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Monday, Aug 26, 2013

How much life insurance do you really need?

   [Source : The Economic Times]

Insurance is possibly the best financial tool to protect yourself as well as your valuables from unforeseen circumstances. Have you, however, ever wondered how much insurance - particularly life insurance -- is actually good enough for you? For instance, you might have several insurance policies, but are you also adequately insured? You need to know this, not only as an individual but as a consumer too - particularly in view of the fact that a majority of Indians are still either uninsured or underinsured.

For, while too little life cover could result in the family not being financially self-sufficient in the event of the unfortunate death of the policyholder and chief wage earner, too much insurance would mean higher outgo of premiums at the cost of other necessary lifestage and lifestyle spends. However, getting adequately covered is also not easy as "there is no one formula for deciding the amount of life insurance one needs," informs Ashish Kapur, CEO, Invest Shoppe.

There are, however, certain thumb rules which could be used to determine the life insurance needs. A very rudimentary method is 10-12 times your annual earnings.

"This is a thumb rule used to calculate the amount of insurance required by an individual. The sum insured basically should be equal to an amount which, if invested, should fetch a regular income for the dependants of the insured so that they are able to maintain a lifestyle which they are used to. In case there are any liabilities, such amounts should be added to the amount of insurance required," says Rajesh Relan, MD, PNB MetLife India Insurance.

The optional approach to ascertain the life insurance need is the financial need analysis approach. This is an approach which can take care of specific needs of an individual. Here the basic objective is that the insurance coverage should be sufficient to provide for the dependents' needs in case the breadwinner should die early.

"The needs should include the client's financial liabilities such as home loans, car loans etc and the funds required to support the dependants for the desired period. It may also include money required for specific family needs such as son's/daughter's education or marriage," says Kapur.

For example, if Mr A has a housing loan of Rs 40 lakh, a car loan of Rs 5 lakh and his family requires Rs 50,000 per month if he is no more, the life insurance cover should be equal to the amount which will earn Rs 50,000 per month for the family and liquidate his outstanding home loan and car loan.

According to another view, while choosing a cover for a person with dependants, the sequencing should be 'risk cover' first and then 'savings'. "The amount of cover is a factor of income and consequently the paying capacity, the nature of job, expected earning period, and amount of liabilities (personal loans, housing loans etc) reduced by any estate already existing (savings & investments)," says Kapur.

To begin with, he says, an assessment of one's own financial needs taking into account the life stage, risk profile, dependants, disposable income and liabilities has to be undertaken. This will help identify the protection and savings needs for the person. The protection should provide for all the liabilities and future earning potential of the person insured. This will at a minimum ensure that the lifestyle of the dependants is not significantly altered if anything unfortunate were to happen to the person. The savings portion will be determined by the financial goals of the individual.

Thus, the amount required to maintain the standard of living will be based on a comfortable projected monthly expenses indexed for inflation. A person would require at least this amount towards monthly expenses. The actual requirement would be closer to 120% of the amount to account for inflation and increasing it for health related expenses.

For example, let us consider a male aged 30 years with current expenses of Rs 20,000 pm will retire at 60 years. Taking into consideration an average inflation rate of 5% pa, his projected expenses at retirement will be Rs 87,000 pm. However, average expenses per month during retirement @ 120% will be Rs 1,04,000. Thus, the amount required at retirement will be Rs 1.90 crore (assuming no inflation and that the person survives for 15 years after retirement).

"Needless to say, the key to any financial planning is to start early as the contributions required are lower and the power of compounding ensures large savings," advises Kapur.

Another method used is the Human Life Value (HLV) method. According to this method, the amount of insurance one should buy is directly dependent on his/her economic value, otherwise known as the 'Human Life Value'. This varies from person to person. Human Life Value is the capitalized value of the net earning of an individual for the rest of his working span.

Under this approach, the effort is to estimate the future earnings of an individual and capitalize them with an appropriate discounting factor (a reasonable rate of interest) keeping in view the present inflation and bank rate. "This present value of the total future earnings is thus the total economic surplus available to the dependent family (as an economic unit). The surplus amount, however, does not include the individual's self maintenance charges, statutory or legal taxes, and also the existing life insurance premium," says Kapur.

For examples, suppose a person with monthly income Rs 10,000 has his personal expenses of Rs 3000 . He would be able to provide Rs 7,000 to his family every month. This translates into Rs 84,000 on an annual basis. So, in order to provide this money to the family year he needs make an investment of Rs 12, 00,000 which at a risk free rate of return of, let's say, 7% would generate Rs 84,000. Hence, the HLV is Rs 12 lakh.

Under yet another approach, usually called 'Underwriters Thumb Rule,' life insurance need is a multiple of annual income depending on the age (see below). As an indicative rule, for instance, individuals between 20 and 30 years of age should have life insurance worth 15 times their annual income, while those above 56 years of age can have 6 times their annual income.

Once you know how much life insurance coverage you need and for how long, it's important to analyze your needs. Need analysis is fundamental to choosing the right insurance product. "Typically you would have any/all of the following needs - protection, wealth accumulation, wealth maintenance, and retirement," says Relan.

Protection needs include protection against death, disability and dreaded diseases. Products which are suitable for this need are term or whole life insurance with riders like critical illness, waiver of premium (WOP) or accidental death benefit (ADB).

Wealth accumulation needs include saving for children's education, marriage and/or getting them settled. It also includes saving for one's retirement. Suitable products in this category are endowment, money back and whole life plans.

Wealth maintenance need indicates that you have reached a stage in your life where you have already accumulated some money and you now desire to protect and grow it in a tax-favoured manner. Short-pay endowments, pensions and single premium policies are products suitable for you for such a need.

And finally retirement need arises when individual reaches such a stage in life when one does not anticipate future inflows and he/she has to provide for a regular inflow out of the monies that a person has accumulated. "So all your accumulated wealth has to ensure that you go through the golden years of life without any worry. You could consider single pay/short pay pensions or immediate annuities for such a need. A flexible unit-linked endowment structured with regular partial withdrawals also could be suitable for such a need," says Relan.

Once you have understood your need and the suitable products for that need, you have to choose whether to buy a unit-linked or a traditional policy. Unit linked or traditional are two mechanisms to achieve your protection or wealth management goals. Traditional plans generally would have guarantees over the long term and hence are unique in the entire spectrum of financial products. Unit linked plans are also an effective mechanism to plan for your financial freedom as they give you the option to decide where you want to invest your money - equity or debt. However, they generally do not have any significant guarantees.

One significant point to note is that while choosing a cover for a person with dependants, the sequencing should be 'risk cover' first and then 'savings'. However, if possible, the investment part should also be factored in.

"Insurance as an asset class is emerging not only as a means of protection for dying too young but against the risk of living too long. In that sense, the right insurance must have not just protection element but an investment portion too. This is possible if people look at life insurance as a long-term financial plan and allocate at least 20% of their monthly savings to this important asset class," says Dr P Nandagopal, MD & CEO, IndiaFirst Life Insurance.

However, once you have decided on the need, the product and the mechanism, ensure the following before you sign on the dotted line: (a) Understand clearly how the suggested product fits in with your need, (b) understand which part of the amount illustrated is guaranteed and which is not. This is required to be illustrated as per the regulator and you should insist on seeing this. Also, do not accept illustrations based on historical returns of a fund as historical returns are indicative and do not guarantee future returns.

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