A few weeks ago, a friend of mine rang to speak about an investment opportunity he had identified. He wanted to run it by me before he committed. I rarely say “no” as I always end up learning new things looking at diverse opportunities with various risk profiles. Over the last month I’ve looked at proposals to investing in mini-hydro plants ( I now know how to calculate plant factors and reading design flows in cumecs unrelated but quite interesting), automated warehousing, fertilizer manufacturing plant, etc. Naturally, I agreed to have a chat but requested my friend to email me the documents. To my surprise, he did send me a fairly comprehensive and quite a substantial life insurance plan. This led me to question myself;
“Is life insurance really an investment or a risk product …?”
-Me soon after reading the email.
A bit vain to quote myself but we can live with a bit of vanity, its 2022. Don’t roll your eyes. Keep reading.
On any given day if you question a room full of finance professionals “is life insurance a risk product or investment?”, we are more than likely to receive mixed responses. In summary, there is no right or wrong answer. It all boils down to each person’s financial standing as well as their financial requirement.
However, my personal opinion is for the majority of people, life insurance is a risk product and not an investment. Read more to understand why?
Why life insurance is a Risk product for most?
Insurance is usually taken to cover a specific downside financial risk in life. Mostly it is to ensure there is adequate financial coverage in an event of the early demise of the policyholder. This is to ensure the beneficiaries are provided with a desired monetary sum per the policy value. This can be to cover living expenses, education expenses for a child, retirement for a spouse, an emergency fund for the healthcare of parents, etc.
Essentially when obtaining life insurance it’s pivotal to understand the extent of coverage it offers. This is usually the monetary value it offers at the demise of the policyholder and the cost of insurance.
How is life insurance an investment?
However, some High Networth Individuals (HNI’s) utilize life insurance as a tax planning tool. This is to lower/ defer the overall tax bill. Some use it as a tool for estate planning including transferring of generational wealth. I do not plan on discussing this is as these are very specific instances. These also require far more scrutiny on your personal tax structure before making any comments. However, it’s always beneficial to discuss this with your own tax advisor during your next tax planning session. So, in that sense life insurance can be an investment tool.
What type of Life insurance should I opt for when taking life insurance to cover risk?
A common theme (based on the type of life insurance you pick which we will discuss below) is where most insurance companies provide a lump sum at the end of the policy period (which can sometimes be turned into an annuity) which is considered as an investment. Let’s break it down on why I feel life insurance should be covered via term life which is a risk product.
There are usually several categories of life insurance but I have broadly grouped them into two for ease of discussion and to avoid making it highly technical.
- Term life insurance
This is the cheapest form of life insurance (and very rarely you will get insurance agents recommending this product as it has little to none in commissions for them) where it provides insurance coverage at a fixed rate of payments for a limited period of time (relevant term). During the period/term if the policyholder dies the death benefit will be paid to the beneficiary. Apart from that, there will be no other payment at the end of the term.
In other words, if the policyholder does not die there won’t be any payment at the end of the policy.
To the layperson, this appears a very bad option as you will be making monthly, quarterly or annual payments but won’t be having a return at the end of the period. When I explain, most people inquire why should they purchase term life when other life insurance policies offer some form of a return at the end?
My answer is simple. It is extremely cheap than the other types for a similar amount of death benefit. Secondly, you are only trying to cover the risk of death, not make money out of it. So, treat it as an expense to cover your risk. A sane person rarely inquires their car insurance provider for a return at the end of the period in the event they don’t meet with an accident. So why do so for life insurance? So essentially treat it as an expense.
- Whole life, universal life and all other life insurance policies
Almost all of these policies have clearly divided the monthly premiums into two components. One portion of the premium is used to cover the actual risk of death (which is the same as term life insurance, they might even reinsure a portion to reduce the risk to a specific insurance provider depending on the value) and the remaining component is used to invest /reinvest on behalf of the policyholder (The allocations to cover the death benefit and the investment amount are fairly uneven over the policy period but I will not discuss it to keep this topic relatively simple).
The compounding effect of the investment usually provides a substantial return at the end of the policy period which is paid out to the policyholder. In the event of death usually, the death cover is paid (and not the invested portion). So essentially the payout is only via one of the two methods above.
The returns provided on most policies are below market rate (market returns are adjusted for internal management expenses etc.). For someone who lacks discipline in setting aside a fixed sum, each month may still find this beneficial. However, it is very easy to automate a fixed sum via standing order to a different account which can be used to achieve a greater return than the return provided by the insurance companies.
So how much of term life insurance should I get?
The general consensus is to obtain 10 to 20 years of term life insurance covering 10 to 12 times your annual income. It is advisable to do a quick sense check every few years to see there is adequate coverage and maybe speak to the insurance agent to obtain a top-up cover to bridge the gap if required (if salaries have increased or if there are new obligations that weren’t taken into account when obtaining the first policy).
There are many forms of life insurance policies with so many variations. I hope this article has given you a base level of knowledge to understand your financial requirement. This will help you to discuss extensively with your insurance agent, tax advisor, and personal financial planner before committing to a 10-to-20-year plan. This is essential to ensure that you make the most for the money you spend as well as cover the financial requirement as opposed to obtaining the policy that is promoted by the insurance agent/company. Remember don’t commit till you fully understand what you buy.
If you found this useful, please like and share this article with your friends on Facebook, Twitter, or Instagram page. If I have missed out on any other aspect drop comment on our
You might also be interested in our article Are you in debt? (Good debt Vs Bad debt) or Capital markets and managing emotions?