How to choose your tax-saving insurance policy wisely?

Insurance | admin | January 29, 2011 at 9:28 am

In the tax-saving season, buying an insurance policy is a temptation most investors yield to. There is nothing wrong in choosing a long-term product which comes with some tax sops. The problem is in simplistic decision making by most investors when it comes to insurance.

This naiveté is exploited by unscrupulous insurance agents who tend to manipulate the features of the product to misrepresent it to investors. Here are a few pointers before you buy an insurance policy this season.

First, investors see a huge merit in pre-emptive investments. Most are unable to develop a regular saving habit, though they know they have to save for their future. Savings happen only when consumption and spending are cut back, which is practically tough. If an investment product requires making a payment even before the money is available to spend, investors prefer such products, so they are compelled to save.

The decision to buy an insurance policy is mostly done with this noble intent of building a saving habit, or putting aside some money compulsorily. It is important not to be carried away about how much can be realistically put aside, regularly and over a long period. A rule of thumb is to estimate the increase in income from increment and career advancement and direct that to such compulsory saving.

Alternatively, the premium committed should not be over 5% of the monthly income. If one can save more than that, a low premium commitment provides the room for other investments. The premium committed should never over-estimate the ability to save regularly, even under a compulsion.

Second, investors are biased by their immediate need to save tax. They buy an insurance policy that would reduce their immediate tax liability, without taking into account their ability to sustain the high premium payment in the later years. Most tax-saving products are designed to encourage long-term savings. They have a lock-in period during which they cannot be accessed. Insurance policies eligible for tax concessions are also long-term products whose benefits will accrue over time.

Investors need to know their choices if they are unable to pay the premium. Can the policy be made fully paid up (the cover is re-adjusted for premium paid)? Can missed premiums be paid later? Does the policy lapse if premium is not paid? Can it be revived later?

Deciding on a premium amount, based purely on tax saved in the current year, and buying a unit-linked insurance policy (Ulip) with no facility to modify the terms are common errors investors make. Ask your insurance agent specifically about the consequences of not being able to pay the premium.

Third, investors are unwilling to look at insurance as a risk cover, but as investments. They always choose policies that return something to them, over pure term policies that only offer a cover. However, they do not check how these returns might behave over varying holding periods. Good returns may accrue in a Ulip only over long periods.

In an insurance policy, there is the added element of risk cover, costs and the like, which reduce the actual amount invested in the early years. Investors who have to cut short their holding period either because they cannot pay the premium or need money for other uses find that their returns are only in the form of surrender value, which may be negative at the end of the minimum investment period.

Ask your adviser for the specific value of the policy for varying holding periods. Find out how much you would have paid as premium and how much you will get back, to understand if the policy makes investment sense.

A reasonable premium invested in a long-term insurance product to save taxes, to save compulsorily and to earn a reasonable return, is a good proposition. Make sure you are realistic about your ability to pay the premium and wait out that period.

Source: Economic Times