014 Betting on your life

The brush that Indian professionals have with Insurance products is primarily as an investment vehicle to use the Section 80C deduction while filing taxes. While this provision aims to inculcate long-term saving, investment or protection habits, we should look beyond tax benefits of these products to optimize their utility for us.

The core purpose of Insurance is to provide a backstop to the financial position of the policyholder (or beneficiaries) if any unforeseen circumstance trips up our well-laid plans.

Life insurance, specifically, is meant to provide your financial presence in the unfortunate event of your physical absence due to death. The simplest (and cheapest) insurance policy that fulfils this core purpose is a term insurance. This is a product wherein the buyer purchases protection for a fixed term by paying fixed premiums annually. If the buyer dies during that term, his beneficiaries get a lumpsum death benefit. A whole bunch of us pool our risk to pay out a select few Yamaraja beckons.

Think of this as a bet that you enter into against many others:

  1. Premium: All of you contribute a small amount into a communal pot. Since each of you has a different probability of winning (i.e., dying), the amount you pay into the pot may differ and is calculated by the insurer.
  2. Death Benefit: A small percentage of those who contributed take away a big portion of the pot if they win.
  3. Underwriters: This central counterparty facilitates this betting pool by calculating what each of you have to put into the pot based on your risk profiles, their expenses, commissions, taxes and the profit they have to make to ensure they stay in this business of collecting money in pots.
  4. Renewal: If you survive through the year, the pot is now empty and you get to contribute again to stay in next year’s bet.

Alternatively, this is a bet you enter into against the insurer.

  1. You bet a small amount that you will die during the year. The death benefit you stand to receive is large enough relative to the premium paid, to make financial sense for you to enter into the contract.
  2. The insurer bets a large amount that you won’t die during the year. The premium they collect from you is large enough relative to the death benefit paid out, to make financial sense for the insurer. The insurer should be able to profit with your premiums after paying out the % of claims due during the year, post expenses, commissions and taxes.

In both cases, these are bets you should be happy to lose every year.

Insurance is NOT meant to be an investment product. Products that claim to be both tend to be costly and suboptimal, and you receive neither investment returns nor risk cover. You will be better off using term insurance to obtain the risk cover you need and investing the rest of the premium into an actual investment product in line with your objectives.