What is a major advantage of investing money in insurance over other investments like mutual funds or stock markets which give high returns?
This is a very legitimate question. I run into this kind of a question every time I advise someone. This is one of those areas where I have got a strong opinion driven by data and experience.
Before I get into pros and cons, I want to list down the purpose for which Insurance and Investment are meant for.
Purpose of Insurance
Insurance is meant to cover risk of a loss. Suppose a person A is the bread earner in his/her family and financially his/her kid. In an unfortunate event of person A’s untimely death, how will financial needs of the kids be fulfilled? This is one important case where insurance comes into play. Precisely - Term Life Insurance for this case. In term life insurance, you pay a small premium for say 20–30 years. If person A has a term life insurance, his/her kid will be taken care in case of A’s untimely death by the amount the kid will get as insurance coverage of person A.
Purpose of Investment
Investment is the process in which you park your money somewhere in expectation of getting even more money in future. Investments are made to save money for future financial goals like building a house, buying a car, retirement planning etc.
Insurance vs Investment
Now that we know that purposes of insurance and investment are completely different, we can say that it’s not really fair to compare insurances with investments. A person needs both and there is no point of comparing one with the other. An investment scheme should be compared with other investments schemes, and an insurance scheme should be compared with other insurance schemes.
But then, life is not so simple. People do not appreciate the importance of insurance. Some of us think that what’s the use of life insurance if I am not getting anything in ‘return’ while I am still alive. Thing is, insurance is not meant to give you a ‘return’ like an investment does. As mentioned, insurance is meant to cover risk of a loss. Insurance is an expense, not an investment.
The 2 in 1 marketing scheme
Since, people do not appreciate the relevance of pure insurance, insurance companies get creative and come up with insurance schemes which also gives you a ‘return’ - the insurance + investment schemes. These hybrid schemes (endowment plans, ULIPs etc.) sounds like an ideal 2 in 1 instrument. Unfortunately, they are not. It’s not dual benefit, it’s simply doing investment and insurance together. When you invest say INR 50K in a scheme, you will effectively pay INR 500 as insurance premium and INR 49.5K will be invested.
And then, these policies charge you a lot in the name of different things like policy administration charges, fund management charge etc. etc. As a result, the return you get on your investments gets eroded. Historically, these policies have given returns in tune of 5% to 7% in long term. Also, moving out of these schemes also comes at a significant cost. On the other hand, if you are investing for a long term, you have the opportunity to get ~15% return through equity markets or equity mutual funds (provided you are doing it under guidance of an expert). Markets do have their own risks, but so does investment component of ULIPs.
So, why should on go for ULIPs or hybrid (investment + insurance) schemes?
Simple answer, one should NOT go with such kind of schemes. Insurance and investments must be done separately.
You need life insurance? Get a pure term life insurance. You want to invest your money for some financial goal in future? Invest your money (not take insurance for it) in things like Bank deposits, Mutual Funds, Stocks, Bonds etc. depending on your risk appetite and financial goals.
Having said all the above, I must also state the fact that ULIPs have come a long way in terms of reducing the charges in recent years. The charges used to be exorbitant a few years back. Still, the charges are no where at par with those of Mutual Funds or Stock transactions. So, in current state, I’d still advice to go with separate insurance and investment instead of a hybrid plan like ULIP.
Hope it helps. Feel free to ask any further queries in the comments section below.
Originally answered on Quora.