Life Insurance - Myth & Reality

History of modern forms of life insurance in India goes back almost 200 years when Europeans setup their life insurance companies to insure the lives of westerners living in India. Subsequently lives of Indian natives were also covered. First at heavy premiums & later at equitable premiums as compared to the ones being paid by Europeans in India.

Before we move on to the few common myths about life insurance, it is necessary for us to understand the peculiarities of this form of insurance as compared to the rest. Few important differences (from end user perspective) for life insurance as compared to other forms of insurance are:

1) Loss cannot be indemnified – Once the life is lost, there is no indemnity/ repairs. It’s a point of no return.
2) Claim can be made only once – Unlike general insurance, the claim for life insurance can be made only once. E.g. one can claim car insurance multiple times.
3) Initiator of insurance claim – Unlike in other forms of insurance, the claim for life insurance can never be done by the owner of the insurance policy or the insured. The beneficiary is always someone else!

There are a few major reasons why an average person goes for Life Insurance. These are the reasons which carry some of the myths too.

Firstly for safety or risk cover. This has to be the biggest motive behind taking up an insurance policy. The insurance claim can never be made by the insured. Hence the safety or risk cover is always for the family members who are left behind & not for you. I see many people taking insurance policies for their kids. While this has an emotional value, if I look at such insurance policies from pure risk perspective, I see no reason for doing this. Unless your child is an earning member, taking an insurance policy in his/ her name is not going to help. I would strongly recommend insuring only those individuals whose death will cause stoppage of income or increase expenses or will make the survivors pay for his/ her liabilities.

Secondly as an investment option – Many of us go for endowment, money back or Annuity/ pension policies from the point of view of earning returns. However if one looks at the kind of returns one is expected to receive on investments in insurance premium vis-à-vis let’s say long term bank deposits then the investment motive for life insurance begins to look weak. Let’s take an example of Life Insurance Corp (LIC) in India since it has the longest & solid history. One of their best endowment insurance policies today is Jeevan Saral. In our example the insurer is 36 year old male with standard health. He has 2 options – Option 1 is to go for Jeevan Saral with a sum assured of Rs. 2.5 million. Option 2 – go for pure risk cover (Amulya Jeevan) & invest in bank deposit.

Going with life insurance for pure risk cover & investing rest of the amount in bank deposit every year definitely looks lucrative. Option 1 is financially attractive only when the insurer dies during the tenure of the insurance policy.

One may argue that the maturity payments from LIC are tax free which is not the case with returns on bank deposit. I agree completely. However there are a few options there too – one could go for direct investments in mutual funds. Mutual funds have historically provided higher gains than banks & the long term capital gains from these investments are tax exempt! Again I mentioned “direct investments in mutual funds” & not the ULIP (Unit Linked Insurance Policy). Why? The reason is simple – would you want to pay 24% to 70% charges of your first year contribution? Surprised? This is indeed true. LIC has the lowest “Allocation Charges” @ 24% of your 1st premium while some of the private insurance companies can charge as high as 70%!

As one of the “value for money” consumers, I have one simple rule - Pay vendors for their core competencies. Pay the insurance companies for what they do the best i.e. insurance/ risk cover & pay the mutual funds for their investment management skills.

Another point of view is – Why would LIC restrict total sum assured per individual to Rs. 2.5 million on pure risk cover policies? This restriction does not apply to other types of policies. Obviously there appear to be strong business reasons behind this restriction. They surely want to encourage their customers to go for policies where LIC has the most financial benefits! Take this example – I interviewed one of the best LIC agents in Pune. He has around 10 year career with LIC. Over this period he has provided new policies with total risk cover of Rs. 600 million & total insurance premium payments of around Rs. 15 million. Any guesses as to how much total value of claims were made by his clients in these 10 years? Well, it was not more than Rs. 4 million! And he mentioned that the claims were slightly on higher side when he compares with his fellow agents!

To conclude - As a tool for Income Tax rebates & pure risk cover, life insurance definitely sounds attractive. I think pure risk cover policies offer the biggest value for money. Insure only those individuals whose death will cause decrease in income or increase in expenses or will make the survivors pay for his/ her liabilities. One should treat insurance premium as expenditure rather than an investment. Pay the life insurers for their core competence only – risk cover!

Turn your loans into Investments

Did you know that the loan tenure & total repayment amount - payable over this tenure (inclusive of interest & principal) - moves up exponentially with just 1% rise in interest rate? In the following example (Table 1), you will notice that just by increasing interest rate from 11% p.a. to 12% p.a., the tenure increases from 20 years to approx 29 years AND the total repayment amount increases from Rs. 4.9 Million to Rs. 7.2 Million! This is of course assuming that the interest rate will not change in future & that you keep the same EMI as before. This is true for those who have existing floating intt loans. The EMI for such loans has already been decided. Hence any movement in rate of intt directly impacts the tenure.

From Table 1, it should be clear that an intt rate increase of 1% in absolute terms causes both the tenure & total repayment amount go up by more than 45% each! One may ask if this is equally true for fall in rate of intt too. The answer is – No. If the interest rate falls from 11% to 10%, then in the same example, the tenure & total repayment will both come down by approx 17.5%! If you are one of those who have a question of why this happens, then send me an email & I will explain. It should suffice to mention here that the pace at which one repays principal largely defines tenure & total repayment amount.

4 year back (June 2004) the home loan intt rates were 7%. Those have been rising steadily up-to 13% today for many banks!

One usual discussion point that I come across on lunch tables these days is – ‘What are the options in current economic trend that can help us beat the superfast pace of inflation?’ While I agree that there are not too many options that can reliably make this happen, I wanted to start discussing about a few that are promising. As mentioned in one of my last posts, it is absolutely important for an average investor to play defensive in economic conditions such as today. As part of the current series of posts, I have already presented the option of Gold. In this post, I am going to discuss the ways in which we can make our existing borrowings work for us.

Most of the types of consumer loans today have intt rates higher than the rate of inflation. Consider one of the most popular & cheaper forms of consumer loans – home loan. Even this presumably cheap form costs more than the inflation today.

My recommendation is to use part of your investable funds to repay at least some part of your loans – if the rate of interest is more than inflation i.e. if the intt rate > 11.7% p.a. (as of today) & if your objective is to beat inflation.

One would argue – what if I invested in some other option than repaying my loan? One of the most reliable long term options (accessible to average individuals) is Bank FD with a reputed nationalized bank. The rate of intt on these is not more than 9% today. Table 2 shows the comparative gains for 2 options. Continuing the same example as Table 1, let’s assume that the rate of intt has gone up to 12% & that you have Rs. 100,000 to invest.

It is clear that repaying the loan is financially wise option, even if we assume that in Option 2, the bank offers monthly compounding option (as assumed in Table 2) on the Fixed / Long Term Deposit! If we assume half yearly compounding (which is realistic), then the gain with option 2 becomes even less glamorous! Again with Option 2, you are not beating the inflation too!

If the option existed for average individuals, then the best thing to do is to borrow in Yens in the International Monetary market & re-pay or invest in India! Yen denominated loans are the cheapest (not more than 0.75% p.a.). One could have used these Yens to repay the Rupee loans. One catch is that one would have to assume the currency fluctuation risks until the Yen loan is squared off. However I think the quantum & surety of gains is worth the calculated risk. But alas! This option is not available (not at least in the direct forms) for people like you & me.

Anyways, back to our original discussion. Lump sum re-payment makes more logical sense when you are expecting that the intt rate on the loan is either going to remain at present level or will go up. It is not ruled out that the present intt rates on various home loans will revolve around current levels for at least few years to come. You can of course actively look at the option of increasing EMI to maintain the same tenure as before. A mix of lump sum repayment & increase in EMI can also be considered.

In general, whether for beating the inflation or not, it is one of the prudent financial policy (for an average investor) to continue re-paying the loans that carry highest intt rates on a regular basis. I have one strong belief – “Becoming risk-free is the solid step in being a high risk-taker.”

In gold we trust! – Part 3: Where to invest?

There are many forms of gold investment. How an individual chooses to invest in gold depends on the size of the investment, his/her reason for investing, and the purpose of the investment.

Physical Holding - Bars and coins, ornaments, Bullion Accounts (allocated & unallocated) with banks, metal vaults, demat gold on commodity exchange etc.

Derivatives or indirect forms - Gold futures, options, gold ETF (Electronically Traded Funds) i.e. gold traded in the form of a security on stock exchanges around the world.

Most of these forms of investment are well defined & explained on World Gold Council’s website at http://www.invest.gold.org/sites/en/how_to_invest/.

I am assuming that the reader has gotten acquainted himself/ herself with these options. I will jump right into my recommendations.

I prefer options that provide Physical Holding over the ones that give indirect ownership on gold. Why invest in derivatives when the paper that you hold is not backed by the equal quantity of gold itself? If one wants to invest in derivatives of gold, then why not hold currency notes?! This may sound little extreme or even misplaced to some. However if one looks at the evolution of global monetary system, even today gold has a significant role to play. May be that role has somewhat been diluted since collapse of Bullion Standard. However there are a few vivid examples in recent times that point to the significance of gold even today. Remember the occasion in 1991 when Indian central bank (RBI) had to pledge physical gold with the UK? Central banks still try to back their currency through gold reserves. Almost 12% to 15% of total reserves held by central banks are in gold. So the currency notes are in a certain way still a derivation of gold itself! Why go to other gold derivatives when some of your wealth is anyways in form of cash or bank deposits?

Now let’s turn our attention to physical forms of gold investment. According to World Gold Council, 75% of gold demand is for jewelry, 10% for industrial use and only 15% is for investment purpose. For centuries, an Indian has been “investing” in gold by buying jewelry. I wonder why we think that buying ornaments is a form of “investment”. After interviewing few jewelers, I discovered that any person who buys ornaments stands to lose anywhere between 7% and 18% of the original investment – depending on the making charges for the design – when it is time to encash the so called “investment”. Making charges vary from Rs. 50 per gram for very simple designs to even Rs. 250 for some exotic varieties. No jeweler – not even the one from whom you purchased the jewelry – puts any value to the making charges when you want to sell it. Similarly the buy/ sell spread for jewelry is usually high. You would hardly find any jeweler who would give you cash for the jewelry purchased from any other jeweler. He may offer to exchange it though; however the discounting could be high.

Gold bars & coins – During the last decade, Indian banks were allowed to import gold & sell it in the open market to the retail customers. However here too, the loss is too much to bear. E.g. ICICI Bank charges up-front premium of approx 15% over the ruling gold prices! Besides, they are not going to buy the same gold if you wish to sell! You still have to turn to the jewelers to sell it. And guess what – the jewelers will mostly deny giving you cash in return!! They might exchange it for their own gold though.

So what is the way out? Here is what I would recommend.

If your quantity is limited, then find a local jeweler who has a strong history & credibility in the market. Purchase ‘Vedhane’ from the guy. ‘Vedhane’ is kind of a bare-bones gold ring without any special making charges. The advantages are that this comes in pure gold form - 23.5 to 24 carats - & does not attract any making charges. Plus the buy/ sell spread when you go to encash the same, is minimal. Based on my interviews with a few well known jewelers, I concluded that the transaction charge (including buy & sell) can be as low as 0.75% to 1% barring VAT which anyways is common for any option you take. Safety of your investment is a challenge in this option. Hence a Safe Deposit Vault with a reputed bank is recommended.

If your quantity is in kilos, then demat gold (e.g. i-Gold offered by Multi Commodity Exchange of India – MCX) or metal vaults (e.g. something like Bullion Vault) are recommended. In both these options, the investor gets a guarantee of physical delivery if one demands it. Also the buying, selling, storage & safety of your investment are virtually the non-issues. However the charges are obviously slightly high. E.g. if you bought & sold 1 kilo of demat gold through i-Gold in single fiscal year, then you would end up paying anywhere between 2.25% to 2.8% as total transaction charges depending on the turnover commitments that you make. These charges include brokerage for buying & selling, service tax & custody + insurance charges for 1 year. I have not considered VAT here too since it is going to be common for any transaction (1%).

So to conclude – have your gold investments as a mix of “Vedhane” from a reputed jeweler & something like i-Gold, depending on the individual’s deal size, safety parameters & comfort level. If you have a choice, then I would recommend buying this form of gold in non-festive & non-marriage seasons. As for me, I am a regular buyer & seller of “Vedhane” & have had adequate returns! I am actively considering an i-Gold account for myself. Remember – any investment is as good as the quality of your decision to buy AND sell. I strongly believe in realized gains.

In gold we trust! – Part 2: How much to invest?

In my earlier post, I evaluated gold as one of the recommended investment options in the present global economic situation. It would be worthwhile taking a look at some more hard facts before we move to questions like – How much to invest? In what forms to invest?

In the recent months, a tiny country like Vietnam has doubled it’s appetite for gold as compared to last year. It has been tipped to have surpassed even India! Why? One wonders. But look little carefully & there is a fact that probably explains this phenomenon – rising inflation! The current rate of inflation in this tiny nation is 25%. As I mentioned in my last article, inflation, interest rate & demand for gold seem to have shown close interrelationship yet again!

Gold has returned slightly higher than it’s 1980 peak of > $ 900 per OZ. When you look at stock markets from 1980 most have more than doubled. More so in the emerging economies. Even looking at the levels after present battering, the global stock markets are easily sitting at more than double the levels as compared to 1980’s. By this comparison, gold remains the grossly undervalued investment option as compared to stocks, real estate, crude oil etc.

Again does this all point us – the average investor with average risk posture – to having gold-heavy investment portfolio? Again - Absolutely not! Not even in the current inflationary & somewhat recessionary trend! There are a few reasons for this:

First, gold is uniquely positioned – as a commodity as well as store of value. While it is great as store of value & in some occasions, a trusted medium of exchange (world’s central banks hold around 12% to 15% of their reserves in gold), gold is not a directly consumable commodity, except for the industrial usage.

Second, the rules of diversification apply to any investment option including gold. “All eggs in one basket”… While we are witnessing a general slowdown, I firmly believe that India growth story is not complete yet. The present situation (political & economic) may throw some more nasty blows in next 2-3 years & the growth rate may see further dip; however Indian economy is expected to find it’s original growth trajectory eventually. Diversification continues to be a fundamental reality of good investment strategy.

For an investor with average risk appetite, I would recommend keeping gold exposure of 5% to 20% of their periodic investments; depending on the opportunities presented & economic conditions. In the current situation of inflation, rising interest rates (India) and slowdown in growth, 10% to 15% of one’s periodic investment to be put in gold, seems logical to me.

Now let’s turn to the part 3 of my gold series to know my views on the recommended forms of gold investment.