SWARANJEET ARORA
Insurance is a basic form of risk management which provides protection
against the loss of the economic benefits that can be enjoyed from assets.
These assets may be physical assets, such as buildings and machinery, or they may be
human assets. Assets are subject to the risk that their ability to generate benefits could
be lost or reduced due to unforeseen or unexpected events. There is a financial or
economic consequence to the risk, and insurance indemnifies or protects against these
consequences. For example, the ability of human beings to generate income from
occupation may be affected by illness, disabilities and death; factory buildings &
machinery may break down or may be destroyed leading to loss of output.
The events themselves cannot be avoided. The consequences of the loss
can either be borne by the person to whom the benefits accrue (risk
retention) or they can be transferred to another (risk transfer).
Insurance enables risk transfer from the beneficiary (insured) to the
insurance company (insurer), which undertakes to indemnify the insured
for the financial loss suffered. In return, the insured pays a periodic fee, called
premium, to the insurer to receive this protection. To be insurable, the event being
insured against, such as death, accident or fire must result in a financial loss which
can be quantified and insured against.
The premium payable will depend upon this expected loss and the
probability of the event occurring during the period of contract. For
example, the premium payable on a health policy for an individual whose parents have
a history of ill-health that are considered genetic, such as ailment of heart, cancer or
diabetes, is much higher than that for an individual coming from healthy stock. This is
because the chance that the insurance company will be required to pay medical
expenses in the first case is much higher than what it is in the second case. In the
absence of insurance, the loss arising out of the event has to be borne by the person
who would have otherwise enjoyed the benefit from the asset.
a. Large number of exposure units: Large group of similar, though not
necessarily identical, units are subject to the same peril or group of perils. An
insurance company is able to offer the protection it does because it operates a
common pool in which only a few will suffer loss in any one year. The entire pool pays
premium but the liability for the insurance company will be only to a few in a year. In
the absence of a large number of people being exposed to the same risk, the premium
payable would be much higher and it would be unviable for the insurer and the
insured.
b. Accidental and unintentional: Loss must be accidental, unintentional and
uncertain. The only exception is life insurance where the event being insured against,
namely death, is certain. However, the time of death is uncertain, which makes it
insurable. Loss should be fortuitous and outside the insured’s control.
c. Determinable and measurable: Loss should be definite as to cause and
amount.
d. No prospect of gain or profit :A further characteristic of the insurable risk is
that it does not involve any prospect of gain or profit. This means that, if it was
possible to insure against not making a profit from selling goods in a shop, there
would be very little incentive to try to sell the goods if the owner knew the insurance
company would step in and pay up anyway.
e. Chance of loss must be calculable: Insurer must be able to calculate with some
accuracy, average frequency and average severity of future losses.
f. Premium must be economically feasible: Premiums should not only be
affordable but also far less than the value of the policy. Else the option to retain risk
will be more feasible than transfer risk through insurance.
Insurance removes the risks to the income of a household from situations such as loss
of income, reduction in income or an unplanned and unexpected charge on income
which will upset the personal financial situation of the household. Consider the
following situations:
Siddesh dies young leaving his dependent wife and kids without financial support.
Arushi is a CAD professional who meets with an accident that makes it difficult for her
to sit for long hours at the computer.
Sindhu’s car met with an accident and requires a large sum for repairs.
Mohit suffers from arthritis and has to spend a large sum each month on
physiotherapy.
Jayant’s daughter is getting married in a few days. The house is full of gifts and
valuables. There is a burglary in the house and the valuables are stolen.
In all the situations described above, there is either a loss or reduction of
income or a large expense that has to be met out of available income.
Income is at the base of all financial plans and any event that will affect income of the
individual will affect the achievement of the goals that the financial plan seeks to
achieve.
Insurance can be used to protect the income so that the financial goals are
not at risk. If Siddesh had a life insurance policy for a sum adequate to meet his
family’s financial needs and goals, then he would have protected them from the
financial effects of his death. Similarly, a personal accident insurance would have
provided the income that Arushi required till she recovered from her accident and a
motor insurance policy would have covered the cost of repairs to Sindhu’s car and her
income would not have been affected. There are insurance policies available to provide
cover against most situations that can cause disruption to the income and therefore
the financial situation of the individual.
Insurance is also seen as a way to save and invest. Some insurance policies include a
saving component along with the risk protection. The premium collected will be
higher, with one portion assigned for risk protection (Insurance component) and the
other for the saving component (Investment component). The type of investment
envisaged will determine the risk and return from the investment.
a. Identify insurance need
b. Estimate the amount of insurance required
c. Evaluate the type of policies available for their costs and features
d. Evaluate insurance needs periodically since needs keep changing
Insurance is primarily a tool for protection from financial
loss. Identifying insurance needs therefore requires
identifying all those situations that can result in a loss of
income or an unexpected charge on income. Insurance
needs can be broadly categorized as:
Income replacement needs in the event of risk to the
earning ability of an asset, which includes the life of an
individual as an asset generating income. Life insurance,
Identify
insurance for the maintenance and replacement of plant
and machinery, annuities, are all examples of insurance
products that meet this need.
Income protection needs which protect the available
income from an unexpected charge. Health insurance and
insurance
motor insurance are examples of insurance products that
will take over such expenses if they occur, and thereby
protect the income from a large and unplanned outflow.
need
Asset protection needs which include the need to
protect assets created from theft or destruction. Household
insurance is one such product.
The type of insurance required depends upon the age
and stage in the life of the individual. Insurance
implies a cost and buying insurance that is not required
is a wasteful use of income.
A young individual without any dependents may
probably need a personal accident insurance policy that
will give him an income in the event of him being
incapacitated in an accident, more than a life insurance
policy. The life insurance policy will replace his income Identify
in the event of his death, but since he has no dependents
it may not be as relevant at this stage in his life. insurance
For an individual with dependents, the primary
need is income replacement to support his family in the
need
event of his death and therefore a life insurance policy
that does this will be more relevant. The personal
accident insurance is usually available as an addition to
the life insurance policy.
The purpose of insurance is to compensate the
financial loss suffered from a specified event. It
is not to profit or gain from it. The amount of insurance
required must be calculated giving due consideration to
factors such as the future value of the costs being sought
to be replaced, the period for which protection is
Estimate
required and, the ability to bear the cost of insurance.
Under-insurance will imply that the beneficiary who
is likely to suffer the loss is retaining a portion of the
risk with themselves. Over-insurance would impose the amount
of
unnecessary costs in the form of higher premiums.
insurance
required
Insurance products can be differentiated on the
basis of their features such as premium
payment, nature of cover provided, structuring
of benefits, among others. A product should be
chosen based on the features that are applicable to the
individual, and not merely on the basis of multiplicity of
features available in it.
Evaluate the
type of
The cost associated with the insurance is an
important parameter while evaluating
insurance products. Insurance is a long-term
commitment, and exiting midway is difficult and has policies
financial implications. It is therefore essential to available for
their costs
consider the suitability of the product, features and cost
before signing on.
and features
Every change in the lifecycle of the individual
will warrant a review of the adequacy and
coverage provided by insurance. These include
change in status from single to married, having children
and approaching retirement. Similarly, changes in Evaluate
insurance
financial situation and commitment such as higher or
lower income levels, purchase of home, all trigger an
insurance review.
needs
periodically
since needs
keep changing
A wealth manager has to assess the risks to
which the client is exposed to, and suggest
suitable products to mitigate those risks.
The following insurance products are available
for risk mitigation:
Life insurance policies, to protect the family
from the financial consequences of demise of the
assured
Health insurance policies to cover medical
expenses that the client may have to incur on
self or family
General insurance for protection against loss
of assets through fire, theft, earth quake,
terrorism and such other exigencies.
Life insurance products can be defined by the benefits
that they provide to the insured. The insured would get
the following benefits from life insurance products:
Death cover: Where the benefit is paid only on the
death of the insured within a specified period. If death
does not occur, then no benefit will be paid.
Elements of Life Insurance Products
Survival benefits: Where the benefit is paid when the
insured survives a specified period.
Most insurance policies are a combination of the above
two features. Policies with survival benefits combine
saving and protection benefits while policies with only
death benefits are pure protection products.
Insured: This refers to the person whose life is being
insured and can be individuals, minors or joint lives. If
the life being insured is different from the person buying
the insurance policy, such a buyer is called the proposer An insurance contract has the
following several elements, the
or policy holder and such person should have an definitions of the key ones are as
insurable interest in the individual being covered. follows:
Term of the contract: This is the period during which
the insurance cover will be available to the insured. In
some cases, the insurance company may specify an
upper age limit at which the term of the policy would
end. .
Sum assured: This is the amount being insured. The
Insurance Regulatory and Development Authority
Regulations require all life insurance products with
terms of more than 10 years to provide a minimum sum An insurance contract has the
following several elements, the
assured of 10 times the annual premium for individuals definitions of the key ones are as
below 45 years of age and seven times the annual follows:
premium if age is above 45 years. If the term is less than
10 years the minimum sum assured shall be five times
the annual premium for all individuals. The insurance
contract may also specify situations, if any, when the
sum assured will change. For example, if a term
insurance is taken to cover outstanding mortgage
payments, the sum assured will decrease as the
outstanding loan decreases.
Payment of sum assured: The payment of sum assured
will be on the occurrence of a specific event such as death
of the life insured or expiry of the term of the policy. The
mode of payment of the sum assured, whether in lump sum An insurance contract has the
or as instalments will be specified in the contract. following several elements, the
definitions of the key ones are as
Premium payable: This will depend upon the sum
follows:
assured and the term of the policy. The mode of payment of
premium, such as monthly, quarterly, half-yearly or
annually will be included in contract. Some policies involve
the payment of a single premium at the start. Non-payment
of premium due on a policy within the grace period allowed
will make the policy lapse. The policy can be revived during
the reinstatement period by paying the pending premiums
and penalty.
Bonus: Bonus is an amount that is added to the sum
assured, announced periodically as a percentage of the
sum assured. It is paid out along with the maturity value
or on the occurrence of the insured event.
Guaranteed bonus: Guaranteed bonus is paid for the
first few years of the policy period, say, five years and is An insurance contract has the
following several elements, the
paid as a percentage of the sum assured. It forms part of definitions of the key ones are as
the benefits of the policy and is received at the end of the follows:
term.
Reversionary bonus: This is based on the
performance of the insurance company and is declared
for policy holders at the discretion of the insurer.
Reversionary bonus is declared after the completion of
the guaranteed bonus period and is applicable to
participating policies.
Bonus: Bonus is an amount that is added to the sum
assured, announced periodically as a percentage of the
sum assured. It is paid out along with the maturity value
or on the occurrence of the insured event.
Guaranteed bonus: Guaranteed bonus is paid for the
first few years of the policy period, say, five years and is An insurance contract has the
following several elements, the
paid as a percentage of the sum assured. It forms part of definitions of the key ones are as
the benefits of the policy and is received at the end of the follows:
term.
Reversionary bonus: This is based on the
performance of the insurance company and is declared
for policy holders at the discretion of the insurer.
Reversionary bonus is declared after the completion of
the guaranteed bonus period and is applicable to
participating policies.
While policies are sold under various names, broadly a policy is either a pure insurance
plan or a savings-cum-insurance plan. Insurance premium may be payable only one-time
(single premium policy) or regularly over the life of the policy.
Pure insurance policies are also called term plans. They cover the life of the
assured for a fixed period of 5 to 30 years. In the event of death of the assured, the policy
amount is payable by the insurer to the family of the deceased. If the assured survives the
term of the policy, then nothing is payable by the insurer. Term plans offer life insurance
cover at the lowest premium. Younger the age at which the assured buys the policy, lower
would be the premium.
Savings cum insurance plans are also called as cash value plans. They may be
offered as ‘with bonus’ or ‘without bonus’. If the policy is with bonus then the policy
holder’s account will be credited with a bonus every year subject to the profitability. The
bonus will be paid to policy holder if he survives the term of the policy, or to the family if
policy holder passes away, subject to profitability. The bonus will be paid to the
policyholder if he survives the term of the policy, or to the family if the policy-holder
passes away. The premium payable is higher on ‘with bonus’ plans.
Endowment plans are typically used for covering long term financial
planning goals such as child’s education or marriage. In the event of death of
the assured, the policy amount is received by the family. If the assured survives the
policy period, then an agreed endowment is paid.
Whole life plans offer cover for the entire life of the assured. Policy amount
is payable to the family on death of the assured. Depending on the terms of the policy,
the assured has to pay premium for 35 years or until he attains the age of 80,
whichever is later.
Money-back plans offer the assured the benefit of some money being paid
back by the insurer at regular intervals during the policy period. For
example, 20% of the policy amount may be paid every 5 years in a 20 year policy. In
the event of death during the policy period (of say, 20 years), the entire policy amount
would be payable by the insurer.
Mortgage redemption plans are linked to mortgage loans that the assured may
have availed. They protect the family of the assured, in the event of death of the
assured. The family does not have to repay the loan to retain the property. The policy
amount will cover the amount payable by the assured as on the date of demise. Over
the life of the loan, the outstanding amount will reduce with each equated monthly
instalment. The cover offered by the mortgage redemption plan also keeps reducing
accordingly. The premium on a mortgage redemption plan can be quite attractive,
especially when the mortgage financier works out special arrangements with an
insurer.
Unit linked insurance plans (ULIP) offer the facility to investors to decide how
the savings component should be invested. Out of the premium paid, a certain
percentage is appropriated by the insurer for the risk cover and expenses. The balance
is invested. As in a mutual fund scheme, the policy-holder can choose between
portfolios. The insurer announces the NAV from time to time.
Given the ever increasing medical costs and ever widening range of ailments, every
family should have medical insurance. The policy may be cashless or re-imbursement.
The cashless policy works better because the individual does not need to pay the
hospital. With a reimbursement policy, the individual needs to pay the hospital and
then file a claim for reimbursement. This takes time, and comes with the risk of the
insurer rejecting the claim or reducing it substantially.
Exigencies like fire or theft or floods can completely destroy the wealth
that the person builds. Insurance against such events offer peace of mind at a
nominal cost. It is also possible to get cover against terrorism.
It is important to understand what is not covered, before the policy is taken. Damage
arising out of terrorism or riots may not be covered in the policy. Depending on where
the person stays, it may be better to buy a rider, which will extend the coverage of the
policy to such events.
Motor insurance to cover third parties is mandatory. Motor repair costs
arising out of accidents can be quite steep. In some cities, there is also the risk of
floods affecting the car. Motor insurance policies can offer effective protection in such
situations. Insurance premia goes down, when the insurance buyer agrees to bear part
of the costs in a claim.
The amount of life insurance cover required depends upon the economic
value that can be attached to human life. This is called the human life
value (HLV). This is the value that insurance needs to compensate for if there is a
loss to the life, or disability which results in a reduction in the ability to generate
income. HLV is the present value of the expected income over the working life of the
individual that is available for the dependents. That is Human Life Value and would be
the amount of insurance required after considering the future value of assets already
available that will contribute to this value. There are different ways in which the HLV
can be calculated.
Human Life Value (HLV) is a methodology to
determine the appropriate amount of sum assured
you need to have at present in case of future loss of
income. In simple words, it is that amount, which
can ensure that the standard of living of the family
is not affected even if the earning member is not
there. HLV calculation is a tool that is used very
effectively for financial planning around the world.
It is a systematic way of understanding the gaps in
the financial planning. Human Life Value is
determined by three main factors:
1. Your age
2. Current and future expenses.
3. Current and future income
This approach focuses on income of the
individual and family while arriving at the
HLV. This approach is based on the simple
reasoning that the value of one’s life is equal
to his earning capacity. In the event of death
of the breadwinner in a family, it is the
current as well as prospective income of the
family member which is the real financial
loss to the family. Hence the sum insured
should take care of loss of income rather
than anything else.
Mr Vivek Rao aged 41 years has an annual
income of `10 lakhs, spends `3 lakhs on his
personal expenses (including Taxes). He has
Fixed Deposits of `6 lakhs. He also has a
loan of `10 lakhs and plans to spend `10
lakhs each on his son’s education and his
daughter’s marriage. Calculate his HLV.
Information Required The information required to
calculate HLV based on this method is as follows:
The number of years the individual is likely to earn
(Retirement age less present age)
Average annual earnings during the earning years
Amount of personal expenses like taxes, personal costs, Income Replacement Method when
rate of return is given
insurance premium which is deducted from annual
income.
The rate at which the income is expected to grow over
the earning years
The rate of return expected to be earned on the corpus
Example: Siddhartha earns Rs.8 lakhs p.a. He is 28
years old and would like to retire at age 55. Calculate the Income Replacement Method
insurance he needs as per the income replacement
method if we assume that his income would have gone
up each year by 5% and investment would have earned a
return of 8%.
Method of calculation The amount of insurance required
is that sum of money which if invested today at a return
of 8% would replace the income that Siddhartha would
have earned each year, taking into consideration the
annual increment.
The amount required has to take into account two rates
that work here: the rate at which the income is expected Income Replacement Method
to rise each year and the rate of return which the corpus
will earn during the given period. The rate used in the
calculation will be adjusted to reflect the effect of both
these rates on the corpus required. Then the PV function
can be used to calculate the present value of the corpus
required. This will be the amount of insurance taken.
Steps to calculate HLV
1. Calculate the adjusted rate to be used in the calculation of
the corpus.
a. ((1+Investment rate)/(1+Increment rate))-1 is the
formula to be used
b. Investment rate given is 8% and increment rate is 5%.
The adjusted rate therefore is ((1+8%)/(1+5%))-1= 2.857%.
Income Replacement Method
2. Use the PV function in excel to calculate the corpus
required by giving the following data
a. Rate: This is the adjusted rate calculated i.e. 0.02857
b. Nper: This is the number of earning years. Here it is 27
years. (Retirement age- Current age)
c. PMT: This is the income in each year starting with Rs.8
lakhs in the first year in this example.
d. The amount calculated is the corpus required to
generate the income that Siddhartha would have earned
over 27 years. In this case it is Rs. 1,53,39,470.
This is a method of calculating the human life value, and
therefore the amount of life insurance required by an
individual or family, based on the amount required to
cover their needs and goals in the event of the demise of
the earning member. These include things living
expenses, mortgage expenses, rent, debt and loans,
medical expenses, college, child care, schooling and Need Based Approach
maintenance costs, emergency funds.
The need based approach considers what is already
available in the form of investments, assets, and dues
such as EPF, gratuity that will contribute to the corpus.
Insurance will be taken for the remaining value.
Information Required
The needs and goals that have to be met and their
current value
Inflation rate applicable
The current value of the available investments
Need Based Approach
The rate at which the investments are expected to grow
Example:
Anil currently has a monthly income of Rs. 1,50,000. He
pays an insurance premium of Rs. 25,000 per month
and an EMI of Rs. 32,000 on a loan of Rs. 40 lakhs that
he has taken for this house. His wife’s expenses are Rs.
10,000. He wants to provide insurance protection for his
wife who is currently 49 years old and is expected to live Need Based Approach
till 80. If the expected inflation is 6% and return on
investment is 8%, what is the insurance cover he should
take? His current insurance cover is for Rs.1 Cr and he
has other investments amounting to Rs.50 lakhs. His
house is worth about Rs.50 lakhs.
Method of Calculation:
The first step is to calculate the current value of the
income required to be provided for Anil’s wife.
The next step will calculate the corpus required that will
generate the income required. For this the applicable
rate will be the rate adjusted for inflation and expected Need Based Approach
rate of return from the investment of the corpus.
To this, the values of any other obligations or needs are
added to come to the total funds required to meet needs.
The values of the existing investments are deducted to
arrive at the corpus that needs to be created.
This will be the insurance amount
Steps for Calculation
1. Calculate the current value of the income required to
be provided.
a. (Portion of income used by Anil for personal needs+
EMI payments+ Insurance Premium)
b. = (Rs. 10,000 + Rs. 32,000 + Rs. 25,000) = Rs. Need Based Approach
67,000 per month
c. =Rs. 8,04,000 per annum
2. Calculate the applicable rate after adjusting for
inflation and investment return
a. Inflation rate =6%
b. Investment rate= 8%
c. Adjusted rate= ((1+8%)/(1+6%))-1= 1.88%
3. Use the PV function in excel to calculate the corpus
a. Rate is the adjusted rate of 1.88%
b. Nper is the number of years for which the income has to
be provided. In this case it is 31 years (80 years – 49 years)
c. PMT is the income that has to be provided, starting at Rs.
8,04,000
Need Based Approach
d. The value calculated is the corpus that will generate the
income required when invested at a rate of 8%. This is Rs.
1,91,11,441
*The calculation considers payment at the beginning of
each year. This is indicated in excel by putting in ‘1’ in the
PV function for the argument ‘Type’
4. From the total amount required, the existing insurance
cover of Rs.1,00,00,000 and Rs. 50,00,000 of investments
is deducted to arrive at the amount of insurance cover that
will be required for Anil so that all the needs are met. This
amount is Rs. 4111441.
Expense Head Amount
Sandip aged 32 lives with his (`)
wife Shweta, 30 and two
children, Ayush, 6 and Arohi,3. House rent 6,000
Sandip is a software professional
School fees 4,000
and works with a leading
software company as a Senior Food 5,000
Systems Analyst. His annual
gross salary is `8,00,000. Fuel, telephone, and 5,000
Shweta is a homemaker. The conveyance
family lives in a rented house but
plans to buy a house shortly. His Healthcare 1,000
expenses per month are given
below: Entertainment 2,000
Car Loan instalment 4,000
If the expected inflation is 6% and return on investment is 8%, what is the insurance
cover he should take? Sandip is currently covered under the group insurance scheme of
his employer under which there is a life insurance cover of `5,00,000 and health
insurance cover of `1,00,000. Sandip is wondering whether he requires any further life
insurance and health insurance cover. Please advise him suitably.
Julian, age 45, would like to determine how much life insurance to purchase using the
human life value approach. He assumes his average annual earnings over the next 20
years will be $40,000. Of this amount, $20,000 is available annually for the support
of his family. Julian will generate this income for 20 more years and he believes that 5
percent is the appropriate interest (discount) rate. The present value of one dollar
payable for 20 years at a discount rate of 5 percent is $12.46. What is Julian’s human
life value?
Solution: Julian has average annual earnings of $40,000. His family receives
$20,000. The present value of $1 payable for 20 years at a discount rate of 5 percent is
$12.46. Julian has a human life value of $2,49,200 ($20,000 × $12.46).
Particulars Amount
Funeral costs and uninsured medical $ 10,000
bills
Kelly, age 35, is a single
Income support for her son $ 2,000 monthly parent and has a 1-year-old
for 17 years son. She earns $45,000
annually as a marketing
analyst. Her employer
Pay off mortgage on home $ 150,000 provides group life insurance
in the amount of twice the
employee’s salary. Kelly also
Pay off car loan and credit card $15,000 participates in her employer’s
debts 401(k) plan. She has the
following financial needs and
College education fund for son $150,000 objectives:
Particulars Amount
Checking account $ 2,000
IRA account 8,000
401(k) plan 25,000
Individual life insurance 25,000
Group life insurance 90,000 Kelly has the
a. Ignoring the availability of Social Security survivor following
benefits, how much additional life insurance, if any,
should Kelly purchase to meet her financial goals based financial assets:
on the needs approach? (Assume that the rate of return
earned on the policy proceeds is equal to the rate of
inflation.)
b. How much additional life insurance, if any, is needed
if estimated Social Security survivor benefits in the
amount of $800 monthly are payable until her son
attains age 18?
Funeral costs and uninsured medical bills $ 10,000
Pay off mortgage $150,000
Pay off car loan and credit card debts $15,000
College education fund for son $150,000
Total cash needs $325,000
Kelly also has the following income needs:
Monthly income support of $2000 for 17 years for her son $408,000
Total needs $733,000
Less existing resources (checking account, IRA, 401K plan,
individual and group life insurance) –$150,000
New life insurance needed, excluding Social Security $583,000
b) Kelly needs $419,800 Cash needs $325,000
of new life insurance if
Income needs (inclSocial Security) $244,800
Social Security benefits
are considered. Cash Total needs $569,800
needs remain the same.
If Social Security Less existing resources –150,000
benefits of $800 New life insurance needed $419,800
monthly are considered,
only $1200 monthly for
17 years, or $244,800, is
needed
Richard earns an average annual income of $60,000. One-third of his income is spent
on taxes, insurance premiums, and personal expenses, and the remaining amount is
available for his family. Assuming he will continue to support his family for the next
20 years and the discount rate is 6% per annum, calculate Richard’s Human Life Value
(HLV) using the present value of an annuity approach.
Richard has average annual earnings of $60,000. One-third of his earnings, or
$20,000, is used for taxes, insurance premiums, and the costs of self-maintenance.
His family receives the remaining $40,000. The present value of $1 payable for 20
years at a discount rate of 6 percent is $11.47. Richard has a human life value of
$458,800 ($40,000 × $11.47).