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Avoid These Six Common Life Insurance Mistakes
Life insurance is one of the most important components of any personal financial plan. However, there are many misconceptions about life insurance mainly due to the way life insurance products have been sold in India over the years. We’ve discussed some common mistakes insurance buyers should avoid when purchasing a policy.
1. Underestimating insurance needs: Many life insurance buyers choose their coverage or coverage based on the plans their agent wants to sell and the premiums they can afford. This is a wrong approach. Your insurance requirements are based on your financial situation, not the products available. Many insurance buyers use a rule of thumb such as 10 times annual income as cover. Some financial advisors say that coverage of 10 times your annual income is sufficient because it provides income for your family for 10 years while you are away. But this is not always true. Let’s say you have a 20-year mortgage or home loan. How will your family pay EMI after 10 years when most of the loan is still outstanding? Let’s say you have very young children. Your family will run out of income when your children need it most, such as for their postsecondary education. Insurance buyers need to consider several factors when deciding how much coverage is enough for them.
· Repayment of all outstanding debts of the policyholder (e.g. home loan, car loan, etc.)
· After repayment of debts, the coverage or sum assured should have surplus funds to generate sufficient monthly income to cover all living expenses of the policyholder’s dependents, taking inflation into account
· After repaying debts and generating monthly income, the sum insured should also be sufficient to cover the policyholder’s future obligations such as children’s education, marriage, etc.
2. Choose the cheapest policy: Many insurance buyers prefer to buy cheaper policies. This is another serious mistake. Cheap policies are no good if for some reason the insurance company can’t honor the claim in the event of premature death. Even if the insurance company fulfills the claim, if it takes a long time to fulfill the claim, it is certainly not an ideal situation for the family of the insured. You should look at claims ratios and length of death claims wise for different life insurance companies to choose an insurance company that will meet its claim fulfillment obligations in a timely manner should such an unfortunate situation occur. The IRDA Annual Report (on the IRDA website) provides data on these indicators for all insurance companies in India. You should also check claims reviews online before choosing a company with a proven track record in claims handling.
3. Thinking of life insurance as an investment and buying the wrong plan: A common misconception about life insurance is that it is also a good investment or retirement planning solution. This misunderstanding is mainly due to the fact that some insurance agents like to sell expensive policies in order to earn high commissions. Life insurance doesn’t make sense at all as an investment if you compare its returns to other investment options. If you are a young investor with a long-term view, equity is the best wealth creation tool. Over a 20-year time frame, investing in equity funds through a SIP will yield at least three or four times the amount to maturity of a 20-year life insurance plan, with the same investment. Life insurance should always be considered as protection for your family in case of untimely death. Investing should be a completely separate consideration. Although insurers sell unit-linked insurance plans (ULIPs) as attractive investment products, for your own assessment you should separate the insurance and investment components and pay careful attention to how much of your premiums are actually allocated to invested. In the early days of the ULIP policy, only a small amount was used to purchase units.
A good financial planner will always advise you to purchase a term insurance plan. A term plan is the purest form of insurance, a policy of immediate protection. Premiums for term insurance plans are much lower than other types of insurance plans, and it leaves policyholders with a larger investable surplus, which they can invest in investment products such as mutual funds, which offer higher long-term returns compared to Donation or Refund Program. If you are a term insurance policyholder, in certain specific circumstances, in addition to your term policy, you may choose other types of insurance (such as ULIP, donation or refund plans) to meet your specific financial needs .
4. Purchasing insurance for tax planning: For many years, under Section 80C of the Income Tax Act, agents have tricked clients into purchasing insurance plans to save tax. Investors should be aware that insurance can be the worst tax-efficient investment you can make. Insurance plans have returns between 5% and 6%, while another 80C investment, the Public Provident Fund, has a risk-free and tax-free return of closer to 9%. Equity Linked Saving Schemes are another 80C investment that offer higher tax-free returns in the long run. Also, returns from insurance plans may not be fully tax-free. Gains at maturity are taxable if premiums exceed 20% of the sum assured. As discussed earlier, the most important thing about life insurance is that its goal is to provide life insurance, not to generate the best return on investment.
5. Surrendering or withdrawing from a life insurance policy early: This is a serious mistake that can jeopardize your family’s financial security should an unfortunate event occur. Life insurance should not be touched until the insured passes away unfortunately. Some policyholders surrender their policies to meet urgent financial needs, hoping to purchase a new policy when their financial situation improves. Such policyholders need to remember two things. First, mortality is out of anyone’s control. This is why we buy life insurance in the first place. Second, life insurance becomes very expensive as policy buyers age. Your financial plan should provide a contingency fund for any unexpected emergency expenses, or a period of liquidity in the event of financial distress.
6. Insurance is disposable: I’m reminded of an old motorcycle ad on TV with the punchline “Fill it, close it, forget it”. Some insurance buyers feel the same way about life insurance. Once they buy enough quality life insurance plans from a reputable company, they think that their life insurance needs will be taken care of forever. This is a mistake. The financial situation of insurance buyers changes over time. Compare your current income to your income ten years ago. Hasn’t your income increased several times? Your lifestyle will also improve dramatically. If you purchased a life insurance plan ten years ago with your current income, the sum insured would not be sufficient to cover your family’s current lifestyle and needs in case you die untimely. Therefore, you should purchase additional term plans to cover that risk. Life insurance needs to be reassessed periodically and any additional coverage should be purchased if needed.
Investors should avoid these common mistakes when purchasing an insurance policy. Life insurance is one of the most important components of any personal financial plan. Therefore, life insurance must be carefully considered. Insurance buyers should be wary of questionable sales practices in the life insurance industry. It is always beneficial to hire a financial planner to take a holistic look at your entire investment portfolio and insurance so that you can make the best decisions when it comes to life insurance and investments.
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