Why do Indians prefer insurance over mutual funds?

So, why life insurance as an investment is more popular than MFs, however, as any financial planner with a basic understanding of things will tell you, MFs are clearly the better way to invest. In fact, what most life insurance companies in India sell in the name of insurance is not actually pure insurance or term insurance, which involves payments to the nominee in the event of the death of the policyholder.

Take Life Insurance Corporation of India (LIC). In 2020-21, the new business premium generated from selling term insurance policies was just 0.33% of LIC’s new business premium during the year. Given that LIC sold nearly three-fourths of all new individual policies sold in India in 2020-21, what is true for LIC is also true for insurance companies.

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So, what do insurance companies actually sell? They sell investment plans with a dash of insurance. These are endowment plans and unit linked insurance plans (ULIPs). Endowment plans are referred to as traditional insurance plans because for a very long time these were the only kind of plans sold by LIC, which had the monopoly to sell life insurance in the country.

These schemes offered agents very high commissions. The government was okay with this as a good part of the money invested in these schemes was in turn invested in bonds thus helping the government to finance its fiscal deficit. In that sense, how financial repression prompted the government to make people invest. Of course, to make these schemes attractive, investing in them came with tax deductions.

Its hangover can still be seen in many fathers (yes, fathers at large) who encourage their children to buy traditional insurance policies. The trouble is that the returns earned on these schemes barely beat the rate of inflation. Given this, it makes more sense to invest money in Public Provident Fund (PPF) and save tax than buying a traditional insurance policy.

ULIPs, or Unit Linked Insurance Plans, are another popular form of investment through insurance companies. ULIP directly competes with MF. It is very easy to find out which are the best performing MFs. Log on to any financial website that publishes this data. On the other hand, given the complex structure of ULIPs, it is very difficult for an average retail investor to ascertain which ULIPs are performing best.

Therefore, for those who want to invest indirectly in stocks, it makes more sense to invest in equity mutual funds and buy a separate term insurance policy instead of investing in ULIPs.

Despite these weaknesses, insurance as an investment is more popular than MFs. Why? Firstly, investing in any kind of life insurance policy provides tax savings. This is not true for MFs, unless one specifically invests in tax-saving MFs. Since many people are unable to differentiate between tax saving and investment, they buy insurance policies.

Second, investment in India is still something that needs to be pursued. Therefore, the commission paid to the agents becomes important in deciding exactly what to sell. Data from the red herring prospectus filed by LIC ahead of its initial public offering shows that in 2020-21, the average commission paid by the top five insurance companies was 4.4%, with the average commission on new business premium at 9.2% . , This is much more than what MFs are allowed to pay.

Third, for a very long time, mutual funds were not allowed to use celebrities to advertise, but insurance companies were. This tilted the game in favor of insurance. Mutual funds are now allowed to use celebrities for advertising.

Fourth, given the financial illiteracy prevailing in India, most of the new investors invest only through a financial intermediary who manages to reach them first, and at times it happens that an acquaintance is an LIC agent.

Fifth, mental accounting is also at work. As Daniel Kahneman writes in Thinking Fast and Slow: “We keep our money in segregated accounts … we have money, general savings, savings earmarked for our children’s education or medical emergencies.” Investments through insurance policies are designed to cater to mental accounts. If you buy a child plan, you are saving for the future of your child. If you buy a pension plan, you are saving for retirement.

However, at the end of the day, money is money, as long as one saves. Tags attached to it shouldn’t really matter. The money saved can be used for the child’s education, child’s marriage or expenses during the retirement years. Sadly, many people don’t understand this basic point and end up investing in a way they shouldn’t.

Having said that, mutual funds are catching up to the mental accounting game and positioning their schemes accordingly.

Vivek Kaul is the author of ‘Bad Money’.

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