Learning Objective

HOW MUCH

LIFE INSURANCE

ONE NEEDS ?

Methods of calculation

• Thumb Rules

• Needs Based Approach

• Capital Liquidation Approach

• Capital Retention Approach

• HLV Approach

Thumb Rules

• Income method

• Expense method

• Premium as a percentage of income

• Income plus expenses method

• Multiples of salary method

Income Method

• Basic rule is that life cover has to be a multiple of net income ( Gross income less personal expenses of the bread earner)Age Minimum Multiple Maximum Multiple

Below 35 years 12 15

35-50 years 10 12

50 years onward 8 10

Premium as percentage of income

• Based on premium one needs to pay rather than life cover:

• Under this rule 6 % of bread earner's gross income needs to be spent as premium.

• Further an additional 1 % for each dependent should be spent on premium.

• Example: Mr. Kumar has a gross salary of Rs. 2,00,000. His wife is a homemaker and they have two children. His premium allocation by this method would be:

• (Rs. 2,00,000 X 6%) + (3 X 1% X Rs.2,00,000) = Rs. 18,000

Advantages & Disadvantages

• Disadvantage - it does not consider age,expenses,Family-dependents Liabilities

• Goals & needs also not taken

• Advantages-Simplicity in terms of understanding and calculation

• Can be proposed for someone to start with

Expense Method

• Here a multiple is applied to Expenses

• Generally it is 10 times the annual expenses of the family.

Income Plus Expenses Method

• Here cash needs at the time of death &debts are taken

• Any goals like child education are added• Further gross income with a multiple of 5 is

added.• So,in effect it is 5 times Gross income plus

total expense like final expense,loan & special needs

Example

• Loans-3 lakh,medical bills due-50 k ,child education- 3 lakh,other expenses-25 k. are the needs of Mr.Ramesh…further his gross salary is 3 lakhs.So,what amount of cover he needs to take ?

As per income plus expense method…

Multiples of salary method

• Assumes spouse is a home maker and family can live on 75 %

• From the chart a multiple factor is found out on the basis of income and age of non working spouse …say 50 k income & 45 age of spouse…factor is 7.5.

• This is multiplied by income and added to the expenses.

Needs Based Approach

• Also called family needs approach

• It is on the grounds that life insurance is required to cover the surviving family member’s immediate expenses as well as their ongoing expenses in future after the death of the insured.

Needs Approach

• Here family needs are divided in to

• Cash needs – immediate needs at death &

• Net Income needs-ongoing family needs

Cash needs

• Final medical costs/bills

• Funeral/burial expense

• Settling credit cards & other debts

• Emergency fund for unexpected expense.

Assessing Net income needs

• The net income needs may be categorized in to different periods based on requirements in the life span of the surviving spouse until death.These periods include

• Readjustment period-this is a initial 2 year period after insured’s death.The family needs to pay off insured’s obligations and deal with transition with out the insured

Income Needs

• Dependency period(5 years)- The children here still need support and are not ready to be on own.

• Black out period(5 years)-children have grown up but surviving spouse hasn’t retired.

• Retirement period(5 years)-surviving spouse retires.

Income Needs

• These needs are quantified and discounted back to present value.

• After assessing cash & income needs assets available are deducted

• This represents family’s needs that life insurance proceeds and future investment of the proceeds must cover.

Capital Retention or Liquidation

• After working out the family needs it needs to be decided whether to fund these needs by liquidating assets & insurance OR

• Through investment returns on assets & proceeds OR

• Combination of 2

Capital Retention or Liquidation

• Capital liquidation is commonly used but if the capital has to be passed to next generation,retention would be ideal.

• The choice will effect the final estimate of amount of life insurance needs.

• More accurate than thumb rules…but requires assumptions & calculations

Human Life Value Method

• S.S.Huebner proposed HLV method to calculate the amount of life cover required

• It is actually a process to quantify a persons total earning potential…hence name HLV.

• First,persons earnings are taken and taxes deducted….further ..personal expense are deducted.

HLV

• Consider the number of years he or she would work until retirement.

• An inflation adjusted growth in salary is factored in.

• Now,the PV of expected income stream is calculated using a discount rate.This is the amount of cover required.