Life insurance is one of the most important parts of any person’s financial plan. However, there are many misconceptions about life insurance, mainly due to the way life insurance products have been sold in India for many years. We have identified some common mistakes to avoid when buying insurance.
1. Underestimating insurance needs.
Many life insurance buyers choose their coverage and amount of insurance based on the rate the representative wants to sell and the amount of premium they can afford to pay. This is not the right approach. Your insurance needs depend on your financial situation and have nothing to do with the products available. Many insurance buyers use rules of thumb, such as insuring 10 times your annual income. Some financial advisors say that insurance coverage of 10 times annual income is sufficient because your family will still have income for 10 years when you are gone.
However, this is not always the case. Let’s say you have a 20-year mortgage or home loan. How will your family pay the payments after 10 years, when most of the loan is still due? Let’s say you have very young children. Your family’s income will not be sufficient when your children need it most, such as for higher education. Insurance buyers need to consider several factors to determine the right level of coverage for them.
- Paying off all of the policyholder’s other debts (e.g., mortgage, car loan).
- Excess funds that generate sufficient monthly income to cover all living expenses of the policyholder’s dependents after the debt is paid off should be included in the sum insured or in the sum insured taking inflation into account.
- Once the debt is repaid and the monthly income is obtained, the sum insured must be sufficient to meet the policyholder’s future obligations, such as raising children or getting married.
2. Choose the cheapest insurance.
Many policyholders prefer to take out the cheapest insurance. This is another serious mistake. Cheap insurance is useless if, for some reason, the insurance company cannot respond to claims for premature death. Even if the insurance company responds to the claim, it is not very beneficial to the family of the insured if it takes a very long time to respond. To select an insurance company that, in the event of such an unforeseen event, fulfills its obligation to pay claims immediately, it is advisable to look at indicators such as each life insurance company’s claim payment rate and death benefit payment time. Data on these rates for all Indian insurers are available in the IRDA annual reports (IRDA website). You should also search the Internet for claims handling ratings and then choose a company with good claims handling record.
3. Treat life insurance as an investment and buy the wrong rate.
A common misconception about life insurance is that it is a good investment or retirement plan. This misconception is largely due to some insurance agents who want to sell expensive policies to earn high commissions. To say that life insurance is an investment is meaningless when you compare its performance to other investment opportunities. For young investors with a long time horizon, equities are the best way to build wealth: Investing in an equity fund in SIP results in three to four times the payback over 20 years than a 20-year life insurance policy for the same investment.
Life insurance should always be considered as a protection for the family against premature death. Investments should be treated completely separately. Insurance companies market unit-linked insurance policies (ULIPs) as attractive investment products, but in your own judgment, you should separate the insurance and investment components and pay close attention to how much of the premium is actually used for investment.
A good financial planner will always advise you to purchase risk insurance. Risk insurance is the purest form of insurance and is a simple protection policy. The premiums for risk insurance are much lower than for other types of insurance and the policyholder keeps the investment surplus which can be invested in investment products such as investment funds, which offer much higher returns over the long term than savings or cash back plans. If you have taken out risk insurance, you may, in certain circumstances, opt for other types of insurance (e.g., ULIP, savings, or yield) in addition to risk insurance to meet your specific financial needs.
4. Purchase insurance for tax purposes.
For years, brokers have been persuading their clients to purchase insurance in order to pay less tax under Section 80C of the Income Tax Act. Investors should be aware that insurance is probably the worst investment for saving on taxes. Insurance plans yield 5-6%, while another 80C investment, the Public Provident Fund, offers a risk-free, tax-free return of nearly 9%. Equity Linked Saving Schemes are also 80C investments that offer higher tax-free returns over the long term. In addition, insurance income is not necessarily completely tax-free. If premiums exceed 20% of the sum insured, the surrender proceeds are taxable. As mentioned earlier, the bottom line with life insurance is that the objective is to provide security through insurance, not to obtain the highest investment returns.
5. Terminating or withdrawing from life insurance before it expires.
This is a serious mistake that puts the family’s financial security at risk in the event of an accident. Life insurance policies should only be used after the accidental death of the insured person. Some policyholders wish to terminate the policy to meet their immediate financial needs and purchase a new policy when their financial situation improves. These policyholders must consider two things. First, death is out of everyone’s control. That’s why they buy life insurance in the first place. Second, life insurance becomes very expensive as the policyholder ages. Financial plans should include emergency funds to meet unexpected and sudden expenses or to guarantee cash flow for a period of time in case of a financial crisis.
6. Insurance is ephemeral.
I remember a motorcycle commercial on TV that said, “Fill up, buy and forget.” Some policyholders have a similar attitude toward life insurance. They assume that once they have a good life insurance policy with a reputable company, their life insurance needs are covered forever. This is a mistake. People’s financial situations change over time: compare your income ten years ago to your income today. Has your income increased many times over? Your lifestyle has also improved dramatically – if you had purchased life insurance 10 years ago that matched your income, the amount of coverage would not be enough to cover your current lifestyle and your family’s needs if, unfortunately, you were to die prematurely. You should therefore purchase additional risk insurance to cover this risk. You should regularly review your life insurance needs and purchase additional amounts if necessary.
Conclusion.
Investors should avoid these common mistakes when purchasing insurance. Life insurance is one of the most important elements of anyone’s financial plan. That’s why buying life insurance should be carefully considered. Buyers of insurance policies should be cautious and avoid the questionable sales practices of the life insurance industry. It is always beneficial to have a financial planner review the entire investment and insurance portfolio in detail to make the best decisions for both life insurance and investments.
About Author
Lily Poole is a Property and Home Insurance officer at Smart Apple by profession. She is pretty well experienced in the insurance and accounting field. Also, she has an impressive profile in the training and development industry.
