Are you under-insured?
Akash and Varun, good friends and mid-level executives
at an IT firm were part of a financial planning survey conducted in their
office. On being questioned regarding his life insurance status, Akash informed
about two traditional and one ULIP policy that he holds with a cumulative sum
assured of Rs 15 lakhs. Like many people, he had mixed up his family’s
financial protection and investment needs leaving them highly vulnerable.
Varun
smiled at the naivete of his friend. He had kept his life insurance and
investment needs separate. For life insurance, he had a big term insurance
policy of Rs 1 crore. However, the smug look on his face was soon replaced
with a shocked look because after asking both questions regarding their future
goals, current liabilities, investments and family responsibilities the surveyor had concluded that both were
under-insured. Wait. It is a no-brainer that Akash was under-insured but Varun? After
all, he had a term policy of Rs 1 crore. How could he be under-insured?
Read on to unravel this puzzle.
What is Life Insurance?
Life insurance aims to financially protect the dependents
in case of untimely death of the breadwinner. The objective is to provide an
amount that will enable the dependents live a similar quality of life that they
would have led and meet various goals (children’s higher education, marriage,
spouse’s old age needs etc) in case the bread winner was surviving and earning.
Hence most financial experts suggest that life
insurance and savings/investments be kept separate. The best and easiest way to
do so is by choosing a term plan which provides only insurance coverage. It
provides high insurance coverage at very low premium rates.
What is the right life
insurance coverage amount?
The popularity of online policies has seen a surge in
the number of term plans being sold. However only buying a term plan for an ‘x’
amount cannot safeguard your family, the key word here is choosing an optimum
insurance cover. Having an insurance cover which is not able to financially
secure your family’s needs is being under-insured. It is like providing for only
a portion of the needs and defeats the purpose of Life Insurance. This leads us
to the critical question of what is the right insurance cover amount?
Various methods used for
calculation:
One method is to choose an amount that is 8-10 times
your annual income. Another approach is to base the sum assured on the life
stage of the individual. For eg: If you are less than 40 years of age, you should purchase a term plan with a life cover of
approximately 20 times your annual income, if in your 40s then consider a cover of 10-20 times and those in their 50s should opt for a life cover of 5-10 times
the annual income. An expense-based approach suggests that
your life cover be 10-15 times the amount of your dependents annual expenses.
However, these approaches do not consider your current
liabilities, investments and future goals. Every individual’s needs, family
circumstances, number of dependents, life stage, liabilities etc are unique. As
such just choosing an amount that looks big enough or just because your
friend/relative has the chosen that amount without doing the math behind it may
leave your dependents in a financial crunch.
Points to be considered when
calculating your coverage:
1) If
one has a home loan, then on his untimely demise, the entire outstanding amount
will need to be paid in one shot to the lending institution. Going back to
Varun’s example, though he has a cover of Rs 1 crore, he also has an
outstanding home loan of Rs 65 lakhs. In case he meets with an eventuality as
on date, after the loan is paid off, his family will be left with only Rs 35
lakhs for their needs. This should be an eye opener for all of us who are
servicing a home loan or other loans.
2) Further,
inflation needs to be factored in while arriving at the life cover. Yes, Rs 1 crore is a lot of money as on date. You may believe
that this is more than sufficient to take care of your family’s needs. As of
today, it may surely be good. But, assuming a constant rate of inflation of 7%,
after 15 years the value of Rs 1 crore would come down to Rs 36.24 lakh. If the
inflation rate were to increase to 10 per cent or more in these years, the
value would go down further.#
3) The insurance
should also provide for crucial financial goals, such as a children's higher
education, marriage and spouse’s retirement/old age needs.
Just as you periodically review the performance of your various investments and take
corrective action if required, a similar review of your life insurance coverage
needs to be done, especially during critical milestones such as marriage, child
birth etc which increases your financial responsibilities so that the cover is in
sync with your dependents requirements.
Many insurance plans today have an
in-built feature that allows you to enhance your cover amount at periodic
intervals, saving you the trouble of hunting for a new policy altogether. This
feature can also be useful to deal with inflationary trends.
The table
provided below (taken from ET wealth dated July 23, 2018)* presents a cohesive
way to arrive at an optimum life insurance coverage amount. Also, there are
various online calculators for this purpose, however please do keep in mind the
points discussed above.
*Policyholder’s personal
expenses are assumed to be 20% of the household expenses and are to be deducted
**Does not include place of residence as it
cannot be liquidated to meet family’s needs
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