06 December, 2010

Cover Calculation

Take into account current and future family expenses, inflation, investments and sum assured of existing policies.

How much insurance is good enough is a question most people don’t ask themselves. Many don’t even realise that insurance is a security net, and not an investment vehicle. Most argue that they are paying tens of thousands as insurance premium and are reluctant to discuss additional insurance requirements.

Compounding this, people are not even aware that they require further insurance, over what they already have. Also, the most important benefit of having insurance, which is protection, is not fully appreciated.

Ironically, policy holders want to enjoy the benefits of insurance when they are alive (read investment), and opt for plans that give them some returns. That beats the entire purpose of an insurance policy, which is protection.

Insurance companies have, therefore, built in investment options. This also explains the popularity of unit-linked insurance products, which are essentially investment products, with lots of flexibility built in.

Tax savings is almost an article of faith for many of us. Since insurance comes under Section 80C, the premiums paid for insurance policies are eligible for deductions under this section. This has become one of the most important reasons for people buying insurance policies.

Going in for insurance primarily for tax savings is actually a sub-optimal way to go about tax savings. If one does not require insurance, the mortality charge being paid is actually money down the drain. Take the case of a 50-plus person, who may not have much insurance cover requirement. If he goes in for an insurance policy, the mortality charges he would pay for the cover would be a wasteful expense.

So, the first thing people need to appreciate is the requirement for adequate security cover. Then, they need to know how much cover they require. To find out this, we need to adopt the following method.

Take into account all monthly and annual expenses. About 90 per cent of that figure (it could actually be less) would be a fair estimate of expenses in the absence of the income earner. Subtract the insurance premium ( pertaining to the income earner) and personal expenses of the breadwinner.

Multiply the resulting figure by 23. This figure is about 50 per cent more than the corpus that may be required and is an approximation to account for inflation.

Add to this the specific, goal-related expenses such as education, marriage, and so on. Subtract from this the current investments, assets that can be liquidated (like a second home, land, etc) and insurance cover on the income earner. The resulting figure is the amount of insurance to be taken, additionally.

Let’s compute additional insurance requirement for Ramesh Jha using this method.

Jha and his family have a monthly and annual expense of Rs 4 lakh. Of this, 90 per cent is Rs 3.6 lakh. The insurance premium pertaining to Jha is Rs 40,000 a year and his personal expenses are about Rs 20,000 a year. After subtracting these two, the resultant figure is Rs 3 lakh. Multiplying this by 23 gives us Rs 69 lakh, which would be the corpus requirement to take care of the expenses in future. But then, there are other expenses like education and marriage. These are estimated to be Rs 20 lakh at today's cost. When that is added, the amount required comes to Rs 89 lakh.

From this, subtract current investments. These are Rs 11 lakh in this case. The sum assured of the policies on Jha is Rs 8 lakh. Subtracting these two, the corpus requirement comes down to Rs 70 lakh. He also has a second home, valued at Rs 40 lakh. That could, potentially, be liquidated, if there were a need. Hence, the net exposed amount is only Rs 30 lakh.

By this calculation, Jha would require an insurance of Rs 30 lakh additionally to cover the risk-exposure to his family. This can very easily be taken care of at low cost, by going in for a term insurance. It would cost him under Rs 10,000 each year. That is a pretty low cost to secure the family’s future.

Insurance is protection. All other benefits are incidental. It's time people get this right.

Published in Business Standard on 14/11/2010

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