Life insurance is one of the most important parts of any individual’s financial plan. However, there are many misunderstandings about life insurance, mainly because of how life insurance products have been sold in India over the years. We have discussed some of the common mistakes that insurance buyers should avoid when buying insurance policies.
1. Underestimating Insurance Requirement: Many life insurance buyers choose their insurance coverage or insured amount based on the plans their agents want to sell and how much premium they can afford. This is a wrong approach. Your insurance need is a function of your financial situation and has nothing to do with what products are available. Many insurance buyers use rules of thumb like 10 times annual income for coverage. Some financial advisors say coverage of 10 times your annual income is sufficient because it will give your family 10 years of income when you are gone. But this is not always true. Suppose you have a mortgage or home loan for 20 years. How will your family pay the EMIs after 10 years, when most of the loan is still outstanding? Suppose you have very young children. Your family will be left without an income when your children need it most, for example for their higher education. Insurance buyers should consider several factors when determining how much insurance coverage is sufficient for them.
· Repayment of the entire outstanding debt (eg home loan, car loan, etc.) of the policyholder
After repayment of the debt, the cover or insured amount must have a surplus of funds to generate sufficient monthly income to cover all living expenses of the policyholder’s dependents, taking into account inflation
· After paying off the debt and generating monthly income, the insured amount must also be sufficient to meet future obligations of the policyholder, such as raising the children, marriage, etc.
2. Choose the cheapest policy: Many insurance buyers like to buy policies that are cheaper. This is another serious mistake. A cheap policy is of no use if for some reason the insurance company cannot pay the claim in the event of an untimely death. Even if the insurer grants the claim, if it takes a very long time to file the claim, it is certainly not a desirable situation for the insured’s family to be in. claims from various life insurance companies, to select an insurer who will fulfill its obligation to pay your claim in a timely manner should such an unfortunate situation arise. Data on these statistics for all insurance companies in India is available in the IRDA Annual Report (on the IRDA website). You should also look at claims handling reviews online and only then choose a company that has a good track record of handling claims.
3. Treating life insurance as an investment and buying the wrong plan: The common misconception about life insurance is that it is also a good investment or retirement planning solution. This misconception is largely due to some insurance agents who like to sell expensive policies to earn high commissions. If you compare life insurance returns to other investment options, it simply doesn’t make sense as an investment. If you are a young investor with a long time horizon, stocks are the best asset creation tool. Over a 20-year time horizon, investing in equity funds through SIP will result in a corpus that is at least three or four times the term amount of a 20-year life insurance plan, with the same investment. Life insurance should always be seen as protection for your family in the event of an untimely death. Investing should be a completely separate consideration. Although insurance companies market Unit Linked Insurance Plans (ULIPs) as attractive investment products, you should separate the insurance component from the investment component for your own judgment and pay close attention to what portion of your premium is actually allocated to investments. In the early years of a ULIP policy, only a small amount goes towards buying units.
A good financial planner will always advise you to purchase term life insurance. An installment plan is the purest form of insurance and is a simple protection policy. Term life insurance premiums are much lower than other types of insurance plans, and it gives policyholders a much larger investable surplus that they can invest in investment products such as mutual funds that yield much higher returns over the long term compared to gift or cash reschedule. If you are a term life insurance policy, you may, in certain specific situations for your specific financial needs, choose other types of insurance (e.g. ULIP, endowment insurance or cash back schemes) in addition to your term life insurance policy.
4. Buying insurance for tax planning purposes: For many years, agents tricked their clients into buying insurance plans to save tax under Section 80C of the Income Tax Act. Investors should realize that insurance is probably the worst tax-saving investment. Insurance plan returns are between 5 and 6%, while the Public Provident Fund, another investment from 80C, yields nearly 9% risk-free and tax-free returns. Equity Linked Saving Schemes, another 80C investment, yields a much higher tax-free return in the long run. Further, returns from insurance plans may not be entirely tax-free. If the premiums exceed 20% of the sum insured, the proceeds at maturity are taxable to that extent. As discussed earlier, the most important thing to note about life insurance is that the goal is to provide life coverage, not to generate the best return on investment.
5. Surrender or Early Termination of Life Insurance: This is a serious mistake and will jeopardize your family’s financial security in the event of an unfortunate incident. Life insurance policies should not be touched until the accidental death of the insured occurs. Some policyholders waive their policy to meet an urgent financial need, hoping to take out a new policy when their financial situation improves. Such policyholders should remember two things. First, mortality is beyond anyone’s control. That’s why we buy life insurance in the first place. Second, life insurance becomes very expensive as the buyer of the insurance gets older. Your financial plan should provide emergency funds to cover unexpected urgent expenses or provide liquidity for a period of time in the event of financial hardship.
6. Insurance is a one-time exercise: Reminds me of an old television motorcycle commercial that had the punch line: “Fill it, close it, forget it.” Some insurance buyers have the same philosophy towards life insurance. Once they purchase enough coverage in a good life insurance plan from a reputable company, they assume that their life insurance needs will be taken care of forever. This is a mistake. The financial situation of insurance buyers changes over time. Compare your current income with your income ten years ago. Has your income failed to grow several times? Your lifestyle would also be significantly improved. If you purchased a life insurance policy ten years ago based on your income at the time, the sum insured will not be sufficient to meet your family’s current lifestyle and needs in the unfortunate event of your untimely death. Therefore, buy an additional installment plan to cover that risk. Life insurance needs should be re-evaluated regularly and any additional sum insured purchased.
Investors should avoid these common mistakes when buying insurance policies. Life insurance is one of the most important parts of any individual’s financial plan. That is why life insurance should be carefully considered. Insurance buyers should be wary of questionable sales practices in the life insurance industry. It is always beneficial to engage a financial planner who takes a holistic look at your entire investment and insurance portfolio so that you can make the best decision on both life insurance and investments.