Dying too early is a risk which can shake dream of any family. The premature death of the member can have varying financial consequences. There can be huge debt which need to pay off or the family obligations like children education marriage, retirement for spouse, all remains unfulfilled.So the need of adequate protection arises which in the event of death of a person, who has a dependent family, can provide an amount that will put the family in a position where they are able to continue their current lifestyle till they adjust themselves to the new economic circumstances. If it is not financially possible to achieve, then a reduced lifestyle would need to be decided upon.
Till now insurance was perceived more as an investment & tax saving tool. Due to low awareness and pitch of insurance agents it made people think insurance without return are not viable for them. The demand for protection cover was entirely missing. But with changes in financial services industry and increase information flow on benefits of life insurance, the awareness level increased . The importance of term insurance in protecting the family financially gained prominence,especially among young generations. Entry of Financial Planners in this industry has also helped in making people understand the importance of life insurance in achieving their financial goals.
However, the awareness level has surely increased, but the basic question which indian consumers still ask today is How much insurance do I require or How much insurance will be enough to protect my loved ones ? There have been different approaches taken by insurance advisors & financial planners to advise on amount of insurance one may require for protecting your family. None of this approaches are wrong but has their own limitations.
Here I have highlighted three basic approach considered for calculating the insurance cover and what are the pros and cons of using these:
1. Multiple Approach
Insurance agents from long time have been using a very simple approach of a define multiple of current income to advise on the amount of insurance one should buy. The rationale behind such theory is that if the resulting sum is invested at a particular rate of return, it will earn the same income for the family. For e.g if annual income is Rs 2 lakh, with expected future rate of 6%, you need an investible corpus of Rs 33 lakh to earn the same income. This results in buying a term insurance of 17 times of current income. The income multiplier changes with age group and as per your financial situation.
Age group | Income Multiplier |
20-30 | 20-22 |
30-40 | 18-20 |
Above 40 | 10-12 |
Although the approach covers any individual for a certain amount but the result are not accurate. The strategy has two major drawbacks. First is that it does not takes into account inflation which eats value of your money. So the income which is calculated at 6% today might not be sufffient tomorrow with increase in inflation. Secondly, it depends entirely on the perception that investment rate will remain constant. This is contrary to what has happened in the past where in early 90s interest rates were at 15% and by the end of 90s it decreased to 10%.Someone who have planned considering 15% rate would find income inadequate in later years.
2. HLV or Human Life Value Approach
This approach is being used by financial planners globally and is considered estimating one’s insurance needs fairly accurate. Here we calculate total expected earnings in future of an individual and discount it with rate of inflation to get a sum which gives the total economic value of the earning person. The best part of this approach is that when we derive the expected earnings we take income net of expenses into consideration. Let’s clear this by taking an example. Suppose Rajeev earns an income of Rs 500000 working with an IT company and is currently 35 years of age. The total life insurance premium he pays is Rs 20000 p.a. His net income with current expenses are as follows:
Calculation:
HLV Components | Amount in rupees |
Gross Total Income | 500000 |
Less: Self Expenses | 120000 |
Taxes Payable | 50000 |
LI Premium on existing policies | 20000 |
Surplus income generated for family | 310000 |
This surplus income when capitalized through discounting at rate of 8 % per annum for 25 years term, you get the capitalization value as Rs 3573928.
This is the representative economic value which is made available to Rajeev family in case he survives the term. The point to consider here is that we presume income remaining constant throughout the term which actually takes care of inflation and situation like unforeseen sickness, disability or unemployment.Now this is to be protected with LI cover so that the family continue with the same lifestyle. Hence, this is the insurance cover which Rajeev has to buy to provide a reasonable financial security to his family. Thus, as detailed HLV tends to give a fairly correct estimate of the amount of insurance need of a person.
3. Need Based Approach
A human has various needs which are best described in Maslow Need Theory. In taking a need based approach we classify insurance needs on the basis of priority given to each of these. For e.g. An individual has to provide for livelihood and financial well being of his family which includes parents, especially in India. He has to complete social obligations like children education and marriage, purchase of house etc. and simultaneously has to create and asset not only for himself but which can be bequeathed to family. Hence the physiological & safety need and belonging and love need get priority over esteem need and self actualization need. However, all the above obligation can only be achieved if the earning individual can contribute of his economic value to his family. This may be achieved only through LI policy. The amount of insurance to buy is based on estimate of funds required to meet the family needs created on death.
Need based or HLV
Although both these approaches are successful in estimating a fairly accurate result, still there is a difference.The need based approach to life insurance provide guidelines just to estimate minimum insurance required while a HLV approach gives an estimate of maximum insurance required to fulfill the needs. The need based approach is more practical as it involves the life insured in the process of decision making. In the process, individual or family need is first identified, then prioritized.
Right amount of insurance is necessary to protect your family financially. The need of family will change in the course of time and so it’s necessary that an effective approach is taken and assessed periodically to accommodate changes. Need Based or HLV, there is not a mark up difference but the benefit lies in taking factors into consideration which may affect the financial well being of your family when you are not present. So next time an insurance agent visit your door, make sure you ask him to place the right numbers in front of you.
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