Home / Opinion / Columns /  Why do Indians prefer insurance to mutual funds?

The Reserve Bank of India (RBI) published household financial savings data based on select indicators last month. Deposits with banks remain the major form of savings in India. As of March 2022, savings held in fixed deposits stood at 48.9% of gross domestic product (GDP). In comparison, savings through life insurance funds and mutual funds (MFs) stood at 22.3% and 9.1% of GDP, respectively.

So, why does life insurance as a form of investing remain more popular than MFs, even though, 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 under the name of insurance isn’t really pure insurance or term insurance, which involves a payout to a nominee in the event of the policyholder’s death.

Take Life Insurance Corporation (LIC) of India. In 2020-21, the new business premium that came in from selling term insurance policies stood at 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’s true for LIC is also true for insurance companies on the whole.

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

These plans offered a very high commission to agents. The government was fine with this because a good portion of the money invested in these plans was in turn invested in bonds and thus helped the government finance its fiscal deficit. In that sense, financial repression drove how the government wanted people to invest. Of course, to make these plans attractive, investment in them came with a tax deduction.

The hangover of this can still be seen in many fathers (yes, largely fathers) encouraging their children to buy traditional insurance policies. The trouble is that the return earned on these plans barely manages to beat the rate of inflation. Given this, it simply makes more sense to invest money in a public provident fund (PPF) and save tax than buy a traditional insurance policy.

Ulips, or unit linked insurance plans, are the other popular form of investing through insurance companies. Ulips compete directly with MFs. It is very easy to figure out which are the best performing MFs. All one needs to do is to log in to any of the financial websites that publish this data. On the other hand, given the complicated structure of Ulips, it is very difficult for an average retail investor to figure out which are the best performing Ulips.

So, for someone looking to invest indirectly in stocks, it makes more sense to invest in an equity mutual fund and buy a term insurance policy separately instead of investing in a Ulip.

Despite these weaknesses, insurance as a form of investing is more popular than MFs. Why? First, investing in any kind of life insurance policy leads to tax saving. That is not true for MFs, unless one specifically invests in tax-saving MFs. Since many people can’t differentiate between tax saving and investing, they end up buying insurance policies.

Second, investing in India is still something that needs to be pushed. Hence, the commissions that get paid to agents become really important in deciding what gets sold. Data from the red herring prospectus filed by LIC before its initial public offering tells us that in 2020-21, the median commission paid by the top five insurance companies stood at 4.4%, with the median commission on the new business premium standing at 9.2%. This is significantly higher than what MFs are allowed to pay.

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

Fourth, given the financial illiteracy that prevails in India, most new investors simply tend to invest through a financial intermediary who manages to reach them first, and many a time that happens to be a familiar LIC agent.

Fifth, mental accounting is at work as well. As Daniel Kahneman writes in Thinking Fast and Slow: “We hold our money in different accounts… We have spending money, general savings, earmarked savings for our children’s education or for medical emergencies." Investing through insurance policies is designed to cater to mental accounts. If you buy a child plan, you are saving for your child’s future. If you buy a pension plan, then you are saving for retirement.

Nonetheless, at the end of the day, money is money, as long as one saves. Tags associated with it should not really matter. Money saved can be used for a child’s education, a child’s wedding or spending during retirement years. Sadly, many people do not understand this basic point and end up investing in a way they shouldn’t.

Having said that, MFs are catching up with the mental accounting game and are positioning their plans accordingly.

Vivek Kaul is the author of ‘Bad Money’.

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