This article is authored by Devang Shah, MBA (IIM Ahmedabad), CFPCM (India & U.S.), Right Returns.
The question of whether to buy insurance is not an investment question. The need to figure out whether a person needs to buy insurance comes much before evaluating investment alternatives. And, for altogether different reasons than are usually pitched out by the salesmen.
The reason IS NOT because it is a safe investment. Nor is it because everybody is underinsured. Both these are in part myths and in part generalisations that are useless for personal decision making.
The reason why the decision for insurance comes before evaluating investment alternatives is two-fold.
1. Insurance is purchased to protect your weakest aspect of finances.
Consider a chain. Is it sensible to work on the strongest parts of the chain, in order to make them stronger? Or is it more fruitful to first take care of the weakest part of the chain so that it does not break?
Putting it in the perspective of personal finances, if the family has only one breadwinner and not much of wealth, then their dependence on the breadwinner’s ability to bring bread on the table is the weakest part of the chain. You can build lovely risk-return optimised portfolios, but if the breadwinner can’t bring money home, due to death or disability, the portfolio will remain too small to provide for anyone, doesn’t matter what fantastic returns it gives.
So insurance plays the role of taking care of the weakest link in a person’s financial chain - financial circumstances.
2. Insurance is an expense.
Prioritising important expenses comes before finding out even how much to save, leave alone evaluating investment alternatives.
Typically insurance is sold as an investment alternative. This is so because buyers don’t want to “spend” money, if they can avoid doing so. The point is that whether it is sold as an “investment” or as an “expense”, does not change the fact that insurance is an expense. It only changes the label on a cash outflow. Please understand that what anyone pays for insurance DOES NOT come back to him or her. If you want some money to come back, then you need to pay over and above the insurance.
That is the simple reason why any insurance policy is more expensive than a plain term insurance plan. In other words, the plain term insurance plan is like the expense component of any other insurance plan that promises to give you back something. If you want something back, you need to pay more than the premium you would pay for a plain term insurance with the same cover. That additional payment of yours will go towards creating a corpus that will come back to you.
In summary, insurance is an expense. If it helps in protecting your weakest link in the chain of personal finances, it is a very important expense and you need to spend that. If your weakest link cannot be protected by insurance, then insurance might be a wasteful expense.
I would like to end with two important issues closely related to this.
How much should be spent on insurance?
Just enough, so that it does not remain the weakest link in the chain. So for example, the maximum life cover you should buy is of just as much value as the corpus the insured would have built, if the event of death does not occur. However if the corpus needed for the family to sustain itself, in the event of the breadwinner’s death, is smaller than the amount he would have saved up, then the priority is the smaller amount. Because that is the weak link.
If my weakest link is not insurable, does it mean I never need look at insurance?
The weakest link, is a relative term. Your objective is to strengthen the chain as a whole. And the best way to do so is to look for the weakest link. As soon as the weakest link no more remains weak, some other aspect will get the spotlight of being the “relatively” weakest link. The weak point hasn’t become weaker but it is now the highest vulnerability for your chain. So as you progressively strengthen your financial chain/ circumstances, you may find a solution in an insurance cover and hence may have to consider it.
