, and better returns.

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• Lack of Transparency: Transparency is a fundamental requirement in financial services, particularly in life insurance, which many individuals consider for investment purposes. The absence of transparency can result in inefficiency and underperformance. To address this, the Insurance Regulatory and Development Authority of India (IRDA) has introduced guidelines mandating detailed illustrations of non-guaranteed and guaranteed benefits. These guidelines emphasize gross investment returns of 8% and 4%, respectively. Additionally, insurance companies are required to establish a "With Profit Committee" at the board level to enhance corporate governance.

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• High Commissions: Insurance agents typically earn higher commissions compared to agents dealing with mutual funds, Reserve Bank of India products, and other financial instruments. These commissions can amount to around 15% of first-year premiums, with decreasing percentages in subsequent years. Moreover, Unit Linked Insurance Plans (ULIPs) come with multiple charges, including expense ratios, policy administrative charges, mortality charges, and fund management charges, making them less appealing from an investment perspective. ULIPs have faced challenges in the past due to market volatility, which prompted the IRDA to impose charge caps and introduce guidelines to improve their appeal.

The primary issue arises from the misunderstanding of these products by investors. Insurance premiums encompass both mortality charges and investments in the stock market, which can lead to confusion and disappointment when market values decline. However, recent regulations offer hope for greater clarity and reduced charges.

Whole life insurance, although recommended for its guaranteed investment and tax benefits, comes with downsides such as higher costs, complex structures, and a longer time frame to yield returns. Furthermore, it lacks the liquidity of conventional investments.

In conclusion, insurance and investment should not be intertwined. The optimal approach involves assessing the necessary coverage and selecting a cost-effective term insurance policy tailored to your specific life insurance needs. This approach ensures a clear distinction between insurance requirements and investment objectives.

Note: The table below compares returns from insurance and mutual fund products over 25 years, assuming an annual return of 10% for balanced funds and a 25-year investment horizon. It highlights the advantages of separating insurance and investment, as investing in insurance products necessitates a higher annual investment.

[Source: Various sources, including Value Research Online, Equitymaster, and Life Insurance Council]