Calculating Correct Life Insurance Value

How to Find correct insurance value fo bread earner?

Everybody needs life insurance. It is a vital protection for the loved ones of the bread earner in the event of an untimely death. Buying a life insurance policy is a major decision that one takes in their lifetime. And it is extremely important to do a lot of research before making a decision. Research suggests that only 10% of Indians actually have a life cover. The future is very unpredictable and anything can happen in a matter of seconds. No matter the financial situation one might be in, life can throw a curveball and the situation, however good it might be for the bread earner, can worsen in a matter of seconds. Therefore, life insurance is an essential thing to have. Especially in recent years, since the number of people dying young has increased so much. If a family has only one earning member, a life insurance policy will provide a safety net for the family if something were to happen to the earner. The family’s financial future will be secured and their expenses like debt, education, or even basic day to day living expenses will be taken care of. Therefore, it is of utmost importance for an earning individual to have a life insurance policy.

Not only does it provide financial assistance in the time of death, but there are also many other reasons why one should have a life insurance policy. The following are some of them.

Protecting Business

Apart from securing the dependant family members' futures, some life insurance policies also provide coverage to business. In case something happens to the business owner, the business partner can buy out the departed’s business stake and pay the nominee of the dead partner. However, the nominee doesn’t get a part of the stake.

Settling Debts

During the lifetime of an individual, they might avail a loan to purchase a house, a car, or even fund their children’s education. In case of an abrupt demise of the sole earner, the debt obligations will fall directly of the family members of the departed. Even if they are independently earning, it will put an unnecessary financial burden on them and they might not be able to cope up. They can pay off any such remainder debts with the life insurance claim they receive and lead a financially independent life.

Support Retirement Plan

Everyone needs a retirement fund to secure their financial future. This goal can be accomplished by investing in an insurance policy that provides regular income on a monthly basis. Individuals can start saving up for their retirement fund with the income received from these insurance policies and build themselves a good retirement corpus.

Get Tax Benefits

Apart from protection, one of the more significant advantages of insurance is that it also helps in tax savings. No matter what insurance policy one might have, they can save taxes. Under Section 80C of the Income Tax Act, the premium paid for life insurance is eligible for deduction up to a maximum amount of Rs 1.5 lakh. Also, the death benefit or maturity is exempted from tax under Section 10(10D).

Methods of Calculating Life Insurance

I. Human Life Value

Human live value methods calculate how much life insurance is needed for a family based on how much financial loss they incur on the passing away of the insured person in the family. There are various variables mulled over while ascertaining the human-life approach, for example, the age of the insured, gender, planned retirement age, annual earnings, benefits, etc. The human-life approach is fundamentally pertinent to families with working people and stands as opposed to the needs approach. It is imperative to supplant the entirety of the income lost when an employed relative departs when utilizing the human-life approach. While computing a life insurance policy for the human-life approach, there are numerous elements to consider to guarantee that a family won't be left in budgetary pain, for example, expected future income and period of time the cash is required.

Calculation:

This methodology depends on the idea that one should claim a measure of life coverage equivalent to the capitalized value of one’s net earnings. Calculating the capitalized value of net earnings requires 5 steps.

Step 1- Gauge normal yearly earnings from individual endeavors over the rest of the period of salary delivering lifetime.

Following factors should be factored in : 

 Professionals historically reach their maximum annual earnings at about age 55.

 Entrepreneurs and Executives usually reach their maximum annual earnings just before retirement.

For example- Mr A, a 30-year-old Individual, earning ₹10,00,000 per annum will have his lifetime income = ₹2,50,00,000 assuming he retires at 55.

Step 2- Deduct a sensible estimate of yearly income taxes and everyday costs spent on the insured. This gives the real salary expected to accommodate family needs, less the presence of the insured. As a general rule of thumb, this figure should be close to about 70% of the pre-death income, in spite of the fact that this number may change from family to family, contingent upon singular budgets.

Assuming Mr A spent about 15% of his income on taxes and another 15% on himself, his family would require ₹7,00,000 per annum to maintain their quality of life.

Step 3- Determine the period of time for which income should be supplanted. This timeframecould be until the insured’s dependants are fully grown up, and no longer need budgetary help, or until the insured’s expected retirement age.

We assumed that Mr A will retire at 55.

Step 4- Determine the rate of interest to use in discounting those future earnings to infer a present value. The present value is the current value of a future sum discounted at some interest rate, also known as a discount rate. The discount rate, used in coming to a present value, is the annual rate of return that could be earned currently on an investment. Because life insurance companies are appropriately conservative in their assumptions, the rate of interest chosen as the discount rate should be essentially low.

Here I assume the coupon rate to be 5%.

Step 5- Multiply the net salary required by the timeframe needed to determine the future earnings. At this point, utilizing the assumed rate of return, we figure out the present value of future earnings. Therefore, the present value of Mr A’s future salary over 25 years will be approximately ₹51,67,800.

II. Income Replacement Approach

The Income Replacement approach is generally utilized because of its simplicity. Everything a consultant requires to know to compute insurance needs are the client’s age, current income and current insurance coverage; along with certain presumptions around the number of years of income to supplant, rate of return and the percentage of salary to replace (usually its 60% or 70%) For instance, for a 30-year-old individual, earning ₹10 lakhs per annum, with the approximate retirement age of 55, the sum assured will come out to be ₹10,00,000*25 i.e. ₹2,50,00,000.

III. Needs Analysis

In this method, the advisors make a calculated assessment of the most critical factors, such as  insured’s family needs based on the number of dependents the client has and their monthly fixed expenses. Other major considerations to be provided for are: loans (car loan, home loan, etc), the kind of quality of life the client wants to provide, provision for a non-working spouse who would no longer get an income, children’s education and marriage.

The subsequent step is, to sum up, the insured’s existing current assets and deduct the amount required in the event of an unforeseen death. This is the shortfall (considering that the client was to die  immediately) that the insured will need to get covered and shall be the amount for which life insurance cover is required.

This approach is in quite different from the human-life approach, which is more comprehensive in determining the value of an individual's employment potential.

Analytical Comparison

Most course readings, articles and sites recognize that the Income Replacement approach is logically inferior yet appealing on account of the effortlessness of its calculation. The Needs Analysis approach is perceived as a more robust analysis, however harder to implement, as a result of the additional effort to estimate future needs.

How enormous a distinction does it make to the client? In an industry where there are contending duties, a counsellor may be compensated for the insurance sale – nonetheless, as a planner, has a fiduciary responsibility – is it fitting that any value between these extremes “is fair game”? Caveats may acknowledge the income replacement method as a substandard way to calculate the need, however, is a disclaimer adequate to disregard the level of mediocrity?

To what extent might advisors and their firms be permitting the “convenience” of simpler analysis to justify providing poor guidance to the client? It may be simple for a product salesperson to excuse that “you can’t go wrong by selling more insurance than the client really needs”, in any case, this is not the sign of a professional financial planner. Money spent on superfluous insurance premiums could be to the detriment of retirement savings, children’s education or other important financial goals.

In the study conducted by an organisation, they followed three approaches to address the issue of overestimating or underestimating the needs of a client when it comes to their insurance. First, they reviewed actual cases, they did this by accessing anonymous data from client files that had a more robust needs approach analysis done. Next, they did parameter testing wherein they defined a series of reasonable thresholds or parameters that could be applied in the income replacement or expense-based analysis. They performed some analysis and comparisons based on these boundaries and the “rules” used by advisors. And the third approach they used was a site survey wherein they reviewed some randomly selected Internet web sites to determine the assumptions and nature of calculations being provided to clients to determine insurance needs.

In the study, researchers found that 73% of the times Income Replacement Method overstates the requirement of the insured. And it understated the requirements of the survivor 20% of the times. Only 5% of the times this method of arriving at a sum assured requirement correct. They also found out that the robust need-based analysis was a more accurate reflection of the actual insurance needs of the client because it reflects the specific stated needs for the survivor on the death of their partner.

When the Income Replacement Method understated the requirements of the client, it was due to the fact that the unearthing process using the need-based approach resulted in the documentation of a greater number of goals and a greater percentage of the retirement goals to be replaced. These added needs would not be determined in an Income Replacement model.

This study demonstrates an important finding that as financial planners, applying a more short-sighted income replacement approach can prompt both a misunderstanding of the actual client prerequisites and to an understatement of requirements. There are no alternate ways to a proper discovery process.

It is generally perceived with practically no debate that the income replacement methodology is a substandard way to deal with figuring out clients’ life insurance needs. Their basic examination has measured this is not inconsequential, but a significant exaggeration of requirements.

The study finally concluded that Income replacement methodologies ought not to be utilized by financial planners. A financial planner should not apply an intentionally knowing deficient methodology that gives an outcome which is almost twice the essential needs – the application of which would generate a suggestively higher commission for the advisor. This is an undeniable conflict of interest. Advisors with a CFP designation, particularly those charging a fee to the client, ought to invest the time to do a proper expense-based analysis.

The argument is often made that the method of remuneration for a planner should be insignificant in determining the standard of care. For commission-based consultants, it would appear even more important to keep up the better quality of analysis since these decisions affect the insurance companies’ revenues.

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