Insure Yourself and Your Property

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Series: Beginning Investing (7th post)
Section: Before You Invest
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Today's discussion will be on the next important thing to tackle before you start investing - Insurance.

Generally speaking, most of us equate insurance with savings, treating it as an investment mechanism. This midset is reinforced by the tax rebates we get on insurance, encouraging everyone to invest more and more in high-premia endowment plans every year in order to avail of the tax benefit.

However, the main purpose of insurance is to mitigate risk - risk of death (life insurance), risk of loss (general insurance), risk of illness (medical insurnace) or risk of untoward incidents while travelling (travel insurance).

As an individual, and a responsible householder, you should cover all of these risks when you plan your insurance, rather than rushing off to purchase more life insurance just because you get a tax break!

How Much Insurance Do You Need?

This is a fairly straight-forward question to answer:

• Life Insurance: The conventional approach is to insure yourself for an amount equal to about 10 times your annual income, which is a truly staggering sum! However, I believe this is a better way of looking at it. I also subscribe to the concept of layering your insurance plans so that you can increase your insurance amount over time till a point, after which it starts to reduce because you have saved a good amount by then and might not need so much insurance
• General Insurance: Insure your house (an option that generally is offered with many home loans nowadays - go for it) and your valuables. Burglaries and other mihaps happen and you'll sleep much better knowing that you have a fallback option. There'n no reason for you to learn this the hard way as general insurance premia are really low and definitely well worth the benefit!
• Medical Insurance: In general, try to get yourself and your family covered for major illnesses and surgeries. Some banks, such as Andhra Bank, offer a floating cover that can be shared by the entire family, which I think is a very useful facility as it saves the trouble and expense of insuring each family member independently
• Travel Insurance: This is a must while travelling. If you are abroad and things get stolen, your personal funds will not really help much, I can tell you!

A Bit on Life Insurance

There are two basic kinds of life insurance policies: endowment, wherin it is a risk cover cum saving scheme (this includes money-back policies, unit-linked insurance etc) and term assurance , which is a pure risk cover. The returns on your investment in the former are generally worse than you can do with other comparable investments in the market so I'd always recommend term assurance as the best form of life insurance. It has the added advantage of having very low premia because you need not invest anything in savings. However, due to its nature, the entire premium is an expense. Once you pay it, it is gone and you will not get it back unlike in an endowment policy.

Next Post on Beginning Investing: Set Aside Emergency Cash

Mutual Funds - Make Your Own Unit-Linked Insurance

Much is written and said nowadays about unit-linked insurance, which is touted as one of the best savings schemes for the retail investor, especially one with some appetite for risk.

Unit-linked insurance plans are essentially bundled savings offerings that combine the risk cover of insurance with stock market-linked returns of a mutual fund. These schemes are likely to generate superior long-term returns to the traditional endowment policy while allowing the individual to retain the tax benefits available on insurance – a win-win situation. As with any market-linked instrument there is a modicum of risk attached but over the long term that insurance policies are (or should be) held, the chances of loss are negligible.

There is a catch, however. Unit-linked insurance plans are always offered against funds managed by the insurance provider, which might not be among the better-performing options available in the market. Therefore, while you would be better off than if you invested in an endowment policy, the returns could have been higher. And the power of compounding is such that over the twenty-year period of the average insurance policy, a difference of even one percent could mark quite a significant increase in the size of your nest egg.

Do-It Yourself

Ideally, we’d like to have our insurance linked to the returns of the market-leading mutual fund and there is a way to achieve this. The solution lies in term assurance.

Term assurance is a no-frills insurance that covers risk, full stop. There are no returns – even your principal will not come back. However, the premium payments are really low, much lower than with the savings-oriented insurance schemes, and the same tax benefits are applicable. Such a pure-risk insurance plan offers us the ability to manufacture our own ‘unit-linked’ insurance, but this time with any fund of our choice.

A Step-by-Step Guide

• First decide on the amount of insurance you want to take on a unit-linked scheme and calculate the premium you’d need to pay
• Then figure out the term assurance premium of an equivalent amount. This would be significantly lower. Take out a term assurance policy for that amount.
• With the money you have left over – and this is where the beauty of the scheme lies - set up a Systematic Investment Plan (check out my previous post on SIPs here) in any fund of your choice. You’d generally prefer a market-leading diversified equity fund with a long and successful track record, like Franklin Bluechip.
• If your policy and SIP renewal period is the same (usually annually) then you need to take little extra effort over what you’d have done for a standard unit-linked insurance
• Sit back and relax – you’re almost certainly going to save more than with any unit-linked insurance scheme

Caveat Emptor!

Thanks to my wife for pointing this out:

Before you rush off to put this idea into action, remember that tax benefits would be available only on the insurance allocation, not on the mutual fund investment. Hence the plan might not hold as much charm for those who purchase insurance for tax benefits alone.