Saturday, April 4, 2009

Role of insurance in financial planning

In my previous blog post, I discussed the importance of having a well drafted financial plan and sticking to the defined asset allocation pattern in achieving ones financial objectives. But one’s best laid out plans could go awry if one’s insurance cover – be it life, health or any other type of insurance- is not sufficient.  

As I discussed the last time, insurance is a cost. So, overdoing insurance is seldom a good idea. There needs to be a fine balance. The amount of insurance should be such that you and/or your loved ones are not left with less than what you/they would need, in case of unforeseen eventualities. At the same time, you need to ensure that you don’t spend more on insurance than you absolutely need to. Remember that there is always the opportunity cost associated with the funds that go into buying insurance; the returns you would be able to generate by investing that money elsewhere.

What kinds of insurance

The way I look at things, one needs the following insurance covers

  • Life insurance
  • Health insurance, AKA mediclaim
  • Personal Accident insurance and
  • Asset insurance
  • Allowance for kids’ education

Life insurance

Calculating how much life insurance you need is fairly simple.  Calculate what amount of money your family needs to qualify for financial freedom, in your absence (Say A). Take an inventory of your assets and liabilities (say B and C). In simple terms, you need to plug the gap. The amount of insurance you need is A-(B-C), to ensure that your family is adequately provided for.

This may need to be adjusted, however, for the kind of assets you have. If you have a substantial portion of your money in risky assets like equity or real estate, you may need more insurance. Things can go wrong at bad times and the markets could crash just when your family needs to encash your equity investments. Providing a 25% haircut to your risky assets may be a good idea. Also, make allowance for the taxes that would have to be paid, if your investments are encashed. Finally, subtract the amount of insurance you already have to arrive at the amount of additional insurance you need.


A.         Amount needed by the family – Rs 20,000,000

B.         Assets – 12,000,00 of which equity is Rs 6,000,000

C.         Liabilities – Rs 2,000,000



D.        Possible diminution of value of risky assets, in case of a fire sale – 25% of 6,000,000 = 1,500,000

E.         Taxes on sale of assets –Rs 500,000 (assumption)

F          Existing insurance cover – Rs 5,000,00

Adjusted value of insurance needed = A-(B-C) +D+E-F= Rs 7,000,000

The amount off insurance you will need will, however, come down if your spouse is working. That adjustment should ideally be made in your math used in arriving at the amount of money your family needs. Of course, your spouse needs to go through an exercise similar to what’s described here to determine her/his insurance needs.

There are many websites that try to help you with calculating the amount of insurance you need. Do a search for a ‘human life value calculator’ and you should be able to find one of those.

What form

Having decided on the amount of life insurance, you need to decide on how you are going to get the same. Go for the option that comes with the least cost. Usually, term insurance is the way to go. All other forms – be it ULIPs, endowment plans, etc- tend to result in less than optimal allocation of capital. There is sufficient material available on the web to tell you why term insurance makes sense. Read that and make sure that you ask the right questions the next time an insurance salesman approaches you, trying to sell insurance to you.

Term insurance is an arrangement wherein you pay the premium and get nothing back if you outlive the term of cover. In other words, you money is spent on just buying mortality cover, which is how it should be. Term insurance costs a fraction of what other types of insurance cost. By investing the money you save – by virtue of the lower premium payouts – you should expect to more than make up for the returns you would have had from your insurance policy, had you opted for other types of insurance. Always bear in mind that mixing insurance and investments is seldom - if ever- a good idea.

Health insurance, AKA mediclaim

Whenever I have spoken to people about the need for health insurance, I hear the refrain that their employers provide health insurance and so they do not need to spend money on that. That’s a risky approach to take.

For one, jobs are not secure – as many of us have painfully realized- and the health insurance provided by your employer protects you only as long as you are on the job, in most cases. God forbid, you lose your job and you or a dependant falls ill when you are unemployed, you would be in trouble. So, having health insurance cover funded by you, protecting yourself and your family, makes eminent sense.

There are other benefits too. You build a track record with the insurer, which comes in extremely handy when you don’t have the protection of the employer provided cover. Also, if you have bought insurance cover for a certain number of years, you would not have to worry about your claims being rejected on the excuse that the claims corresponded to ‘pre-existing’ illnesses. Also, as of now, the government provides tax breaks on the cost of buying health insurance, subject to certain limits.

Private healthcare, though expensive, is not fully out off reach for many of us, as things stand now. But the costs of healthcare – and education – tend to increase at a much faster rate as compared to general inflation. We could well end up like the US, where private healthcare is almost out of reach of those that are not insured. While I hope that we – as a nation – don’t get there, you don’t want to be taking chances!

Personal accident insurance

Imagine a situation where one meets with an accident, is permanently disabled and cannot be gainfully employed. There is a loss of income, and any amount of life insurance does not help. A scary situation!

This is where personal accident insurance comes in. As with health insurance, most employers provide personal accident insurance, but you may need to see if the amount is sufficient. Your employer typically provides a cover that’s 3-6 times your annual gross salary. Using calculations similar to those used in calculating the amount of life insurance you would need, you can see if the amount of personal accident insurance provided by your employer is sufficient. If it is not, go ahead and buy additional cover. It comes cheap.

Asset insurance

Most of us have vehicle insurance because it’s mandated by law. My guess is that very few of us have asset insurance, insurance covering the house and other valuables. Asset insurance can come into play in cases of natural calamities, theft, etc. I know most of us would feel such things don’t happen to us. But when you are planning for financial freedom, it makes sense to be ready for as many eventualities as possible. Remember that things do go wrong.

Allowance for kids’ education

Kids’ education is something all of us want to provide for, to the best off our ability. Given the importance attached to this, it makes eminent sense to make sure that the amount you want to be available for your kids’ education is available when needed, no matter what. So, to me, this is an apt case for buying protection to ensure the desired outcome.

There are many ways of doing this. One is ULIPs, but again the cost structure associated with ULIPs make them the least preferred option. The other way which was available for a brief while, was the insurance protected SIP investments in mutual funds from certain fund houses. This had its own issues too.

My approach has been to estimate the amount of money my kids would need, the time of such need and set aside sums of money, which would grow into the required amounts, at the times of need. If you don’t want to set the money aside today, and want to fund the same as you go along, calculate the amount you would have had to set aside today. Then buy additional life and personal accident insurance for that amount. This way, you can make sure that your kids’ education plans are always well funded



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