Do you know your Human Life Value? Do you look at insurance merely as a tax-saving instrument that you buy at the end of a fiscal? If you draw a blank on the first question, you might not have the right amount, or the relevant life insurance coverage. And if you say yes to the second, it is one of the worst financial mistakes you can make.
Insurance is first and foremost a protection instrument. That it also helps you save tax is only an added advantage.
The bottom line: When you buy it for the wrong reasons, you end up paying too much premium for inadequate coverage.
How much would you need?
The amount of payment made by the insurance company to your dependents, called the sum assured, should be enough to cover all your liabilities so that they are able to fulfil their critical life goals. With the help of a simple mathematical calculation, you can quantify the sum total of all your obligations and your existing financial liabilities, and therefore the coverage you would need at a given point in time.
Illustration: Raajan / Mint
This amount is called the Human Life Value: the monetary value of all the future needs of your parents, spouse, children and other dependents, and all your current outstanding financial liabilities. Once you have this value, you can easily calculate whether you have enough life insurance or not. If you have no financial dependents, then most likely you do not need any life insurance coverage. Similarly, you don’t need to buy life insurance for your school-going children because they do not have any income and they are not supporting you.
Also See How to Calculate Your Human Life
The industry rule of thumb regarding the amount of insurance you should have is 5-10 times your current salary. Through the Human Life Value calculation, however, you can arrive at a more precise figure.
The insurance amount you buy must be proportional to your current, and potential, earnings capacity, and the financial commitments you might have.
Underinsurance is common in India because the insurance purchase decision has been driven by the need to save tax, not to financially protect the family.
For example, Amit Singh is a 31-year-old software engineer with a multinational company (MNC). He is married, has a four-year-old daughter and is the only breadwinner in the family, which includes his retired parents.
Singh has an annual income of Rs10 lakh. He has Rs1 lakh saved in a bank account and Rs4 lakh in other savings and investments. He has the following financial obligations and liabilities:
• Finance for his daughter’s education (school and college): Rs30 lakh
• Paying back a home loan: Rs25 lakh
• Paying back a car loan: Rs5 lakh
• Household and living expenses for the surviving family: Rs30 lakh
• Healthcare support for his parents: Rs10 lakh
Singh’s total financial obligations are Rs1 crore, and this is his Human Life Value. If something were to happen to him, his family would need Rs1 crore to settle outstanding dues and pay for future obligations.
After joining the workforce when he was 24, Singh bought an insurance policy every year to save taxes, i.e., he has seven policies. The sum assured from these policies is only Rs10 lakh. Singh is currently paying a cumulative premium of Rs1 lakh across all these policies. With seven policies, he believes he has enough insurance and is secure.
He isn’t. Despite having seven policies, he still does not have adequate coverage. If something happens to him, all he has planned for is Rs10 lakh in insurance, and Rs5 lakh in savings and investments. His family will face a shortfall of Rs85 lakh.
He bought insurance for the wrong reasons, i.e., to save taxes, without really analysing whether he was getting suitable and adequate coverage. If he were aware that he needed to protect his family by up to Rs1 crore, he could have achieved this by buying a term insurance policy with an approximate annual premium of Rs50,000 that would give him a coverage of Rs1 crore, rather than spending twice that amount for only a tenth of the coverage.
Revisit your coverage amount
You must evaluate your life insurance coverage annually or at least every time there is a change in your situation because your financial situation changes too (and so does your Human Life Value). For instance:
• Change in marital status—whether you get married or divorced
• Birth and death in the family that adds to or reduces the number of your financial dependents
• A move to a bigger house
• A home loan to purchase a house
• A change in job, which results in a higher level of income
• When your children become financially independent
The lesson: Buy insurance for the right reasons and get the right coverage. Insurance is a protection instrument more than anything else. Always keep in mind that you must identify the cheapest and most efficient option for you. Not all policies are suitable for everyone.
Check | Loan against FDs
Most banks offer a loan against fixed deposits (FDs). By using an FD as collateral for the loan, you also get the loan at lower rates: The rates are usually pegged at a few percentage points higher than the fixed deposit interest rates. Usually, banks advance up to 90% of the FD being held in a loan. Before opening an account, choose the tenure and amount you are comfortable with so that you need not make a premature withdrawal. Also, don’t forget to ask the bank representative to explain the rate and the income you will be earning from the FD interest rates, both pre- and post-income tax.
Know | Insurance with investment
Some types of life insurance have an investment feature attached to them. Remember, you too can recreate such hybrid products by simply combining a pure life insurance product along with a mutual fund. What adds to its advantage is that you will pay less in fees if you do this on your own, because these hybrids have much higher fees. They have a purpose in your portfolio if you are looking for some capital appreciation along with life/risk cover. Ultimately, you need to decide what your needs are and whether the product you are looking at meets your needs or not.
Dhruv Agarwala and Kartik Varma graduated from Harvard Business School and are co-founders of New Delhi-based iTrust Financial Advisors. They can be reached at firstname.lastname@example.org
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