Insurance: What and how much do you need?
Insurance in its purest sense is protection against a financial loss / uncertainty which includes the risk of illness, disability, damage to property, and the most final of them all - one's demise. The value of your loved one's life is a very sensitive issue as your loved ones are priceless. But it becomes necessary to evaluate a human life in terms of money, in order to safeguard from problems caused by under-insurance.
Human Life Value (HLV) of an earning member in the family could be defined as the amount that the family would require to retain the same standard of living in the absence of the earning member. This would be the maximum amount for which a person can seek insurance protection. The amount of insurance you require can be calculated in a few different ways -but a comprehensive method of calculating this is the PersonalFN's HLV method.
How to calculate HLV
The first step towards calculation of HLV would be to determine the net annual income of the person after deducting the amount spent by him for his personal use. This amount will be the amount that he affords to his family annually.
Mr. Sinha, aged 40 years, earns 15,00,000 per annum and spends 4,50,000 per annum on himself. Hence, he earns a net income of 10,50,000 p.a. for his family. Therefore, as income replacement, his family would require 10,50,000 p.a. for 1 year of life expenses. Each year, with inflation, the family's expenses would proportionately increase, which must also be taken into account.
The calculation will also include specific goal related expenditure.
For example, suppose Mr. Sinha has a son and a daughter both of whom would require 10 lakhs for their educations i.e. a total of 20 lakhs. In Mr. Sinha's absence, this amount is still required such that the children's educations do not suffer. Hence this goal amount can be added to the financial value of Mr. Sinha's life.
Once the HLV has been calculated, the next step is to choose the appropriate insurance product to cover your needs. There are a number of insurance products available in the market today - from term plans to ULIPs to endowment plans and so on. It is important to assess the available products and select the right insurance for your needs.
A term policy is a simple pure life insurance which provides a sum assured in case of the policy holder's unfortunate demise. Most people are not in favour of a term policy, as there is only a death benefit. Also, it is believed that since the insurance is available only for a particular term after which there is no cover, it is not a comprehensive policy.
But the reality is that term policies are the purest form of insurance available today. They are very cheap compared to other insurance policies.
These are traditional policies floated by Insurance companies.
An endowment policy covers risk for a specified period, at the end of which the sum assured is paid back to the policyholder, along with the bonus accumulated during the term of the policy.
The returns on endowment policies are typically very low - approximately 3% to 4% per annum - and often do not beat inflation.
Unit Linked Insurance Plans
These are insurance policies with an investment component. In these policies, the policy holder pays regular premiums (or a single premium) of which part of the money is invested and another part goes towards providing the life insurance cover.
ULIPs therefore combine insurance protection with wealth creation opportunities.
What should you opt for?
It is recommended to always opt for a pure insurance product rather than combining insurance with investments such as what is done by way of marked linked insurance policies i.e. ULIPs etc.
Also, it is seen that traditional policies such as endowment policies and money back policies provide very poor returns, giving a yield of less than 5% per annum over the entire term. This does not even match inflation and hence it is not recommended to take these products. Products like ULIPs and the like have hidden charges and high commissions, which lead to an inefficient use of your funds which could otherwise have been invested. Until these products become transparent, it is not advisable to opt for them.
It is also advisable to opt for the following policies, in addition to your term policy:
• Health Insurance (Mediclaim) - this is a must have for every family member. It can be taken as an individual policy or as a family floater. This will cover regular hospital expenses in case of any hospitalization.
• Personal Accident Policy - this will cover you from loss of income in case of an accident. This is a common policy for those who are employed as the policy partly covers you from loss of income.
• Critical Illness policy - this will pay out a lump sum upon diagnosis of any critical illness from the defined list of illnesses stipulated. This policy can be opted for by any member of the family - it is not meant only for people who are employed as a critical illness might strike anyone, and costs incurred in case of such illnesses can be very high.
It is advisable to opt for insurance because it is a cover from risk - and while you might believe that something will not 'happen to you' - that is often exactly what your neighbor is thinking. In case of an unfortunate circumstance, insurance can be a financial boon to you or your family members.
PersonalFN is a Mumbai based Financial Planning and Mutual Fund Research Firm.