Understanding insurance & risk

Amar Pandit explains the importance of life insurance and why it must not be bought in conjunction with investments.
By Guest |  14-02-18 | 
 
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Morningstar invites thought leaders from the investment community to share their insights. Views expressed are personal and should not be construed as investment advice.

There tends to be a certain pattern that most advertisements for life insurance follow.

The husband looks dubiously at his wife prior to signing on the dotted line of a life insurance policy, while the wife is convinced that the insurance cover is necessary and is the only way to secure their future.

The husband then, turns to his wife and asks, “Mere bina jee paogi?”, and the wife responds in the negative.

Upon being asked what she would do with the money should he pass away, pat comes the reply that the insurance money would secure their child’s future and the family’s retirement. She explains how when everything is guaranteed, there is no tension; no tension results in a longer life. Thus, it is essentially for their long lives that he sign on the dotted line.

The ad ends with the husband signing the papers and joking about having to endure the same wife for his entire life.

In case you are rolling your eyes in disdain, I would like to tell you that it was one such advertisement that had my friend’s wife nervous and she coaxed him into purchasing an insurance policy for their daughter’s future and their own retirement. They started by contacting a couple of insurance companies. The pitching of a multitude of products, ranging from children’s plans to pension plans, led to excessive confusion to the point of them approaching me with the question: “What exactly is life insurance?”

Primarily, life insurance is a risk transfer tool which can be used to transfer the financial risk of the family, in case of the holder’s untimely demise, to the insurance company.

Which brings us to other questions.

What is the risk that individuals face?

  • Pure risk is present in situations where there can only be a loss. This would include: risk to life from death or illness, risk to property due to theft or any natural or man-made calamity, professional risk such as the personal liability of doctors and accountants.
  • Speculative risk arises from certain decisions or choices made. For instance, investing in a business can result in a gain (reward for taking the risk) or a loss. Ditto with investing in equities, commodities, real estate and gold, and gambling.

How can one manage these risks?

Keeping the emotional loss aside, the death of the breadwinner is likely to result in financial loss for the family. While trying to understand the financial risk in case of loss of life, he should brace the question: “If something were to happen to me today, will my family have the financial resources to maintain their lifestyle and achieve the financial goals of children’s education and their  respective marriages, etc.?”

The answer can be found only through detailed introspection and analysis.

Do note that the financial loss could either be because there isn’t enough money or due to mismanagement of money. In case of multiple claimants, poor planning might lead to tough times and litigation.

One’s current financial risk can be seen as the gap between their family’s finances (monthly income, as well as one-time needs for the next several years) and what they have accumulated today.

How must one manage risk?

By avoiding, retaining or transferring.

As far as risk related to death is concerned, there is no way to avoid the risk because human beings are mortal.

Retaining the risk of death is an option that is available only to a small set people who currently have the means to address their family’s needs in the future with the assets and wealth they’ve accumulated in the present. This however, isn’t an option for a majority of the population. Hence, the best alternative to address the risk is to transfer it to an insurance company. The insurance company generally accepts this risk (subject to medical and financial underwriting) at a cost, which is the premium one pays.

But, for people, is insurance or are insurance companies simply a means to transfer risks? For them, is life insurance just as important as their car insurance? What I’ve generally found is that the same people who don’t bat an eye while shelling out Rs. 40,000 for their cars, immediately balk at the thought of paying the same amount for a life insurance cover of Rs 1 crore. (This example applies to a 35-year old male purchasing a pure term plan with only risk cover, and no returns). The surprising aspect of this entire situation is how willing, rather how eager, people are to pay for a car that is valued at Rs 20 lakhs, but which depreciates each year, as opposed to insuring their own life.

Then, in an attempt to get a “better deal”, they confuse insurance with investment, end up looking for returns, and make imprudent choices. Do not make this mistake. Get a life insurance with a term cover of a sizable amount and health insurance for family protection. Keep your investments separate.

Amar Pandit is a CFA Charterholder from the CFA Institute and a Certified Financial Planner. He is the founder of Happyness Factory. A version of this post initially appeared on his blog.

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