Is Insurance a Good Investment?

Why Should You Buy Life Insurance?

Let us start with the basics by understanding the purpose of life insurance. The purpose of life insurance is risk transfer. Let us understand with an example. Ajay is a 30-year-old individual married to Anita, and they have a 1-year-old daughter, Tina. Anita is a housewife. 

Ajay is working with an IT company as a software engineer. He has financial liabilities like a home loan and a vehicle loan. He also has the responsibilities of Tina's higher education and marriage, the family's regular monthly expenses, and his own and Anita's retirement.

While Ajay is working towards meeting his financial liabilities and responsibilities, what happens in the event of his sudden demise? Who will pay for his financial liabilities and responsibilities? These are the risks that Ajay’s family faces in the event of his untimely death. Ajay can transfer these risks to a life insurance company by purchasing a term life insurance plan.

Ajay can calculate the total value of his financial liabilities and responsibilities and buy a life insurance plan of an equivalent amount. Let us assume this amount is Rs. 2 crores. Ajay can buy a term life insurance plan with a sum assured of Rs. 2 crores for 30 years (till he turns 60 years). He will have to pay an annual premium to the life insurance company to cover the risk of his death.

During these 30 years, if Ajay dies, the life insurance company will pay his family Rs. 2 crores. They can use this amount to pay off the outstanding loans, for Tina’s higher education and marriage, the family’s regular monthly expenses, and Anita’s retirement. Thus, the term life insurance plan is a risk mitigation plan in the event of Ajay’s untimely death. The term life insurance plans can provide a huge cover at a low cost.

Why Term Life Insurance Plans Are Not the First Choice for Many People

What if Ajay survives the entire 30 years? He would have paid the premiums to the life insurance company for 30 years and would get nothing in return. Many people consider this a loss, which bothers them, and because of this, they are hesitant to buy term life insurance plans. It is also why term life insurance plans are not the first choice for many people.

To address this concern, life insurance companies offer traditional participating plans (endowment, moneyback, whole life, etc.) and ULIPs. These plans have an investment component along with the life risk cover. In these plans, if the insured person dies during the policy tenure, the family gets the death cover. If the insured survives the policy tenure, they get the survival benefit.

Should You Go for Life Insurance Plans With an Investment Component?

With the addition of the investment component, the premium for the life insurance policy goes up significantly. In the case of traditional participating plans (endowment, moneyback, whole life, etc.), the life insurance company invests most of the money in safe fixed-income instruments like Government Securities (G-secs). 

The interest paid on the G-secs is usually in the 6-8% p.a. range. Hence, after deducting all the life insurance company charges, the returns from these products are low. They may or may not beat inflation. Even if they beat inflation, it won’t be by a big margin. Therefore, investing in these traditional participating life insurance plans is not recommended.

In a unit-linked insurance plan (ULIP), the insured decides where the investment component of the premium should be invested. The fund choices usually include equity, debt, money market instruments, a balanced fund (a combination of equity and debt), etc. The investment risk is borne by the insured in a ULIP.

When you invest in a ULIP, the life insurance company will levy certain charges. Some of these include the following.

1. Premium allocation charges
2. Mortality charges
3. Fund management charges
4. Policy administration charges
5. Miscellaneous charges, etc.

Please note the above are only some of the charges levied. Other charges include switching charges, premium redirection charges, rider charges, partial withdrawal charges, surrender charges, etc. The above charges directly impact your net returns from the ULIP. The higher the charges, the lower your returns will be.

Hence, it is not recommended that you invest in a ULIP.

Ulip Versus Term Insurance + Mutual Funds Combination

ULIPs are usually compared to mutual funds. However, there are certain differences between them. Some of these include the following.

Life Insurance Cover

ULIPs offer a combination of life insurance and investment. The life insurance cover comes with mortality charges, which reduces the overall return. Most mutual funds don't provide life insurance. Some of them which do offer life insurance, don't charge any premium for it. There are limiting conditions, like the life insurance cover may be offered only for SIPs, the cover amount depends on the SIP tenure, the maximum cover amount may be inadequate, etc.

Lock-in Period

ULIPs have a lock-in period of five years. In mutual funds, ELSS mutual fund schemes have a 3-year lock-in period. Solution-oriented mutual fund schemes (children's fund and retirement fund) have a 5-year lock-in period. There is no lock-in period for other open-ended mutual fund schemes.

Charges

ULIPs may have a long list of charges directly impacting your returns. Mutual funds have an expense ratio that varies across fund houses and their schemes. However, SEBI has defined an upper limit of 2.5% on the expense ratio that can be charged. Due to competition, most schemes have an expense ratio much lower than the upper limit of 2.5%.

Tax Benefit at the Time of Investment

ULIP investments qualify for deduction from taxable income under Section 80C of the IT Act. ELSS mutual fund investments also qualify for deduction under Section 80C. Other mutual fund schemes are not eligible for deduction.

Fund Switch and Redirection Option

You can shift your existing ULIP investments from one fund to another through the fund switch option. For example, if you have 100 units in an equity fund and want to shift it to a debt fund, it can be done through the fund switch option. It is rebalancing of the portfolio. 

If you want to change how your future premiums should be allocated to a different fund than the existing fund, it can be done through the redirection option. For example, suppose your premium is getting invested in a balanced fund, and you want future premiums to be invested in a debt fund. In that case, it can be done using the premium redirection option. 

In a ULIP, when you change funds using the switch and redirection options, there are no capital gain tax implications.

Mutual funds don’t have the switch and redirection option. You will have to redeem units from one scheme and reinvest them in another scheme. It will have capital gains tax implications.

Which Is Better: Ulip or Mutual Funds + Term Life Insurance Combination?

With ULIPs, there will be premium allocation charges, mortality charges, and some other charges which will impact your returns. With mutual funds, there is only an expense ratio. There is a lock-in of five years in ULIPs. In mutual funds, there is a lock-in of three years in ELSS. For other open-ended schemes, there is no lock-in. The choice of funds is limited in ULIPs compared to mutual funds. Hence, rather than investing in a ULIP, it is better to go for a combination of mutual funds + term life insurance plan.

When compared with other participating life insurance plans (endowment, money-back, whole life, etc.) also, it is better to go for a combination of mutual funds + term life insurance plan. With these life insurance plans, if you face financial difficulty and have to stop the premiums, you will lose the life insurance cover. However, in mutual funds + term life insurance combination, suppose you face financial difficulty. In that case, you can temporarily pause your mutual fund investments and continue paying the premium for your term insurance plan.

In the long run, the returns from equity mutual funds will be much better than what you will get from a participating life insurance policy. Hence, you should keep insurance and investments separate. Remember, life insurance is primarily for protection and mutual funds are for wealth creation. The role of both financial products is different, and that is what they should be used for rather than mixing the two.