Methods Of Computation Of Life Insurance Requirement
Life insurance is designed mainly to protect the beneficiaries’ standard of living in the event of the unfortunate death of the breadwinner. Through life insurance the beneficiaries will have the financial resources to protect their future income and pay for immediate and future financial obligations
In today’s world, every person is surrounded by uncertainties which might adversely affect the life of an individual and his family. Securing yourself and your family against any unfortunate event is important in order to avoid any financial stress. But how do you secure your family against any financial stress in case of the untimely demise of the breadwinner of the family? The answer to this question is that it can be done by purchasing adequate life insurance. Life insurance helps an insured or policyholder to finance the beneficiary after the death of the insured which acts as source of income for the family.
Death can be source of loss in two ways. The first one is direct loss which arises to foot the funeral costs, liquidation of debts of the deceased and estate transfer costs like probate, etc. The second one is the loss of regular income. An individual who dies doesn’t suffer financial loss; the financial loss is suffered by those who are dependent on the income of the deceased. Ideally, life insurance should be bought by individuals who have dependents and might get financially affected in case of their demise. Students do not need life insurance as they are generally dependent on their parents.
Life insurance is designed mainly to protect the beneficiaries’ standard of living in the event of the unfortunate death of the breadwinner. Through life insurance the beneficiaries will have the financial resources to protect their future income and pay for immediate and future financial obligations. We need life insurance if our financial obligations at the time of death exceed our financial assets. Life insurance is required in all of the following cases where the individual:
• Is married and has dependent spouse
• Has dependent children
•Has low retirement savings and pension which won’t be sufficient for survival of spouse in the future
• Has elderly parents and dependent siblings
•Has a significant debt or financial obligations for which another person would be legally liable after death.
From the above cases we come to know the importance of life insurance. Life insurance proceeds would help dependents to manage financially in the event of death. The consequence of not buying life insurance can adversely affect the family and they may have to sacrifice some life goals without the regular income of the breadwinner to support them. What should an individual consider when buying life insurance? Families should consider their total financial needs and other resources available when determining their need for life insurance. The needs depend on:
• The number and respective ages of dependents i.e. wife, children, parents, etc.
• The standard of living wanted for dependents if the breadwinner of the family dies
• The amount of other financial resources a family has i.e. savings, investments, dependents earning capacity, etc.
The financial needs of the surviving family members may include expenditures related to death of the breadwinner such as funeral expenses, final medical expenses not covered by health insurance, crematorium expenses, etc.; basic living expenses of surviving dependents such as common expenses of food, clothing, in some cases rent, education, etc.; payments of debts such as home loan, in some cases education loan or car loan, etc.; and retirement income for surviving spouse and possibly for other dependents.
1. Human Life Value Approach :
Human life value approach (HLV), also known as income replacement approach, is the method of estimating a person’s human life value. The HLV calculation is based on the theory that the purpose of insurance is to replace the loss of earnings when a person dies. This approach focuses on the earnings of the individual that would have been lost in case of untimely or premature demise. In simple words, HLV is calculated based on the earning ability of an individual by computing the present value of the income lost by the dependents due to the demise of the breadwinner. How does one calculate HLV?
Following are the steps for computation of the insurance using the HLV method:
• Find the current income of the breadwinner
•Deduct his personal expenses, tax liabilities and life insurance premium as after the demise of the breadwinner he will not have any personal expenses and Income Tax won’t be paid by him as income stops after his demise and life insurance premium won’t be there as payment of premium will stop and the beneficiary will receive benefits out of the life insurance taken
•Find the earning life of the breadwinner from the current age (earning life = retirement age – current age)
•Find out the present value of required income stream by using adjusted returns.
Consider an example: Let’s assume that M R Yadav (31) plans to retire at the age of 60. He is the sole breadwinner of the family which consists of his spouse and son. He is the managing director of XYZ Ltd. at an annual remuneration of Rs10,00,000, increasing by 5 per cent per annum. His personal expenses are Rs2,00,000 per annum. He also pays Profession Tax of Rs5,000 and Income Tax subject to allowable deductions of Rs1,50,000. The rate of interest assumed for capitalisation of future income is 9 per cent. Now let us calculate Yadav’s HLV to recommend adequate insurance cover:
• Step 1: Annual income = Rs10,00,000
• Step 2: Personal expenses = Rs2,00,000 (personal expenses) + Rs5,000 (Profession Tax) + Rs1,50,000 (Income Tax) = Rs3,55,000. Net income = Rs10,00,000 – Rs3,55,000 = Rs6,45,000
• Step 3: Earning life = 60 years – 31 years = 29 years (retirement age – current age)
• Step 4: Present value of income stream = present value will be calculated by adjusting the rate of capitalisation (9 per cent) and rate of increase in salary (5 per cent) with net annual income (Rs6,45,000) for the earning life of Yadav i.e. 29 years. Therefore, the present value arrived at is Rs1,16,32,679.
From the above calculation we come to know that Yadav will have to purchase life insurance of Rs1,16,32,679 so that his spouse and their son can survive with the same standard of living in case of his untimely demise. The premium of the insurance policy will vary company to company and depend on the type of policy.
2. Needs Approach
The needs approach is also called the family needs approach or the total needs approach. It is based on the assumption that the goal of life insurance is to cover the surviving family members’ immediate expenses after the insured’s death, forthcoming expenses and ongoing expenses required in the future in order to fulfil the daily needs in case of death of the wage earner of the family. Therefore, the needs approach determines the amount of life insurance required by an individual based on a deep analysis of needs that would have to be met by his dependents. HLV focuses on the income that would be lost; the needs approach attempts to identify the allocation of that income i.e. income used to procure and fulfil the needs.
This method is divided into three main categories:
• Cash Needs: Immediate needs after the death of the breadwinner such as funeral expenses, medical expenses, etc.
• Net Income Needs: Ongoing family needs i.e. normal daily expenses
• Special Needs: Lump sum needs for specific events such as child’s education expenses or marriage expenses.
Needs analysis has three basic steps: first is to assess cash needs, second step is to assess net income needs and the third step is to assess special needs. Consider an example: Let us assume that the net income needs of Hiten Parekh’s family are Rs1,50,000, including Rs50,000 for his personal expenses, for a 25-year period after the insured’s death. His family consists of his wife and daughter. Let’s take the rate of return for investments as 9 per cent and inflation at 5 per cent. Parekh has plans to get his daughter married after 10 years. He estimates that if the marriage happens today the marriage expenses would be around Rs15,00,000. He has a current portfolio of Rs20,00,000. The estimated final expenses are Rs1,00,000.
Now let us calculate the insurance requirement under the needs-based method.
• Step 1: Immediate cash needs + present value of net income needs + present value of special needs – expected available assets. Immediate cash need = Rs1,00,000. Present value of future expenses = present value will be calculated by adjusting rate of return for investment (9 per cent) and inflation rate (5 per cent) with family needs excluding the personal expenses of Parekh (1,50,000 – 50,000) for a 25-year period. Therefore, the present value of future expenses will be Rs16,54,870.
• Step 2: Present value of the marriage expense of his daughter = present value will be calculated by adjusting rate of return for investment (9 per cent) and inflation rate (5 per cent) with marriage expenses of Rs15,00,000 for 15 years. Therefore, the present value of special needs will be Rs8,56,117. Current portfolio = Rs20,00,000.
• Step 3: Therefore the insurance need of Parekh = Rs1,00,000 +Rs16,54,870 + Rs8,56,117 – Rs20,00,000 = Rs6,10,987. Hence, Parekh will have to purchase insurance of Rs6,10,987 after adjusting all the available assets and expenses required in order to survive life with the same standard of living.
3. Rule of Thumb
Many people rely on the rule of thumb since it is a simple guideline that helps to calculate the amount of insurance coverage. But this method has certain disadvantages as this method does not consider many factors used in other insurance computation methods. Some of the common rules of thumb are as follows:
1) Income Rule or Underwriters Thumb Rule: The quantum of insurance is a multiple of annual income based on the age of the insured or policyholder. The following table depicts the rule:
For instance, if your age is from 20 to 30 you need to multiply your net annual income with 15 to determine the insurance requirement. Under this rule, if your net annual income is Rs1,00,000 and your age is 29 years then you must have a life insurance cover of Rs15,00,000.
2) Premium as Percentage of Income: This rule is based on the premium amount rather than the amount of life insurance coverage. Under this rule, 6 per cent of the breadwinner’s gross income plus additional 1 per cent for each dependent should be spent on life insurance premiums. For instance, Mohan Mekani has a gross salary of Rs2,00,000. His wife is a homemaker and they have two children. As such, his premium allocation by this method will be = Rs9,000 (Rs1,00,000 @ 6 per cent) + (3 @1 per cent @ Rs1,00,000).
Generally, either HLV approach and needs based approach is used in order to compute life insurance as they consider realistic factors whereas the rule of thumb approach fails to consider the unique aspects of each case and treats every case in the same way.
To conclude, we saw three methods which can be used to compute adequate insurance. You can compute your life insurance needs by using any of the above methods based on your requirements in order to avoid over-insurance and under-insurance. Over-insurance as well as under-insurance can adversely affect an individual and his family financially. Over-insurance unnecessarily makes you pay higher premiums and in case of under-insurance you will unable to claim your full loss. So, every individual should understand and know his or her insurance needs.