What does financial planning mean to you? Is it only about investment? Investment in stocks, mutual funds, real estate, gold and commodities.
More often than not, insurance does not find a place of priority in your financial make over. If that is the case then it is time to change course.
Compared to investment many people don't appreciate the importance of insurance as part of their financial planning.
This happens because people are generally less informed about the role of insurance in financial well-being. And hence are more likely to make basic mistakes in their insurance purchases.
Here are some tips to avoid common insurance mistakes.
1. Don't combine insurance with investment
It's human nature to want something in return when you give away money. And paying a premium month after month without getting anything in return may seem unsatisfying.
Hence the temptation is to buy products like unit linked insurance plans, ULIPs, which combine insurance with investment.
The problem is that such products often do a poor job on both fronts: they will leave you with insufficient cover and provide you with sub-par returns.
The better approach is to separate your insurance and investment decisions.
Figure out how much cover you need for each of the big risks you face and buy a pure cover product to manage that risk. That will be much cheaper than an endowment or cash back plan which combines insurance with investment.
The money that you save can be invested in mutual funds or fixed deposits to earn a higher return. You will also have much more flexibility in your insurance and investment decisions if you don't bundle them together.
2. Don't depend too much on your insurance agent
This is closely linked to the previous point. When buying insurance you should always remember that the incentives of insurance agents might not coincide with your own. For example insurance agents often get paid a higher commission for selling ULIP's though these may not be the best product.
This is why it's important to do enough research so that you are not completely dependent on your insurance agent.
This involves understanding the general principles of insurance as well as the detailed nitty-gritty of what individual plans cover and how much they cost. Do listen to what your agent has to say but ultimately you need to make your own informed decision.
3. Don't confuse insurance with tax planning
For some people buying insurance is more a matter of getting the relevant Section 80C benefits than an important financial product in its own right. This approach may leave you underinsured.
The amount of insurance you buy should be determined by the risks you face not the limits prescribed in the tax code. Of course you should take into consideration any tax benefits that you receive from insurance but make you sure understand what the real role of insurance in your financial planning is.
4. Don't forget to revisit your insurance needs
You buy insurance to cover the big risks of your life. As your grow financially in life, so will your insurance needs. You should not make the mistake of automatically renewing your insurance plans without considering how your risk profile has changed.
For instance, for every child you have, you need to increase your life cover since your family will require more resources in the unfortunate event of your demise.
Conversely as you grow older and your retirement fund accumulates your need for insurance decreases. Or as your car grows older and less valuable your need for auto cover decreases as well.
5. Don't forget disability insurance
Life insurance provides your family with funds in case you pass away but doesn't apply if you are disabled and unable to work.
In financial terms severe disability will have similar consequences to death in terms of lost income and will likely be more difficult because of additional medical expenses. So make sure you buy adequate disability cover.
Often this can be purchased as part of a life insurance plan; otherwise purchase a separate disability insurance plan.
6. Don't over-insure small risks
Insurance companies set premiums so as to make a profit which means they make sure that your premium is adequate given the risk that is being covered.
From your point of view this means that you should not waste money covering every conceivable risk.
The question you should be asking is: is this a risk that will change my life fundamentally if the worse happens or will it just cause a temporary financial loss?
In particular you might be better off not insuring household items like electronics unless they are very expensive. This isn't a hard and fast rule though.
If you feel insurance premiums are low and will buy you peace of mind then perhaps you should insure. But in general you should focus your insurance on the big risks: life, health and home.
