What to do before selecting the right Insurance Cover?

This is a guest post by Pattu, Physics Prof at IIT-Madras and Founder, FreeFinCal.com.

Before we go to select the right insurance product, we need to get some basics right. For example, first we need to get a handle on the amount of insurance cover you require. So we will first calculate the value of the insurance that you require.

Let’s face it. All of us are going to die. When we are young, we have this idea about death: people are born; they grow up, study, go to work, have a family, have kids, grow old, retire, grow older, get sick and die.

Yes, all of us are going to die. The question is, what is the guarantee that all of us are going to die in old age after retirement?

The grim truth is that death can strike anytime and in 100 different ways. School kids die. College kids die. Newlyweds die.

So the moment we have someone in our life dependent on our income (wife, children, parents,  we must have a if I die plan in place.

If I die today, how will my spouse/kids/parents manage their day to day expenses? It is not my duty to ensure they receive a corpus upon my death with which they could generate income?

What about my kids education? Some portion of this corpus ought to be put away, to be used later for education.

So I should have an insurance policy that will payout a lump sum to my dependents with which they could manage their expenses and other goals.

If we agree on this, we will also agree that we will no have to answer two natural questions:

  • What should the sum assured of the policy be?
  • What kind of policy should we buy?

The insurance value will depend on your present and future income & expenses, your age, your responsibilities towards your family (especially spouse and children). In technical jargon, this is known as Human Life Value.

Let attempt to answer this question by considering an example.

Vishnu is a 30 year old with an unemployed wife and a 5 year old son. He calculates the value of the insurance policy (the sum assured) in the following way.

The family’s current expenses are approximately Rs. 40,000 a month. Let us assume that his family could make do with an income of Rs. 30,000 if Vishnu died today.

This income will of course increase depending on inflation in lifestyle expenses school fees etc. For the moment will ignore inflation.

Vishnu’s son is now 5. It will take him another 20 years to earn a decent salary. So Vishnu has two choices:

  • He could opt for a sum assured which will provide Rs. 30,000 per month for the rest of his wife lifetime or
  • He could opt for sum assured which will provide an income that increases in step with inflation for the next 20 years. That is until his son starts earning.

For simplicity, we will ignore inflation and calculate the sum assured required for a constant monthly income of Rs. 30,000

We will assume as we did before an annuity rate of 5%. That is 5% of the sum assured will be paid out each year to Vishnu’s spouse for the rest of her life.

Therefore,

Yearly payout needed: 12 x 30,000 = Rs. 3,60,000

Annuity Rate 5%

Corpus required: 360000/5% =Rs. 72,00,000. Or Rs. 72 lakhs

Now Vishnu will have to provide for his sons education. He would like to have a sum of Rs. 60 lakhs available for college expenses.

Assuming a rate of return of 8%, a sum A (obtained from the insurance policy) invested for 20 years should yield Rs. 60 lakhs

Therefore,

6000000 = A x (1+8%)20

Here (1+8%) has been ‘raised to the power of 20’. That we multiply A with (1+8%), 2o times!

A = 600000/ (1+8%)20 = Rs. 12.87  Lakhs. or Rs. 13 Lakhs approximately.

Putting it all together,

Rs. 72 Lakhs is needed for providing regular income to his family

Rs. 13 Lakhs is needed to be invested for funding his son’s education.

Therefore the insurance must pay out Rs. 85 lakhs, or shall we say, Rs. 90 Lakhs if Vishnu dies today.

As mentioned before, this illustration assumes a regular income after death, ignoring inflation and plans only for one child. A more general calculator suitable for a family with two children can be found here:

http://freefincal.com/financial-planning-calculatorsresources/comprehensive-child-planner/

Now that we have discussed the way in which the value of the insurance is calculated, we are now ready to answer, what kind of policy should we buy?

Download the spreadsheet and calculate with your own numbers and note it down below:

Sl. Particulars Insurance requirement Value
1. Monthly expenses at present
2. Children’s responsibilities
3. Liabilities
4. Assets
Final Insurance Requirement

But with hundreds of insurance plans available, selecting the right plan will take some effort from you. We will talk about how to select the right insurance in another article.

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