Life insurance policies may be a common mode of investment, but few are aware of the basics. Most of the people don’t buy life insurance plans as protection against death. The policies are mainly purchased on considerations of savings and tax benefits. Since protection is not the primary concern, people often end up buying the wrong products that charge a hefty premium and provide inadequate cover. Hence, there are a few things one needs to consider before purchasing life insurance policies.
What’s life insurance?
Let us first understand what life insurance is all about.
When you buy a life insurance policy, you enter into a contract with the insurer under which the latter agrees to pay the policy value to your nominee or family in case of your death during the term of the plan. As a policyholder, you will have to pay a premium to the insurer as the cost for the life cover.
The policy value or the sum assured is the financial protection to the family against the loss of income that you could have made during your earning years.
Thus, the optimum amount of life insurance should be enough to replace your future income to protect your family against financial crisis in your absence. A life insurance policy should be bought to cover only the income earning years of your life and not the superannuation stage. For life after retirement, you need a pension plan.
Replacement method
The simplest way to calculate your insurance amount is to measure how much money if invested in a fixed-income instrument can generate an interest income equivalent to your current annual income. Let us assume that you have an annual income of Rs 1 lakh and banks are offering an interest rate of 6.5 per cent on a one-year fixed deposit. Then, you should buy a policy with a sum assured of Rs 16,66,667 (Rs 1,00,000 divided by 6.5 per cent). In other words, your family can earn an annual interest of Rs 1 lakh (which is your current income) by investing the policy proceeds (Rs 16,66,667) in a fixed deposit.
Multiplier of earnings
Another way to calculate your future income is the “multiple of earnings” method. Under this formula, you multiply the current annual income with a suitable multiplier (see chart 1) to arrive at your earnings at the age of 60.
The chart shows that if your are 25, you will use a multiple of 25, though you have 35 years left for your retirement at 60. If you are 55 , you will use a multiple of 10, though you have only 5 years to go before your retirement. This is because the probability of a 25-year-old person’s death is less than that of a 55-year-old.
However, the shortcomings of the above two methods are that they do not take into account the increases in future earnings of the policyholder. The impact of inflation and the additional income that the family can get by investing the policy proceeds in suitable instruments are also not taken into account
Human life value
A more accurate measure, called human life value, was formulated by Solomon S. Huebner, founder of The American College of Life Underwriters, in 1920. The US courts used this method to decide the settlement amount for victims of the terrorist attack on September 11, 2001.
This is the present value of the policyholders’ future earnings, net of their personal expenses, insurance premium and taxes. For instance, Sameer is 40 years old and plans to retire at 60. His monthly income is Rs 25,000. Of this, his personal expenses are Rs 5,000. So, his net annual contribution to the family is Rs 2,40,000.
Till the age of 60, it is assumed that Sameer’s income will grow at the rate of 10 per cent every year. So, his net annual contribution to the family’s income will be Rs 16,14,599.99 at the age of 60.
But at an annual inflation rate of 5 per cent, the value of Rs 2,40,000 will be equivalent to Rs 6,36,791.45 after 20 years. While buying a life insurance policy, Sameer will also have to provide for depreciation because of inflation in the value of income. Thus, the optimum life insurance cover that Sameer needs is Rs 22,51,391.44.
