Both insurance and investment form part of your financial plan. They are important but different elements. Occasionally they are combined into a single product. In this article, I will start by describing the purpose of insurance and then the purpose of investment. We shall also look at what happens when you combine the two.
Insurance is a contract between you and the insurance company. Usually, the type of thing insured does not occur very frequently but when it does it has a big financial impact. Therefore, it makes sense to protect yourself against these events where possible. Examples are
Health Insurance to pay for medical bills if you get sick. Life insurance provides money to your family in the event of your death, and Car insurance which pays for car repairs and injuries to other people.
In some instances, such as car insurance, you are required to have covered by the law. However, for life insurance, the need for cover varies through-out your life. A married couple with a young family, very few assets and a large amount of debt will need more life insurance than a single person with no debts or family ties.
You should start investing once you have protected your family’s standard of living if your income were to suddenly stop.
Investing is the process of building up and protecting assets for your future. This takes time, sometimes a lifetime.
Taking our married couple above, if they decided to invest before they were adequately protected, this could have disastrous effects on the family finances if the main earner was to suddenly pass away. For example, $500 invested in a savings plan for one month will probably be worth no more than $500 whereas payment of the same figure to an insurance plan would provide a much greater sum for your family.
Is Insurance An Investment?
Insurance provides financial security for you and your family if you are unable to provide for them due to sickness or dying early. This provides you with peace of mind that the money you had intended to save over your lifetime or contribute to raising your family will be there if you are not. However, it is not an investment.
There are a few policies on the market which attempt to combine insurance and investment. One of these is generically known as whole of life insurance.
Whole of life insurance can provide a range of insurance benefits.
How Whole of Life Insurance Works?
The person who owns the plan pays a premium to the insurance company. The insurance company invests this premium into a fund, chosen by the policyholder or their adviser. The cost of the insurance benefits is then paid for by canceling some of the units just bought by the contribution.
For example, the premium maybe $500 per month and the cost of the insurance maybe $200 per month. The $500 buys units in a fund and then the insurance company cashes in $200 of units to pay for the insurance. This leaves $300 in the fund.
This would appear to offer both an investment and protection, so what is wrong?
- First, the cost of insurance benefits is not fixed. As you get older the cost rises. Eventually, the cost will exceed the premiums being paid and so the value of the fund will fall. Buying pure life insurance with a fixed premium is cheaper
- Investment charges on these plans are relatively high compared to modern savings plans
- The product is not designed to be used as an investment (although it is often promoted as such).
- If the investment fund underperforms, the insurance company can ask you to increase your contributions or reduce your insurance benefits.
The other factor which may be relevant at this time is that if you have your insurance and investments in separate policies, you can stop saving for as long as you wish and this will have no effect on your insurance.
Historically, one of the key benefits these policies had over term assurance is something called ‘guaranteed insurability’. This is the feature of the policy which means that if you continue to pay the premium the insurance company cannot cancel the policy. Pure insurance policies (term insurance) have a finite life. Once the term insurance expires, if you still need insurance you will have to reapply and be assessed on your health at the time.
Another use which many UK advisers used these plans for was the payment of UK death duties or inheritance tax. The arrival of very long-term assurance plans, some up to 40 years has largely removed the need for the combined plan. However, where they are used, they are not a substitute for investment.
In summary, to the question ‘How Ideal Is Insurance as an Investment?’ the answer is – it is not.