Life insurance is one of the most important components of any individual’s financial plan. Although there are many misconceptions about life insurance, mainly the way life insurance products have been sold in India over the years. We have discussed some common mistakes that insurance buyers should avoid while buying an insurance policy.
1. Underestimating the insurance requirement:
Many life insurance buyers choose their insurance cover or sum insured based on the plans their agents want to sell and the premium they can afford. This is the wrong way. Your insurance requirement is a function of your financial situation and has nothing to do with what products are available. Many insurance buyers use rules of thumb such as 10 times the annual income for cover. Some financial advisors say that a cover of 10 times your annual income is sufficient as it gives your family 10 years of income when you are gone. But this is not always true. Suppose, you have a mortgage or home loan of 20 years. How will your family pay the EMI after 10 years, while most of the loan is still outstanding? Suppose you have very young children. Your family income will run out when your children need it most, eg. for his higher education. Insurance buyers need to consider several factors in deciding how much insurance cover is sufficient for them.
- Repayment of entire outstanding loan (like home loan, car loan etc.) of the policy holder
- After loan repayment, the cover or sum assured should have additional funds to generate sufficient monthly income to cover all living expenses of the dependents of the policy holder, taking into account inflation
- After the loan repayment and earning monthly income, the sum insured should also be sufficient to meet the future obligations of the policy holder, such as children’s education, marriage etc.
2. Choosing the cheapest policy:
Many insurance buyers prefer to buy policies that are affordable. This is another serious mistake. A cheap policy is not good if the insurance company cannot meet the claim in case of untimely death due to some reason or other. Even if the insurer does fulfill the claim, if it takes a very long time to complete the claim, it is certainly not a desirable situation for the family of the insured. You should look at metrics like claim settlement ratio and settlement by a period of death. Claims from various life insurance companies, to select an insurer who will honor its obligation in fulfilling your claim on time, should such an unfortunate situation arise. Data on these metrics for all insurance companies in India is available in the IRDA Annual Report (on the IRDA website). You should also go through the claim settlement review online and only then choose a company that has a good track record of settling claims.
3. Treating life insurance as an investment and buying the wrong plan:
The common misconception about life insurance is that it is a good investment or even a retirement planning solution. This misconception is largely due to some insurance agents who prefer to sell expensive policies to earn higher commissions. If you compare the returns from life insurance with other investment options, it doesn’t make sense as an investment. Equity is the best wealth creation instrument if you are a young investor in long term. Over a period of 20 years, investment in equity funds through SIP will result in at least three or four times the maturity amount of a life insurance plan with a tenure of 20 years with a single investment. Life insurance should always be viewed as protection for your family in the event of an untimely death. Investing should be a completely different idea. Even though insurance companies sell Unit Linked Insurance Plans (ULIPs) as attractive investment products, for your evaluation you should separate the insurance component and the investment component and take into account what part of your premium is actually allocated for investment in In the initial years of a ULIP policy, only a small amount goes to buy the unit.
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A good financial planner will always recommend you to buy a term insurance plan. A term plan is the purest form of insurance and is a direct protection policy. Term insurance plans have very low premiums as compared to other types of insurance plans, and this leaves a huge investible surplus with policyholders that they can invest in investment products such as mutual funds that offer long-term comparisons. Gives very high returns. Endowment or money back plan. If you are a term insurance policyholder, in certain circumstances, you can opt for other types of insurance (such as ULIP, endowment, or money back plan) in addition to your term policy for your specific financial needs.
4. Buying Insurance for Tax Planning Purposes:
For many years agents have motivated their clients to buy insurance plans to save tax under Section 80C of the Income Tax Act. Investors should understand that insurance is probably the worst tax-saving investment. Returns from insurance schemes are in the range of 5-6%, while Public Provident Fund, another 80C investment, gives around 9% risk-free and tax-free returns. Equity Linked Savings Scheme, another 80C investment, gives very high tax-free returns over the long term. Also, returns from insurance plans may not be completely tax-free. If the premium exceeds 20% of the Sum Assured, maturity proceeds to that extent are taxable. As discussed earlier, the most important thing to note about life insurance is that it aims to provide life insurance and not generate the best investment returns.
5. Surrender the life insurance policy or withdraw it before maturity:
This is a serious mistake and compromises the financial security of your family in case of an unfortunate event. Life insurance should not be touched unless there is an unfortunate death of the insured. Some policyholders surrender their policy to meet the immediate financial needs with the hope of buying a new policy when their financial condition improves. Such policyholders need to remember two things. First, the death rate is not in anyone’s control. That’s why we buy life insurance first. Second, life insurance becomes very expensive as the insurance buyer gets bigger. Contingency should be provided in your financial plan to meet any unforeseen immediate expenses or to provide liquidity for some time in case of the financial crisis.
6. Insurance is a one-time exercise:
I remember an old motorcycle ad on television that had the punch line, “Fill it, take it off, forget it”. Some insurance buyers have a similar philosophy towards life insurance. Once they buy enough cover in a good life insurance plan from a reputed company, they assume that their life insurance needs are met forever. It is a mistake. The financial status of insurance buyers changes over time. Compare your current income with your income ten years ago. Has your income not increased manifold? Your lifestyle will also have improved a lot. If you had bought a life insurance plan based on your income ten years ago, in the unfortunate event of your untimely death, the sum assured would not be sufficient to meet the present lifestyle and needs of your family. So you should buy an additional term plan to cover that risk. Life insurance needs should be reevaluated regularly and any additional sum insured should be purchased, if necessary.
Investors should avoid these common mistakes while buying an insurance policy. Life insurance is one of the most important components of any individual’s financial plan. Hence, thoughtful consideration should be devoted to life insurance. Insurance buyers should exercise discretion against questionable sales prevalent in the life insurance industry. It is always beneficial to engage a financial planner who looks at your entire portfolio of investments and insurance on a holistic basis so that you can make the best decisions regarding both life insurance and investments.
1 thought on “6 Common Mistakes To Avoid in Life Insurances”
I also made some of these mistakes but thanks for helping.