Life Insurance - Why taking Endowment Policy Doesn't Make Sense!!

Disclaimer - I am an IIM Ahmedabad alumnus and VP in an education company, and have nothing far and wide to do with insurance sector :) I write this as an informed customer. Anyway, let's begin.

Recently, I took a life insurance policy. And as most people would have experienced, I was advised to take an 'endowment policy' (instead of a 'term' policy). An amazing number of people, unlike me, take that advice. And make the insurance company happy (losing money in the process obviously).

Commonsensical isn't it, to ask the evergreen question "Kitna deti hai?"

Well, in this case, it's actually not. Unless, you are adding the phrase "Tapakne ke baad" before that "Kitna deti hai" question of yours - that is how much do I get after I die? Because that's the only thing a life insurance policy should be about.

But most people don't do that. They add, quite wrongly, another dimension to it. They look for some money in the form of returns even before the 'tapakna' happens - treating it like some kind of mutual fund in addition to life insurance.

Well... guess what? You are flushing your money down the toilet if you do that.

To understand why, imagine what life insurance is in its pure form. It's called 'Term' insurance - and in my opinion, the only form of life insurance worth taking. How does 'Term' insurance works?

Imagine a group of 500 in which there is a serial killer. The serial killer murders 1 person, and only 1 person, in a year. No one knows who that person is (I mean the guy who dies, not the serial killer; everyone knows who the serial killer is). Since you belong to that group too, you could be the one getting murdered! (You are loving me, don't you :)

Anyway, the chance of you dying is obviously is very small, since the serial killer has no particular preference for your blood. The chance is only 1 out of 500. Now life insurance is simply a pot where these 500, totally frightened people, deposit money for a year. And since you could get murdered too, even though the chance is very small, you also contribute your amount in the hope that your nominee will live richly after you have kicked the bucket. In the end, a murder happens and one person takes out all the money from the pot - the nominee of the person who is murdered. Simple!

So if everyone contributes 7000 a year - the total amount is 7000 times 500 equals 35 lakhs. Now the insurance company is a generally vella dude who spends all his time collecting money on behalf of the group, and the group pays him a salary of 5 lakh to do the job. The rest 30 lakhs goes to the nominee of the 1 person who was murdered.

Meanwhile the next year arrives and the group prepares for the next murder and the vella insurance dude goes around collecting money and life (and murder) goes on. Thrilling, isn't it! And yes, no points for guessing who the popular serial killer is and why no CID is being brought to catch him.

Well, that's 'Term' insurance. So what's 'Endowment' then? And why doesn't it make sense to take it.

Go back to the 'Term' thing - remember why it works. Well, it works precisely because if you don't get murdered and you don't die, you get nothing. And so the one who dies gets everything. That's the basic mathematics behind insurance - distributing risk of anything going wrong over many. Everything in insurance, life, vehicle, medical, works from this principle. Many people pay for one person.

Compare that to an 'Endowment' policy. Everyone's getting something at the end (whatever the insurance companies pay you)! How's that possible? That violates the basic principle of insurance! And I am sure you know there is no free lunch in life.

Well... this is what is happening. The insurance company is taking money from you more than the 7000 that was required (go back to the 'serial killer in the group' example if you are confused where the 7000 came from) ... 14000... 15000... 16000... whatever, and investing the extra money it has taken in stocks/mutual funds etc. The returns that it promises you as part of 'Endowment' is basically return from that investment of that extra money. (Note the word extra!)

So, what's wrong with that? Nothing wrong essentially... except it's somewhat similar to going to a dentist to have your eyes checked. What's wrong with that? After all, both are doctors!

No, that's stupid, you will likely say, won't you? Both are doctors, but both are experts in different organs! The dentist will do a poor job of checking your eyes!

Well... taking 'Endowment' policy from an insurance company is stupid in a similar way! Insurance companies are experts in 'insurance', not in 'investment', even though both may come under financial products (like the way both eyes and teeth are your organs too).

Insurance is about maximizing the money in the pot for you (in case you die) by choosing a group of people least likely to die, and then having a strong collection system so that everyone pays their share, and then doing strong checks to make sure the 'murdered' person has indeed been murdered and is not faking it thereby cheating the group. That requires a very different set of knowledge and skills when compared to the knowledge and skills required to invest your money well (in the way being a dentist requires different knowledge and skills from being an ophthalmologist).

So to go to an insurance company, and pay them extra money in the form of an 'endowment' policy' so they can manage it for you and pay you some returns in the end is similar to going to a dentist and letting him have a look at your eyes just because he is a doctor too.

You don't want to do that. If you have money, stop buying 'endowment' policies, and invest that extra money (beyond what you would pay for a 'Term' policy) into pure investment products by going to a company that specializes in investment (FDs, PFs, Mutual funds, stocks, Gold ETFs whatever). Which will be very similar to going to an ophthalmologist if you want to have your eyes checked or an orthopedist if your muscles are giving trouble. And very wise too!

'Insurance' and 'Investment' are two conceptually separate financial products, with totally different mathematics governing them, and though you may not understand that maths (I hope now you do understand the basic math for insurance at least; if in doubt, go back to the 'serial killer in a group' example) , please treat them and invest in them separately. That is the next time you are tempted to buy an endowment policy, hold your wallet, calculate the extra money you are paying (minus the 'Term' policy) and invest that money separately.

If you do that, I guarantee you will make more money doing that than what is promised to you in the form of endowment. (In fact, just do a simple FD in a nationalized bank with that extra money, and you will make more)

Then why people choose endowment in such large numbers? Why? Because of... Well, I am sure you know it too.

You had it too right? - The painful feeling of not getting anything in the end (unless you died) despite paying so much year after year. It hurts, it bites. Kuch toh mil jaye yaar, nahin bhi mare toh. In business, it's called the 'psychology of loss' - human beings hate to lose, much more than they love to gain. And businesses know how to exploit that.

So year after year, you are willing to pay the insurance company money just to avoid that feeling of immediate loss that comes with buying 'Term' insurance. Even though you are making true losses in the long run by foregoing the gains you would have made if you invested the extra money well.

I know that feeling - that'psychology of loss'. But I also had enough knowledge and sense to overcome it, and thus take action that will make for me real money in the long run. So I bought 'Term' insurance. If I tapkofy in the next 5 years, my parents will be so much the richer. And if I don't die, well... I know I will be richer coz I know how to invest sensibly - where to invest and where NOT to.