The Myth of Life Insurance

The Myth of Life Insurance

Here is one of the best kept secrets in Financial Services in India. The country’s largest bank is not SBI nor ICICI Bank, it is the Life Insurance Corporation of India. Yes you heard that right.

India’s largest bank is LIC.

You may ask why. Because while SBI garnered fresh fixed deposits (“new money”) of about Rs. 50,000 crores in 2015–16, LIC mopped up more than that in “New Business”, Retail Savings Policies.

Why has this happened?

Back in 1956 when life insurance was nationalised, the customer did not want to buy insurance. Buying life insurance meant facing one’s own mortality and more importantly, agents did not want to talk to customers about death.

So they adopted what was then an innovation in the US market. They created the Endowment Plan. Called “Table 14” in Insurance Circles (a reference to the table number in the LIC Agent’s handbook that had the premium charts) and this product was and continues to be a blockbuster.

Simply put, it converted the need for protecting against death to a savings pot which paid a lump-sum amount at the end of 15 or 20 years. Like the proverbial TATA STEEL advert,“We also make steel”, the endowment plan also paid out on death during the period.

But what about Returns?

Endowment products invest 75% of premium in government securities, the balance is used to offset expenses of the insurer.

Refer to the table below on Segment wise Expense Ratios for FY 2014–15 of Life Insurance Companies

*Source IRDA, Towers Watson Analysis

It shows expense ratios of some of the life insurance companies in the country today. “Participating” plans refers to the savings based endowment product we spoke about earlier. “Unit Linked” refers to ULIPs. An average expense ratio of 25% for endowments means that these products will invest 75% of your premiums.

They will therefore give you a yield @75% of government securities yield. Today, government securities are at 6.5%. Therefore you can expect to get a yield of about 4.8% in the next 20 years, which brings us back to the key point of this post — Do you need life insurance?

Yes you do. if you have any kind of financial liability or if you have dependents. Do you need to earn 4.8% on your savings? The answer is a resounding No!

But what of Unit Linked Insurance Plans (ULIP)?

You may ask ! And there is the second part of the myth of life insurance. With unit linked products, the Life Insurance company laughs to the bank, because they don’t need to guarantee even that 4.8% that we spoke about earlier. Here, you take all the risk. So it’s like having a mutual fund bolted onto your life insurance cover.

Which brings up the question of why buy a mutual fund product from a Life Insurance company. Superior Investment expertise? Not really. It’s reasonable to assume that the best fund managers work for the Mutual Fund industry, because that’s where they get maximum recognition and money.

Now here’s another reason why not to buy a mutual fund product from a life insurance company and it’s called Commission. Most agents in mutual funds earn between 0.5% and 2% of the money you invest. In the case of insurance, its 15% in year 1, and that tapers down to about 3 to 5% thereafter. That means life insurers will pay more from your premium to agents as commission, so they will not invest the same amount as a Mutual Fund would. Even assuming that they both earn the same in percentage terms, in absolute terms, you will be worse off.

This is why using specialists makes sense. You need life insurance? — buy Insurance (not investment linked insurance) from a Life Insurance company. If you need an investment plan, buy that from the mutual fund specialist.

So the myth of Life Insurance is that you are buying something that is supposedly doing a “lot more” than life insurance. But what we need is life insurance. So buy to suit the need, don’t buy something that is available just because it is available.