How much Insurance a person needs- Insurance Evaluation methods
Insurance protects a person and his/her family from financial difficulties. However, in most cases, people find it difficult to estimate the correct value of insurance they need.
There are several simple methods available to broadly estimate one’s life insurance needs.
Five simple rules are:
1.Human Life value Method
It is a method of calculating the amount of life insurance a family will need based on the financial loss the family would incur if the insured person were to pass away today. It is usually calculated by taking into account a number of factors including but not limited to the insured individual’s age, gender, planned retirement age, occupation, annual salary, employment benefits as well as the personal and financial information of the spouse and/or dependent children.Since the value of a human life has economic value only in its relation to other lives such as a spouse or dependent children, this method is typically only used for families with working family members.
This method estimates the amount of insurance coverage needed to provide adequate cash flow to cover the identified expenses (child care,etc) for the risk duration. This would apply to the homemaking spouse because replacing his/her efforts in the event of their death has a quantifiable expense.
This is one of the basic methods of insurance calculation and is based on one’s current annual income.
Insurance needs = annual income * number of years left for retirement.
If a person’s annual income is Rs 5,00,000 and is 45 years old with 15 more years for retirement.
then his/her insurance cover equals Rs 5,00,000 * 15 = Rs 75,00,000.
Another way in which income replacement works is to multiply the annual income by 10 (also known as Income Replacement Multiplier).
Another variant states that the Income Replacement Multiplier changes with age. So between the ages of 20-30 years, the income multiplier is 5-10, and from 30 to 40, the income multiplier is 15-20.
It drops to 10-15 between the age of 40 and 50 and further to 5-10 between 50 and 60.
Some calculations also take into account any outstanding loan amount that one may have on housing loan, personal loan etc
Capital fund rule
Suppose a person needs Rs 1 lakh p.a. for family needs, and there are no other income-generating assets. Then he/she can create a capital fund of Rs 1.25 million which can yield Rs 1,00,000 annual income @ 8% p.a. To do this one can buy a life insurance policy of Rs 1.25 million.
Family needs approach
A person should purchase enough life insurance to enable the family to meet various expenses in the event of his/her death. Under the family needs approach, one has to divide the family’s needs into two main categories: immediate needs at death (cash needs), and ongoing needs (net income needs).
If the family is reasonably wealthy and its protection needs are relatively low, one can buy a smaller amount of insurance. Similarly, if family members have independent earning capacity one may reduce the insurance.
There is a broad relationship between needs and assets over a period of time. Thus, not much life insurance is needed in the initial stage. The same is true in the empty nest stage ie the retirement stage.
The maximum need for life insurance arises during the mid-phase, when one is married and has children. In other words, one may go for life insurance so long as the asset-level is lower than the need-level.
How much insurance does one need for business
A business person needs to first check contracts where it is mentioned how much business insurance cover is needed – often a minimum level of public liability or professional indemnity insurance is mentioned. If they do then this minimum cover is required. However one may decide to take more cover than the contract asks for.
Employer’s liability insurance is required by law if one have employees. Premium rating is governed tariff. It depends on the nature of work carried on by the insured.
When buying property insurance the most important thing is to make sure that one is not under-insured. A person should be sure to calculate the total value of all the entirety of the property – one cannot pick and choose what one wants to be covered.
How much Home insurance is needed? Factors to be considered while buying Home Insurance
By and large, the covers and premium rates with various insurers are the same. Therefore, shopping for home insurance is not very difficult. However, there are a few things one should keep in mind.
Adequacy of sum insured: Since sum insured is the basis of compensation, it is important that it reflects the correct property value. Most people make the mistake of choosing the sum insured equal to the market value of the house. However, the company pays on a reinstatement basis, which keeps fluctuating with construction costs.
On an average, one can take a 10-15% increase in the cost of construction (this differs from city to city) every year. One can check construction rates from the municipal corporation or real estate websites. However, arriving at an exact figure is difficult.
A customer can also opt for an escalation clause for increasing the sum insured every year. The escalation may be up to 25% of the sum insured
Tenure of the cover: One can either go for an annual cover or choose a multi-year policy. While the annual policy will give the option to revisit the sum insured’s adequacy every year, a long-term policy offers discounts which can be as high as 50%, depending on the tenure.
Service: Though most products look alike, the quality of service may differ. So, it will be wise to check the claim settlement record of the insurer. A customer-friendly approach to reporting and handling of claims will be of immense help in the event of a loss.
Estimating Retirement Corpus needed which can be used to identify retirement goal and corpus needed to fund during retirement. This amount should also be ideally added to one’s Insurance analysis.
Step 1: Estimate your current needs
The first step in calculating the retirement corpus is finding out how much money one requires currently. Consider for example that the person’s family earns Rs 4 lakh annually and savings is around Rs 1 lakh. This means that about Rs 3 lakh is required annually to meet expenses.
Step 2: Adjust for inflation
After the amount that is required per annum is derived, one needs to calculate how many years the person has to accumulate the retirement corpus. Suppose current age is 35 years and plan to retire is at 65. Financial support is needed from the age of 65, which is 30 years from today.
Further, an assumption of average inflation rate of 8 percent for the next 30 years is taken into account. The inflation adjusted amount can be calculated by using the following formula:
Today’s value * [(1 + inflation rate) number of years left to retire])
We now substitute our estimated figures in the above formula:
= Rs 30,00,000 (figure rounded up)
This means that 30 years from now, about Rs 30,00,000 every year is required to maintain the same lifestyle.
Step 3: Determine approximate life expectancy
For calculating retirement amount, let us assume that the person will live till the age of 85. This means a plan is needed for 20 years.
Now, in the earlier step, we calculated that Rs 30,00,000 is required every year. So for 20 years, we will have to multiply this amount by 20.
Rs30,00,000*20 years= Rs 6,00,00,000
Keeping in mind that current expenses add up to Rs 3 lakh per annum, the approximate amount required after retirement is Rs 6,00,00,000.
By substituting the values in the above example with one’s yearly expenses a person can derive the amount he/she needs for retirement years.
We hope we have answered your queries on why planning for retirement at an early stage is beneficial for you. If you still have any unanswered questions or need help, feel free to contact us here.
We would be glad to help you with your planning and investment related decisions.
Debalina Roy Chowdhury
17 June 2016