Do we need insurance? This is a question is in everybody’s mind If yes, what is the amount of insurance cover one needs? In this article we have tried to answer for all the queries.
Life insurance and its Need:
Life insurance or Life assurance, is an agreement with the an insurance company which guarantee’s you to compensate for the specified loss, damage, illness or pre-mature death of insured in return for payment for a specified premium and term. The origin of insurance is from old French word ‘enseurance’ later Middle English word ‘ensurance’.
It’s an unpleasant thing to imagine that tomorrow “I” may not be there in this world, leaving your loved ones’. But if you do not want to leave your loved ones’ with financial distress then it is necessary to think about having adequate life cover, so that your family does not compromise on their standard of living in your absence.
It does not make sense to look at life insurance as an investment vehicle but rather a Risk covering instrument. Certain types of Life Insurance have some part of savings element which is used for investment purpose by the insured company. Accrued interest over pooled capital is distributed among Insured’s which is commonly called cash-value. This is much like a bank paying certain percentage of interest for making use of your money.
Need for insurance at different stages of Life:
Most of us have financial goals and we start saving/investing for these goals. This saving will have an impact from the required life insurance proceeds to provide for that particular goal. One’s Insurance requirement keeps changing at various stages of life, depending on their liabilities, goals, net worth.
Following are the different stages of life according to which the need for insurance changes:
|Young Professional||Long Term Wealth creation and Parents’ caring.|
|Newly Married||Securing non earning member’s future (meeting expenses), liabilities (Loans if any), long term savings.|
|Proud parents||Children’s education, safeguarding and enhancing existing wealth, planning for retirement.|
|Retirement : Golden Years||Security for spouse, regular income, health and medical expenditure.|
Evaluating your insurance needs:
People merely stick to a round off number say 50 lakh to 1 crore as a combined cover through various policies wherein situation may arise such that their total debts and future obligations exceed this value. At the time of purchasing Life Insurance, one should assume the situation that if one dies, how and what is the corpus the family would require. Thumb rule for taking insurance cover is 10-15 times of one’s annual income. For instance: if a person has a net annual earning as 10 lakh the total cover required by them is 1 crore-1.5 crore. Normally, insurance needs can be evaluated by three methods:
- Income Replacement.
- Economic value of Human Life (HLV).
- Need Analysis Method.
Income Replacement of evaluating life insurance needed:
In this method, based on the future earning potential of the client present value can be estimated and accordingly one need to go for appropriate Insurance cover. Considering the factors like, client’s current salary, anticipated salary growth rate, and his/her work-life expectancy (retirement age) we can arrive at the amount of Insurance need.
Below is an illustration showing the amount of insurance needed using the Income Replacement Medthod of calculating Life Insurance
|Current Salary||Rs.10,00,000 p.a|
|Salary Growth rate||5%|
|Estimated Insurance Need||1,61,41,074|
This method fails to address the issue of retirement needs for the surviving spouse irrespective of his/her employment and contribution to the family.
Human Life Value or Economic value of Human Life (HLV):
This theory is different from previous one where, a person’s earning capacity is capitalized over his/her lifetime. Dr. Solomon S. Huebner purported the HLV approach.
Although everyone is unique and irreplaceable in their own way, each human life potentially has an economic value, in the way of their earning capacity and financial dependency of other lives on that earning capacity. In this method, present value of person’s net future earnings after deducting tax payable, self-expenses and insurance premiums being paid is capitalized as insurance cover. Factors considered for calculation are: Future income of the earning member (excluding self-expenses, tax payable and insurance premiums borne by earning member), monthly income to the dependent members and rate of interest at which the HLV is estimated.
The best way to understand is by the illustration tabled below:
|Net Income||Rs.10,00,000 p.a|
|Age of the person||30|
|Salary Growth rate||5%|
|Estimated Income Corpus||Rs.1,30,30,696|
|Monthly household expenses||50,000|
|Estimated Expense Corpus||1,08,91,452|
|Outstanding Loans’ amount (if any)|
|Total insurance cover( after adding loans’ and education expense)||2,39,22,149|
|Liquidable assets ( if any)||1,00,00,000|
|Existing insurance cover||50,00,000|
|Additional insurance cover required (after deducting liquidable assets and existing cover)||89,22,149|
There were few issues which was overlooked in the above calculation mentioned below:
Firstly, it presumes that spouse has no economic value.
Secondly, several financial obligations were not taken in to account as there may be immediate expenses which might leave family in distress.
These issues led to the adoption of most widely used, need analysis method or Expense method.
Need Analysis Method or Expense Method of Evaluating Life Insurance needed:
As the name suggests, this method mainly focus on needs of family rather than assessing insurance needs through one’s income. Deeper analysis on one’s family liabilities, goals and expenses makes a person feel more comfortable with need analysis approach. Currently most of the financial advisors approach this method to get more realistic results.
In Conclusion, it is advisable for one to consult a financial planner /adviser who can delve into your goals and expenses to get a realistic need for the amount of insurance needed. realistic
We hope we have answered your queries. 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.
Para Planner- Dilzer Consultants Pvt Ltd