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Less Is Not More

Author: Sunil Kumar Singh /Tuesday, February 23, 2010/Categories: Insurance, Profit

Less Is Not More

Rs 5 lakh, 10 lakh, 25 lakh, 50 lakh, 1 crore or more? Have you ever found yourself at your wits’ end on how much life insurance cover you should actually buy? Many prospective insurance buyers are at a loss as to how to fix on the sum insured of the life insurance plan they intend to go for. Many of them end up buying a life cover either because their agent has told so or because of their sheer ignorance of the insurance cover. 
Whatever it is, but if you are one of these prospective buyers beware as you could to buy a cover that is not enough for your family. The whole idea behind buying a life insurance cover is to ensure financial security for your family members and dependents and meet their financial needs, when you as the sole breadwinner of the family are not there. 
The amount of life cover therefore should be able to provide the same standard of living to the family after the demise of the family’s sole earner. The cover should be able to meet the family’s expenses going forward and the goals which member would have identified.  
Finding a right life insurance cover thus involves a process where you must calculate the actual financial needs of your family members when they truly need it. Many a time, you must have heard a financial advisor talking about the thumb rule that says one needs to take a cover equivalent to 10-12 times of the annual income. The thumb rule gives you an estimate but it is not enough. What you need to know essentially is a well-calculated figure of how much insurance cover is appropriate for your family. 
There are broadly two ways you could measure adequate life cover and figure out how much life cover you require — Human Life Value (HLV), and second, Need Based Analysis.

Finding A Way Through HLV
The human life value of a person in simple terms is his expected lifetime earnings. There are several ways to arrive at the HLV. The simplest and the commonest way is to multiply your existing yearly income with the number of years you intend to work more. For instance, if your current annual income is Rs 6 lakh, your age is 30 years and you plan to retire when you reach 65, your HLV would be: 35×6=21 crore. This amount then needs to be discounted for inflation to arrive at the present value of future money. That is the least amount you would end up earning until you reach 65, assuming your annual income remains constant. However, the biggest problem with this simplest approach is that your income doesn’t remain constant all through your life. Rather it keeps on increasing and hence this approach doesn’t give you the exact amount of insurance cover you need to buy.   
There are several other ways to arrive at the HLV however there is one thing in common in all methodologies: the HLV gives you the total earnings or amount of rupees you are expected to earn through the rest of your working life, less taxes and personal expenses. Thereafter your future earnings have to be discounted for inflation to arrive at the current HLV, which is the amount that must equal your life insurance cover. 
There are three most crucial factors when estimating the human life value: your age; the current and future expenses; and the third, the current and future income. For instance, if you are a 33-year-old working executive, earning a yearly income of Rs 480,000 with annual personal expenses of Rs 50,000, pay a total tax of Rs 30000, have a liability of Rs 25 lakh (including home loan, personal loan and credit card outstanding balance), have liquid assets (in the form of cash, FD, bank savings, MF, shares), have existing life insurance of Rs 5 lakh, your estimated HLV comes to Rs 2.5 crore. 
There are various other ways to arrive at the HLV. In How to Find Your… you can calculate how much is your HLV. HLV method however is more suitable for youngsters who have recently been employed, are unmarried and are not having any dependents. As Prakash Praharaj, SEBI Registered Investment Adviser and founder, Max Secure Financial Planners, Navi Mumbai says, “For younger persons not having dependents, human life value approach in which the discounted value of future income is taken as a yardstick.”

Need Based Analysis Method
The human life value method takes cumulative earnings of the insured through his entire life without taking into consideration the actual needs of the dependents and self. It is exactly this gap that the need based analysis seeks to address.
In experts’ view, need based analysis is a more accurate and reliable way to arrive at an insurance cover as it takes into consideration each of the dependents' needs as well as goals in case the family’s sole earner is no more. 
“A need based analysis is the more appropriate method of estimating the insurance cover requirement as it is based on the actual need of the family. Human life value takes into consideration only the income but leaves the other requirements such as child education and loan liabilities which may be more important and will need instant money to fulfill them else the family may face difficulties,” says Jitendra Solanki, Founder, JS Financial Advisors, New Delhi.
The need-based method is more appropriate for married persons who are the sole earning members and who have dependents and liabilities such as children's education, their marriage and home loan.  Adds Praharaj, “The adequacy of life insurance cover is best assessed by needs analysis approach in which the amount of each financial goals say educational goal, marriage goal, expenses of the family in the remaining period of life with the current life style, current liabilities on account of loans are added and available liquid assets are deducted.” 
The basic premise that a need based analysis works is find out the actual amount that would be needed to not only maintain the surviving dependents but also to meet their needs and goals. That way need based analysis is more comprehensive than HLV that considers only your income.
Ask these questions if you want to arrive at an insurance cover using need based approach: Does your dependents (such as spouse or child) have enough funds money to pay off your debts such as home loan etc? Do your dependents have enough income if you are no more? Is your child has enough funds to complete his education?
Let’s assume Aditya has to figure out the amount of insurance he needs to take care of his small family comprising of his spouse and a 6-year-old son. If he follows the need based approach, he has to first estimate his family’s immediate needs for the remainder of his life as follows: Family medical expenses: Rs 5 lakh; loans including credit cards outstanding balance: Rs 40 lakh; emergency fund: Rs 10 lakh. Subtotal: Rs 55 lakh. Further, he has to estimate current and future needs and expenses of his family that include: needs and education expenses for his dependent child for 20 years: Rs 20 lakh; his wife’s needs for the next 30 years if she is not earning: Rs 1.2 crore. Subtotal: Rs 1.4 crore. By adding both the sub totals the sum is Rs 1.95 crore, the amount that his family would need should he die. However, he also has to take into consideration the total assets (current as well as long term) that he owns vis-à-vis his needs to arrive at the right insurance amount. His assets include bank deposits: Rs 5 lakh; investments in FDs, mutual funds and stocks, PPF: Rs 7 lakh; retirement savings: Rs 3 lakh; existing insurance cover: Rs 5 lakh. Subtotal: Rs 20 lakh. 
This means his actual life insurance need is the difference between his family needs (Rs 1.95 crore) and his existing assets (Rs 20 lakh) i.e Rs 1.75 crore. 

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