Expert advice

Nov 07, 2012,14.39 IST

Do you have optimum insurance cover?

In an interview to CNBC-TV18 Harshvardhan Roongta of Roongta Securities answered personal finance queries of investors. He also shared his views on how can one know their optimum insurance cover.

Below is the edited transcript of Roongta's interview with CNBC-TV18.

Q: If being under insured is a problem, so is being over insured. What are the complications that an investor might face due to this and how can an investor decide what is the optimum insurance cover for them?

A: The purpose of insurance is that you replace an earning member of the family financially for the dependents. The intent is never to make profit out of it. If under insurance is a concern, so is over insurance - for example, a 30 year old person earns Rs 1 lakh per annum and has got about 30 years of working life ahead of him. Now, we take the economic worth of a person. He has Rs 1 lakh into 30 years of his working, so it's about Rs 30 lakh.

Obviously the next year's income is going to rise, but the number of working years will reduce accordingly. So, we would say a maximum cover a person should take is what he would earn in the entire period of his insurance. Now, because term insurance is available at a very reasonable and a very low premium these days you can get Rs 1 crore cover at a cost of Rs 12,000 per annum. If this person goes ahead and buys a cover of Rs 1 crore in case of his death, his family has to their disposal about Rs 1 crore unlike and otherwise he would have got Rs 30 lakh, so this leads to a situation of over insurance.

This situation leads to a couple of negatives. First, there is a moral hazard in this kind of a situation. If it is more beneficial for this person to die then what is he going to be alive for? There could be instances of crime such as murder to take the benefits of the insurance proceeds. We are not talking about an individual case but we are talking in general and this could lead to a situation like this. Insurance related crimes are a known phenomena world over.
Look at the other side, if after a couple of years a person is under undue financial distress feels like committing suicide because his family will benefit out of the insurance proceeds, he might do so. Suicides are paid for in insurance policies after a one year waiting period and he will not otherwise be able to manage that.
The other impact that is likely to happen is that all individuals have limited resources. We need to allocate them for all our personal finance needs Insurance is just one area of personal finance. There are medical insurances which are required; there is disability insurance which is required. You need to make provisions for your retirement, for holidays, kid's education. In case you are buying more insurance than what you require you are certainly paying more premium, sometimes more than what you otherwise would be paying. You need to balance all these and take adequate cover in each and not overshoot your limits in any one area itself.
Regarding your question as to what is the optimum level of cover that one should have, there are lots of methods by which a person can determine how much cover he should have. For layman’s understanding purposes, one option is that he looks at his annual income. He takes an insurance which is 12-15 times of it. For example, a person earns Rs 10 lakh every year. He buys an insurance upto Rs 1.5 crore and adds another amount which is equivalent to his liabilities.
Suppose he has a housing loan outstanding of about Rs 50 lakh, he then goes for a cover of Rs 2 crore at one shot or he looks at another method which is an expense replacement method. He ascertains that he needs to provide a particular amount every month to his family.

For instance, Rs 50,000 every month and the post tax returns available is about 6 percent. If he has an insurance of Rs 1 crore, his family can deposit that into a bank which post tax returns would be 6 percent, that is Rs 50,000 a month. These are the two basic methods a layman can use for determining the maximum cover he should own. Basically, he would protect himself from over insurance.

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