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Under this, the insured person pays the premium regularly to insurance company, once a policy is taken, and in lieu of this, the insurer promises to pay a fixed sum of money at the time of the death of insured or on the expiry of a specified period of time, whichever is earlier. The payment for life insurance is certain but the event for which insurance is taken is not very certain.
A Beneficiary can be a Person, Business, Trust, or Estate.
The Owner of the policy is the Person or Organization who pays the premiums and has ownership rights :
The right to name the beneficiary
The right to receive dividends and to surrender the policy for cash
The right to change ownership
The right to assign a policy as collateral for a loan.
‘Death is certain, but when it occurs is not’
Life insurance is of utmost importance for all individuals, businesses, communities, society and general public at large. If offers protection against loss of income and compensates the titleholders of the policy. It has other principal functions besides making cash payment on death of a life insured.
Life is unpredictable. As the head of the family, everyone wants a secured life for their family members. The nightmares about your family’s financial protection keep haunting you.
You need life Insurance because typically the need for income continues for those who are financially dependent on you, but there is no guarantee of your ability to earn consistently and for the rest of your life.
Life insurance can help you safeguard the financial needs of your family.
To replace income the family would need to maintain their standard of living after the death of a wage earner.
Life insurance insures your life and reduces any hardship your family may have to bear in the unfortunate event of your death.
Insurance can provide an emergency cash reserve.
It can provide capital to pay “last expenses” and operating capital during a family’s readjustment period.
to pay off a mortgage loan and other personal and business debts or to create a rent fund.
To create a fund for children’s education.
To create a family emergency fund or a fund for a family member with special needs.
Life insurance proceeds generate a financial lump sum that can be used to cover a family’s current and long-term operating expenses.
It facilitates savings for old age to enjoy secured and peaceful life as the earning capacity of a person is reduced after retirement.
It encourages people to save money by making them obliged to pay premium regularly when a life policy is taken.
It helps to mobilize savings of the public to channelize it for investment and thus promote economic development of the country.
It (policy) can be used as a security to raise loans and thus improves credit worthiness of an individual or a business.
It also has tax benefits as under Income Tax Act, premium paid is allowed as a deduction from the total income.
Exhibit 1 : Life Expectancy
Graph of life expectancies from birth and from age 65 from 1900 to 2003.
In order to estimate the amount of life insurance that is required an agent must be able to assess with the client which costs would be faced by the survivors resulting from the premature death of the proposed life insured, and how much it would cost to maintain the same or similar standard of living. A fact-finding interview with the client will begin by establishing ‘qualitative goals’. Once quality of life has been planned then this figure can be assigned to meet those objectives. These figures are called ‘quantitative goals’.
Qualitative Goals – Qualitative goals are “quality of life” goals. They reveal lifestyle choices that have a direct bearing on expenses, risk tolerance, and investment choices. For example; a family chooses to vacation each year in England of a month has made a qualitative decision.
Quantitative Goals – Quantitative goals are the dollar figures assigned to qualitative goals. For example, the family who vacations in England for a month needs Rs.22,000 to pay for their holiday.
What Is Life Need Analysis ?
“It is the actual amount that would be needed to maintain the surviving dependants for the period they remain dependants”.
By considering all offsetting resources and benefits, the aggregate need for insurance can be trimmed to the unmet need for insurance – the gap to be filled in order to satisfy the established goals. This net estimate may be used as the basis for a specific sales proposal. The nature of the unmet needs might also suggest the amounts and combination of types of insurance to recommend, such as a specified amount of whole life or other form of level coverage and a specified amount of decreasing term coverage.
There are three basic methods for measuring life insurance needs :
The Human Life Value Approach and
The Needs Approach
The Capital Retention Approach
Each approach is a tool to help determine the amount of life insurance needed by an individual or family. Life insurance provides protection from the permanent loss of income that arises from premature death. The approaches are based on the principle that a life has economic value. This value is called ‘capitalized value of life’. Capitalized value may be represented by the sum earned as salary by an income-earner who dies during the prime of his or her life. Capitalized value may also be represented by the loss of income-in-kind such as the cost of having to provide day-care, then costs of day-care or nanny services will be a cost for the survivor to pay.
The objective of insurance is to replace the capitalized value of the life insured with a sum of money that – when invested at the interest rate in effect at the time of need analysis – will provide an annual income stream equivalent to the annual lost earning power of the life insured.
This can be expressed as :
Annual Income Need ÷ prevailing Interest Rate = Lump Sum insurance required
Capitalization of income determines the amount of insurance needed to replace that lost income. Capital retention determines the amount of insurance needed to pay capital costs of survivors by providing a lump sum-the interest earned on the lump sum provides the income.
For example; if today’s interest rate is 4%, the capitalized value of a life insured who earns Rs. 60,000 annually is Rs. 60,000 / 4% i.e. Rs. 15,00,000. This means Rs.15 lacs would have to be invested at 4% so that Rs. 60,000 could be used annually for expenses that would have been paid by the income earner.
For the Financial Dependency of Survivors
The three phases of financial dependency and the costs that survivors will face during these phases are :
Readjustment/ Last Expenses
Dependency/ Ongoing Expenses
Survivor Life Income Needs/ Future Expenses
(all explained later in this chapter)
It provides ample information to establish the most effective means for that potential loss. Considerations can be personal, property or the liability. Needs Analysis can help determine the right amount of life insurance that is appropriate for your needs. It explains the overall principals behind estimating the costs associated with the death or disablement of an income earner and the provision of ongoing support for any dependants and/or the insured. Also outlines the factors to consider in the planning the amount of cover for short term disablement or illness. Again it explains how the value of property assets should be estimated for insurance purposes and develops a comprehensive and integrated set of insurance policy options for the particular client’s needs and circumstances. These other assets will help in determining the amount and kind of insurance necessary to meet the applicant’s current and future needs. When estimating the potential contribution of Social Security benefits to survivors’ income, you should be aware of something known as the ‘blackout period’. This is the period of time after the youngest child is 16 years old and before the surviving spouse becomes eligible for retirement benefits. During this period, no benefits will be paid by Social Security to a surviving spouse.
Offsetting benefits may reduce or even eliminate some of the items in the needs list. If existing medical insurance has a large lifetime benefit, any uninsured exposure related to a last illness may be limited to the deductibles and coinsurance, if any. Existing life insurance may substantially reduce a number of needs. Group life insurance will not provide a retirement income, but it will reduce the need for insurance by a working parent working with minor children in the family. An unpaid mortgage may already be fully insured by a credit life policy. Social Security and other available benefits might cut the remaining need for retirement income considerably.
How much Life Insurance/ Determining the Need for Life Insurance (A General Concept)
Well, the answer isn’t really how much life insurance you need… actually your life insurance needs often depend on a number of factors, including whether you’re married, the size of your family, the nature of your financial obligations, your career stage and your goals. It’s how much investment capital your family will need at the time of your death. This excellent question is to which there are as many answers as there are people to ask. Every advisor, financial columnist and relative has a formula that they consider the best. There are a number of approaches you can use to figure out how much insurance you should have.
This section is designed to present the various need analysis methods used, as well as the pros and cons of each method. As these issues deal with how to value a life, it is indeed a very complex proposition. The method that makes the most sense to you is probably the one that may work the best for you. No method is perfect, as you are trying to hit a moving target. Life brings many changes and your needs will change with them. The more assumptions you make, the more complex you will make your planning and the more chances there are that something will not work as planned. This does not mean that you should only use simplest methods – it is to give you a concept of why it is important to actively participate in all of your planning, fully understand it, and constantly monitor it. After all, it is your money. Remarkably, the simplest formulas can often be the best. Another thought to keep in mind is that as your other assets grow, such as retirement plans and investments, your need for life insurance will decrease.
What determines your life insurance need ?
Methods of calculating life insurance need
What determines your life insurance need ?
Life Stages and Circumstances
When determining your life insurance need, you should first consider your life stage and circumstances. Marital status, number of dependents, size and nature of financial obligations, your career stage, and your intentions to pass on your property are all factors to consider. Your need for life insurance changes as the circumstances of your life change.
In the “Starting Out” stage of life, you may be just beginning your career or family. You may not have children or other dependents at this stage, but that doesn’t mean you have no obligations. For instances, if you paid for your college education with student loans, you likely had a cosigner for your loan-may be your parents or a grandparent. The same may be true of your car loan. If you were to die before the loan is paid, your cosigner would be obligated to pay the debt. Under law, a cosigner is responsible for full payment of a debt in the event of default. Death doesn’t erase the debt obligation.
A growing percentage of the population now falls into the single adult demographic group. This group covers a broad spectrum of ages, lifestyles, and obligations.
Although you may not have a spouse, your death could have a serious financial impact on other family members. If, like many adults, you are supporting your parents (either financially or with care), your death could have a major impact, both emotionally and financially. They would not only lose the support you have been providing to them, but they would also need to come up with the money for your final expenses.
If you are a single parent, the primary financial support for your children would die with you. If you are lucky, you may have family members who would step in and help your children if you died. If you are even luckier, they will be able to provide your children with the education and lifestyle you had hoped for them to have. Your need for life insurance as a single parent is even greater than that of a dual-parent, dual-income household, which would still have one income if one parent died. Life insurance is a cost-effective way to make sure that your children are protected financially should anything happen to you.
In this stage of life, you may still be paying for or even still accumulated education loans. You may have purchased a house or condo with a cosigner. If you died, your cosigner would be legally liable for the payments on the debt.
Protect Your Insurability
Another reason to buy life insurance at this stage of your life is to protect your future insurability. Once you buy a permanent, cash value life insurance policy, it remains in effect for your entire life (assuming the premiums are paid), even if your health changes. If you were to experience a serious change in health, you might not be able to buy additional insurance coverage, but you would still have the permanent coverage you already own.
Dual-Income Couple or Family
If you and your spouse both earn an income, it is possible that if one of you died, the other may be able to cope financially on the remaining income. If there are mortgages, joint credit cards or other debt, or children in the picture, the loss of one income could be much more difficult to overcome. The more people who depend on your income while you are alive, the more life insurance you should own. If you died today with insufficient or no insurance, your mate could be forced to give up the residence or lifestyle for which you have both worked. When there are children involved, the loss of one breadwinner could mean a setback in the daily way of life, not to mention any plans for private school or college.
Parent of Grown Children
Just because your children have grown up and left the nest doesn’t mean you have no need for life insurance. you may have spent your entire adult life building an estate that you intend to pass on to your children, grandchildren, or favorite charity. You can use life insurance to ensure that the bulk of your estate passes to your heirs or designated charitable organization subject to certain tax advantages.
Part of Overall Financial Planning
Determining your life insurance needs should not be done in isolation. Instead, it should be looked at as part of your overall financial plan, with consideration given to your goals for savings and retirement, as well as tax and estate planning. As your life changes, your financial goals may change, as well as your need for life insurance, making it important to also periodically review your coverage.
Methods of Calculating Life Insurance Need
Several methods are used to calculate the appropriate level of insurance for you and your situation. While they all share common features, some methods strive to be more simplistic, while others involve more sophisticated calculations. You may want to determine an amount on your own, using one of the simpler methods. This can provide a basis for your discussions with your financial planner.
Before you begin calculating your insurance needs, it is important to determine insurable interest. Basically, having an insurable interest in a person’s life means that you would suffer emotional or financial harm or loss if that person were to die. It is always assumed that you have an insurable interest in your own life. However, to prove an insurable interest in someone else’s life, you must have a relationship to that person based on blood, marriage, or monetary interest. You must have an insurable interest before you can purchase an insurance policy.
Family Needs Approach
The family needs approach is one of the more comprehensive methods of calculating your life insurance needs. It assumes that the purpose of life insurance is to cover the needs of the surviving family members. This method takes into account the immediate and ongoing needs of the surviving family members, as well as income from other sources and the value of assets that could be used to help defray the family’s expenses (such as bank accounts and real estate).
Capital Retention Approach
The capital retention approach is one of two calculation methods under the family needs approach. This approach assumes that life insurance principal will support the family indefinitely into the future. Because you will purchase more life insurance under this method, you will be in a better position if the surviving spouse lives longer than expected.
Capital Liquidation Approach
The capital liquidation approach is the second of two calculation methods under the family needs approach. This method does not provide as much continuing capital for the surviving spouse or for heirs after the death of the surviving spouse. However, it does allow you to spend less money by purchasing a lesser amount of life insurance coverage.
Estate Preservation and Liquidity Needs
The estate preservation and liquidity needs approach attempts to determine the amount of insurance needed at death for items such as taxes, expenses, fees, and debts while preserving the value of the estate. This method considers all the variables of family lifestyle and the total cash needed to maintain the current value of the estate while providing adequate cash needed to cover estate expenses and taxes.
Income Replacement Approach
The income replacement calculation is based on the theory that the purpose of insurance is to replace the loss of your paycheck when you die. This analysis determines an economic or human life value and factors in salary increases and the effects of inflation in determining the appropriate level of coverage. While more comprehensive than the rules of thumb, this method still fails to consider special circumstances or financial needs and operates on the premise that the current level of income provides a satisfactory standard of living that will remain level throughout the future.
Rules of Thumb
The rules of thumb are extremely basic calculations. They provide a starting point but fail to recognize special family circumstances or needs and focus only on the most basic components.
One rule of thumb dictates that multiplying your salary by a certain number will provide an adequate level of insurance, while another calculates need based on normal living expenses.
The worst mistake you could make concerning life insurance is having a need and not having any insurance at all. Very often, people can find all sorts of excuses for not buying life insurance. It’s no fun to plan for your death, for one thing. For another, there’s the tendency to think that dying won’t happen to you, only to some person you read about in the obituaries. But how many times have you heard about a young, apparently healthy person dying suddenly in a car accident, leaving behind a spouse, a young child, and no insurance? Sadly, it happens, and when it does, the family faces not only emotional trauma but possibly an extremely difficult financial situation, as well.
Not Enough Insurance
The majority of people with insurance are underinsured. Insufficient coverage can occur as a result of buying what is affordable instead of what is needed. Failure to review your coverage periodically could also result in insufficient insurance, even if you started out with adequate levels. Inflation rates, your career, and your lifestyle may have changed. Your family could be faced with a large financial gap and left unable to maintain the current lifestyle if you died today. Consequences could include loss of the family home, scaling back of college plans, and possibly years of financial difficulty.
Too Much Insurance
If you purchased a large policy during one point in your life and then didn’t adjust your coverage when your insurance need was reduced, it is possible that you have too much life insurance. this is another good reason to periodically review your coverage with your financial planning professional. Periodic reviews of your insurance coverage can reveal opportunities to change your levels of coverage to match your current and projected needs.
Nowâ€¦â€¦review your coverageâ€¦â€¦
Trying to figure out how much life insurance is enough isn’t always easy, and that amount will likely change with your changing circumstances. By examining your family’s anticipated expenses during various periods after your death, you get a more realistic estimate of your life insurance needs. Unfortunately, many people underestimate their insurance needs and are under-insured. Often, the purchase of life insurance is based on cost instead of what’s needed. By the same token, it’s possible to have more insurance than you need. You may have purchased a large policy during a particular point in your life, and then didn’t adjust your coverage when your insurance need was reduced. Both of these circumstances are reasons to review your insurance coverage periodically with your financial professional. Doing so can reveal opportunities to change your levels of coverage to match your current and projected life insurance needs.
Determining the Need for Life Insurance/ How Much is Enough? (A General Concept)
HUMAN LIFE APPROACH
“The present value of the family’s share of the deceased breadwinner’s future earnings”.
The human life value concept deals with human capital. Human capital is person’s income potential. The Human Life Value approach uses mathematical computation to determine how much life insurance is needed by valuing a human life. The Human Life Value approach considers the human being to be an “income-producing machine.” It is a device that mathematically converts your output into an amount of cash, your expected income until retirement. It determines the value today of cash that is flowing out in the future. This method focuses on an individual’s future stream of income. It considers such things as annual salary and expenses, year’s remaining until retirement, and the future value of current rupees and translates this into an amount of insurance needed to replace the income stream in the event of premature death.
What is your Human Life Value ?
Beyond all doubt, your life is invaluable. Yet, there is a certain worth that can be attributed to the financial support you offer your parents, spouse or children. This worth is referred to as Human Life Value (HLV). In the future, if your family does not have the protective blanket of your presence, they will no longer be able to enjoy the benefits of the income you earned. Put simply, Human Life Value is the present value of your future earnings.
Why should you calculate your Human Life Value ?
You should calculate your Human Life Value so you can accordingly invest in insurance plans that provide your family with adequate finances and hence security even in your absence. The human life value concept goes beyond numbers and considers the entire impact caused by the loss of a human life and the value to a person’s loved ones.
How much are your tomorrow’s worth?
What is your Potential Earning Power (PEP)
HLV of any person can be measured by capitalized value of that part of his income or income earning capacity devoted or meant for dependants arising out of economic forces incorporated within his being, like character, health education, training, experience and ambition. For better understanding let us see some illustrations.
‘Mr. X’ :- Age-40 yrs, Retirement age-60 yrs, Current salary-3,00,000 per annum (expected to remain same), Personal expenses-1,25,000, Net contribution to family-1,75,000 (300000 – 125000). Suppose he dies at the age of 40. Income lost by the family-175000 * 20 yrs (60 – 40) * discount rate for 20 yrs (Present value factor): 19,00,000.
‘Mr. Y’ :- Age-30 yrs, Age of spouse-27 yrs, Life expectancy of spouse-70 yrs, Age of child-3 yrs, Child’s share of monthly household expenditure-10 %, Child will remain dependant till-22 yrs, Monthly household expenditure Rs. 40,000, Out of this, amount spent on Mr. Y Rs. 10,000. Expected inflation in household expenditure 5 %, Money to be set aside for child’s education (in present value terms) Rs. 10,00,000. Money to be set aside for child’s marriage/ other needs (in present value terms) Rs. 7,50,000. Outstanding loans Rs. 15,00,000. Other liabilities Rs. 5,00,000. Medical expenditure/ emergency fund Rs. 5,00,000. Rate of return on low risk securities/ deposits 8 %. Hence, HLV will be Rs. 1,66,45,475. If the rate of return on low risk securities/ deposits is 7 %, Revised HLV will be Rs 1,81,83,996.
How do you determine your Human Life Value ?
This approach is about determining how much insurance is needed and is based simply on how much income the proposed insured earns. “All individuals who have financial dependants need life insurance.” Factors to be taken into consideration while calculating HLV are age, current and future expenses and current and future income.
The formula is;
Annual Income / Interest Rate = Lump Sum (The Human Life Value).
If the annual income of the primary wage-earner is Rs.30,000, the total amount of insurance needed would be (assuming a nominal rate of interest of 8% and a long-term inflation rate of 3%, the real rate of interest is 5%):
Rs. 30,000 ÷.05 = Rs.600,000 (human life value = amount of insurance required)
If Rs.600,000 is invested at 5%, the return will be Rs.30,000 annually. Thus, the family of the insured has, in economic terms, would replace the income-earning value of the life lost through a policy with a Rs.600,000 death benefit.
An insured makes Rs.42,000 a year and the current interest rate is 3.4%. She has a generous policy plus disability benefits that pay 70% of her salary. How much life insurance does she need based on capitalization of income?
A. Rs. 1428
B. Rs. 12352.94
C. Rs. 1,42,800
There are different school of thoughts and approaches for purchasing and calculating the needs of life insurances, which say as under :
One should purchase insurance worth 5 to 10 times the current annual income. “This is an old thumb rule that does not take into consideration current assets and any special needs the customer or their family may have”. Thus,
When one’s annual income is known, the insurance need is calculated simply as annual income multiplied by the number of years to service left.
One’s yearly outgo towards Insurance premium should be 10% of one’s annual Income. Thus,
Life insurance need is, the financial need analysis approach. This is an approach which can take care of specific needs of an individual. Here, the basic objective is that the insurance coverage should be sufficient to provide for the dependants’ needs in case the breadwinner dies early.
Steps for Calculating Human Life Value Approach
In the human life value approach, the first step is to find the amount of annual income that is surplus to the individual. The surplus is the amount above what the insured would consume himself; which provides the overall standard of living for the individual and the family. The surplus includes amounts spent on education for children, automobiles, vacations, clothing, and food for everyone in the family except him. The items to include in costs of self-maintenance are any money spent on his portion of housing, his clothing, food, the portion of his salary that goes for FICA, federal, state, and local taxes, and all other expenses to maintain the insured as a productive asset. The next part of the human life value approach involves plugging the given information into the mathematical model and calculating the answer. To determine the surplus, subtract the self-maintenance expenses from the average income.
Exhibit 2 : Steps for Calculating Human Life Value Approach
Weaknesses of the Human Life Value Approach
Other sources of income are ignored, (e.g., business earnings), it is calculated by using a constant income stream over the life of the insured since it is difficult to know what increase in income is probable.
It ignores the number of years that income (mentioned above) will be required; a person aged 25 and a person aged 65 would appear to require the same amount of coverage.
In its simplest form, work earnings and expenses are assumed to be constant and employee benefits are ignored.
The amount of money allocated to the family can quickly change because of divorce, birth of child, or death of a family member.
The effects of inflation on earnings and expenses are ignored.
Points to Ponder :
One, HLV is a moving target and to make it meaningful, you must review it once a year. Rather than chasing the revised HLV year after year, the aim should be to get the broad trend right with the expectation that in the long-term, the actual and estimate will converge.
Two, do not get overawed by the HLV numbers thrown up. The `number’ is just a starting point and must be put into the context of your present ability to set aside money.
Three, remain disciplined in the sense that at any point in time you should have planned in such a manner that in your absence, your family will not need to compromise on their yet-to-be fulfilled needs.
“It is a method of calculating how much life insurance is required by an individual/ family to meet their needs (expenses) if the family head dies”.
These include things like funeral expenses, legal fees, estate and gift taxes, business buyout costs, probate fees, medical deductibles, emergency funds, mortgage expenses, rent, debt and loans, college, child care, private schooling and maintenance costs. This approach contrasts the human-life approach.
The needs approach is a function of two variables:
How much will be needed at death to meet obligations ?
How much future income is needed to sustain the household ?
When calculating your expenses, it is best to overestimate your needs a little. By doing this you will be buying and paying for a little more insurance than you need, but if you underestimate, you won’t rea
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