Life Insurance : A Certain Financial Companion in Uncertainty

Why Invest In Life Insurance ?

Life Insurance is a financial cover for a contingency linked with human life, like death, disability, accident, retirement etc. Human life is subject to risks of death and disability due to natural and accidental causes. When human life is lost or a person is disabled permanently or temporarily, there is loss of income to the household.

Though human life cannot be valued, a monetary sum could be determined based on the loss of income in future years. Hence, in life insurance, the Sum Assured ( or the amount guaranteed to be paid in the event of a loss) is by way of a ‘benefit’.  Life Insurance products provide a definite amount of money in case the life insured dies during the term of the policy or becomes disabled on account of an accident.

Why you should buy Life Insurance:
All of us face the following risks:
Dying too soon
Living too long

Life Insurance is needed :

• To ensure that your immediate family has some financial support in the event of your demise
• To finance your children’s education and other needs
• To have a savings plan for the future so that you have a constant source of income after retirement
• To ensure that you have extra income when your earnings are reduced due to serious illness or accident
• To provide for other financial contingencies and life style requirements

Who needs Life Insurance:
Primarily, anyone who has a family to support and is an income earner needs Life Insurance. In view of the economic value of their contribution to the family, housewives too need life insurance cover. Even children can be considered for life insurance in view of their future income potential being at risk.

How much Life Insurance is needed:
The amount of Life Insurance coverage you need will depend on many factors such as:

• How many dependants you have
• What kind of lifestyle you want to provide for your family
• How much you need for your children’s education
• What  your investment needs are
• What your affordability is

3 Ways to calculate your insurance needs

 Calculating how much life insurance you need is one of the most important financial decisions you will ever make. It should never be an isolated decision depending only on how much of a premium you can afford.

Having said that, there are many ways in which you can determine how much insurance you need.

Here we give you a few.

Income Replacement Value

This is one of the basic methods of insurance calculation and is based on your current annual income.

Insurance needs = annual income * number of years left for retirement.

Let's say your annual income is Rs 5,00,000. And you are 45 years old with 15 more years for retirement. 

In this case your 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 you may have on your housing loan, personal loan etc.

Human Life Value (HLV)

This method of calculating life insurance is based on contribution that one makes and would have made to her/his family in case of sudden demise. So HLV is defined as the present value of all future income that you could expect to earn for your family's benefit. It also includes other value you expect to contribute, less personal expenses, life insurance premiums and taxes through your planned retirement date.

Let's see this example for better understanding.

John is 40 years old and plans to retire at 60. His current salary is Rs 3 lakhs and is expected to remain same every year. His personal expenses, life insurance premiums that he pays and taxes are around Rs 1.25 lakhs. His contribution to his family is rest of his salary of around Rs 1.75 lakhs.           Here, John's Annual Life Value (his economic contribution to his family post his expenses) is Rs 1.75 lakhs.

Suppose John dies at 41, then the economic value  (namely Rs 1.75 lakhs) he would have added every year (from age 41-60) to his family is no longer there. So to protect this economic value, John can use life insurance as a safety valve so in case of his death, this economic value can come to the family.

Gross Total Income: Rs 3 lakhs

Less Self - Maintenance Charges: Rs 1 lakh

Tax Payable: Rs 10,000

Life Insurance Premium: Rs 15,000

Surplus Income Generated for Family: Rs1.75 lakhs

If this surplus income is capitalised at a discount rate (expected return rate) of 8 per cent per annum for 20 years, then the HLV will be = Rs 175,000*10.6 = Rs 18.55 lakhs.

In short, Human Life concept arrives at an estimate of insurance cover required as on date to protect the income earners' economic value to their families including their future earning potential and capacity.

This multiplier 10.6 above can be calculated using the Present Value Function in an Excel spreadsheet {Go to excel spreadsheet; click on Insert tab; click on the 'Function' option; select function PV (that is the present value of your investment)  it gives the total value of a series of future payments that is worth today}. A box opens up where in you can fill in the above values for rate (8%, that is the return one can expect over the next 20 years), period (20, assuming you will make payments for the next 20 years) and pmt (payment made every year and which cannot change during the next 20 years) and Type (a logical value which should be 1 at the beginning of the period; it becomes 0 at the end of the period, that is, at the end of 20 years).

Rate = 8 %

Period: 20 Years (Age 41-60)

Pmt: Rs 1 will give you this multiplier. If you put Rs 1.75 lakhs here it will give you the value of Rs 18.55 lakhs

Needs Analysis 

In this method, you can assess your needs and the needs of your loved ones and make a calculated assessment.

The most critical factors are the number of dependents you have and their needs.

Other major factors to consider are:

• Loans
• Kind of lifestyle you want to provide to your family
• Provision for non-working spouse who would no longer get an income
• Child's education
• Child's marriage
• Providing for financially dependent parents
• Special needs
• Dreams and aspirations such as contributing to charitable causes

Once you determine the above factors, you run the following calculations:

1. Lump sum needs on Life to be Insured's death

    a. Home loan payoff

    b. Car loan payoff

    c. Child's education

    d. Child's marriage 

    e. Emergency fund post death

2. Monthly income needs

    a. Monthly expenses  

    b. Income of Living spouse in case she                  earns, or rent or interest.

     c. Shortfall = (a-b)

Shortfall is a-b. Suppose, expenses are Rs 50,000 and spouse's income is Rs 30,000 post tax, then shortfall is Rs 20,000 (50,000-30,000).

   d. Monthly income needs till child turns 21          or is self-sufficient:

   e. Number of years to go: For the child to              reach 21 and post that for the spouse              till her age of 80 or 90 years.

   f. Annual income needs: Of spouse,                       children or dependents

   g. Total income needs: Of spouse, children          or dependents

3. Sum up the current invested assets and current life insurance cover. Now see how much this total differs by what you have calculated above. This will be the shortfall (considering that you die today) that you will need to get covered. But do note that invested assets exclude residence, car and other personal assets.

Picking the right one-

The one that we suggest and is mostly followed by reputable financial planners for decades is the Needs Analysis Method. Once you determine the amount of life insurance need, just buy the lowest cost insurance plan that's available to you.

You should buy insurance after a thorough calculation of capital (lump sum needs on death such as paying off a loan, daughter's marriage or education) as well as the income needs of your family after you are gone.

Ask yourself: If something were to happen to you, what kind of corpus would your family need to maintain their current lifestyle, to fund your child's education as you had envisaged, retirement income for your wife etc.

Most middle-class individuals have insurance policies in the range of Rs 1,00,000 to Rs 10 lakhs. Some of the wealthier ones have more than this.

The question they need to answer is: How long would Rs 10 lakhs suffice?

Finally, remember that your insurance needs go down over a period of time. Hence if you find yourself with a sudden windfall or have accumulated enough wealth, then you can evaluate the need to altogether terminate your insurance policy.

Insurance terms you must know

It's easy to get confused when opting for an insurance policy. The jargon can be quite overwhelming and you may end up getting baffled and going for whatever the agent recommends.

Here we explain the basic insurance lingo that you must get a grasp on.

1. Premium

This is the amount you pay to the insurance company to buy a policy.

A single premium policy will need you to pay just one lump-sum amount.

The annual premium policy will require you to pay every year. This will go on for a fixed period of time. The exact number of years will depend on the scheme in question.

2. Insurer and Insured

The person in whose name the insurance policy is made is referred to as the policy holder or the insured. So, if you have taken an insurance policy, you are the policy holder, the one who is insured.

The person whom you name as the nominee is the one who will get the insured amount if you die. The nominee is referred to as the beneficiary.

The Insurer is the insurance company that offers the policy.

3. Sum Assured and Maturity Value
Sum assured is the amount of money an insurance policy guarantees to pay before any bonuses are added. In other words, sum assured is the guaranteed amount you will receive.

This is also known as the cover or the coverage and is the total amount you are insured for.

Maturity value is the amount the insurance company has to pay you when the policy matures. This would include the sum assured and the bonuses.

Let's take an example of an endowment policy.

If the policy holder passes away before the policy matures, the beneficiary gets Rs 2,00,000 along with the bonus too (if any).

If he is alive when the policy matures, he will get Rs 2,00,000 as well as any bonuses declared during the tenure of the policy.

Let's say the bonuses amounted to Rs 1,00,000. His maturity value would be Rs 3,00,000 (sum assured + bonuses).

4. Bonus

This is the amount given in addition to the sum assured.

Reversionary bonus is a bonus that is added to policies throughout the term of the policy. It may or may not be declared every year. When it is declared, it will not be given to you immediately.

It will be payable as a guaranteed sum to the policyholder either at the end of the policy, or, if death occurs before that, to the nominee.

This bonus can either be a with-profit bonus or a guaranteed bonus.

A with-profit bonus is linked to the profit of the company. If the company makes a profit, it declares a bonus in accordance with the profits. The profits are added to your insurance policy and given to you either on maturity of the policy or to your nominee if death occurs before that.

This bonus will be flexible as it is dependent on the performance of the company. However, once it is declared, it becomes part of your sum assured.

This is offered purely at the discretion of the insurer and depends on the profits made that year.

As opposed to a with-profit bonus, there is a guaranteed bonus.

This is part of the sum assured. It will be paid to you irrespective of the profits of the company.

5.Term

The term is the number of years you bought the policy for. So, if your policy lasts for 10 years (the number of years is your choice), it is referred to as one with a 10-year term.

6. Term Insurance 

Term plan is a type of insurance policy. 

It provides policyholder with protection only. If the policyholder dies within the specified number of years (the term), his nominee gets the sum insured. If he lives beyond the specified period, the policyholder gets nothing. 

This is the cheapest and most basic type of life insurance.

7. Endowment Insurance
You are given a life cover just like term insurance. If you die during this period, your beneficary will get whatever amount you are insured for.

Unlike a term insurance cover, if you live, an amount will be paid to you on maturity of the plan.

This kind of policy combines saving (because money is given to you on maturity) with some protection (your nominee gets an amount if you die).

8. Rider

It is an optional feature that can be added to a policy.

For instance, you may take a life insurance policy and an add on accident insurance as a rider. You will have to pay an additional premium to avail this benefit.

9. Annuity

Annuities refer to the regular payments the insurance company will guarantee at some future date. So, say, after you cross 55, the insurance company will start giving you a monthly or quarterly return. This is known as an annuity (premium is what you pay them).

This is often done to supplement income after retirement.

10. Surrender Value & Paid-up value

Halfway through the policy, you might want to discontinue it and take whatever money is due to you.

The amount the insurance company then pays is known as the surrender value. The policy ceases to exist after this payment has been made. Do remember, you will lose out on returns if you withdraw your policy before time.

Paid-up value is different. If you stop paying the premiums, but do not withdraw the money from your policy, the policy is referred to as paid up.

The sum assured is reduced proportionately, depending on when you stopped. You then get the amount at the end of the term.

11. Survival Benefit

This is the amount payable at the end of specified durations. These amounts are fixed and predetermined.

Let's take an example.

Now the policy promised to give back a portion of the sum assured (10%, 15%, 20%, 25%) every three years.

After 3 years: Rs 20,000
After 6 years: Rs 30,000
After 9 years: Rs 40,000
After 12 years: Rs 50,000
On maturity: Rs 60,000

Should you die during this tenure, your beneficiary will get the entire Rs 2,00,000. Irrespective of whether or not you have been paid any amount till date.

We have tried our best to cover important aspects of life insurance if you still have questions about life insurance you can contact us at info@investaxindia.com.

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