Insurance Planning

What is Insurance?

Insurance is a form of risk management ..

which provides protection ..

against the loss of the economic benefits ..

that can be enjoyed from physical and human assets.

The consequences of the loss ..

1. can either be borne by the person to whom the benefits accrue (risk retention)

2. or they can be transferred to another (risk transfer).

Insurance enables risk transfer ..

from the beneficiary (insured)

to the insurance company (insurer),

which undertakes to indemnify the insured for the financial loss suffered.

As we cover ourself in winter with sweater

As we cover ourself in Rainy season with Raincoat

Like this to cover ourselves from financial losses we need to do INSURANCE

For example,

It protect against loss may be physical assets or human assets key person of family may be affected by illness, disabilities and death;

Many source of income assets like factory buildings & machinery may break down or may be destroyed leading to loss.

In the absence of insurance, the loss arising out of the event has to be borne by the person who would have otherwise enjoyed the benefit of Insurance Money

The insured pays a premium to transfer the risk to the insurance company which in turn creates a pool of similar risk.

To be insurable a risk must be one that a large number must be subject to for the premium to be viable, loss must be accidental and measurable and there must be no chance of gain.

Insurance in personal finance removes the risk to the income of the household from loss or reduction or from a large charge.

Requirements of an Insurable risk

a. Large number of exposure units

b. Accidental and unintentional

c. Determinable and measurable

d. No prospect of gain or profit

e. Chance of loss must be calculable

f. Premium must be economically feasible

Role of Insurance in Personal Finance

Insurance can be used to protect the income so that the financial goals are not at risk.

Insurance is also seen as a way to save and invest.

The premium collected will be higher, with one portion assigned for risk protection (Insurance component) and the other for the saving component (Investment component). The type of investment envisaged will determine the risk and return from the investment.

Steps in Insurance Planning

The steps in insurance planning are:

identify insurance needs as income replacement

Insurance is primarily a tool for protection from financial loss.

Identifying all those situations that can result in a loss of income or unexpected loss on income. Like Death , Health and Accident etc

income protection and asset protection needs,

calculate the amount of insurance required

The amount of insurance required must be calculated by future value of the Assets, the period for which protection is required and, the ability to bear the cost of insurance.

evaluate and select the type of policies and monitor periodically

check features such as premium payment, nature of cover provided, structuring of benefits, among others

Evaluate insurance needs periodically since needs keep changing

Insurance Products

Life insurance and Non-life insurance

Life insurance products provide life cover; non-life insurance covers all others such as health, motor, travel and others.

Life Insurance Products

Elements of Life Insurance Products

Death cover:

Where the benefit is paid only on the death of the insured within a specified period. If death does not occur, then no benefit will be paid.

Survival benefits:

Where the benefit is paid when the insured survives a specified period.

Death benefits from a life policy are available on the demise of the insured during the term of the policy. Maturity benefits are available on the term of policy getting over.

Elements of an insurance contract

Insured

1. Term of the contract is the period during which the insurance cover will be available to the insured.

2. Sum assured is the amount being insured.

3. The payment of sum assured will be on the occurrence of a specific event such as death of the life insured or expiry of the term of the policy.

4. Premium payable will depend upon the sum assured and the term of the policy.

5. Non-payment of premium will make the policy lapse.

6. Bonus is an amount that is added to the sum assured, announced periodically as a percentage of the sum assured.

7. Guaranteed bonus is paid for the first few years of the policy period.

8. Reversionary bonus is based on the performance of the insurance company and is declared for policy holders at the discretion of the insurer.

9. Nomination is the person(s) entitled to receive the policy money, in the event of the death of policy holder

Sum assured: This is the amount being insured which will be paid on death or maturity. If the premium due on a policy is not paid, then the policy lapses and no claim is payable on a lapsed policy.

Most insurance policies are a combination of the above two features.

Policies with survival benefits combine saving and protection benefits while policies with only death benefits are pure protection products.

Types of Life Insurance Products

Term Insurance

Term insurance is a pure risk cover product.

It pays a benefit only if the policy holder dies during the period for which one is insured.

The three key factors to be considered in term insurance are:

1. Sum assured (protection or death benefit) 2. Premium to be paid (cost to the insured), and 3. Length of coverage (term).

Endowment

Endowment is a level premium plan with a savings feature.

At maturity or death whichever is earlier, a lump sum is paid out, equal to the sum assured plus any accrued bonus.

Money Back Insurance Policies are a type of endowment policies that covers life and also assures the return of a certain per cent of the sum assured as cash payment at regular intervals.

Whole Life insurance provides life insurance cover for the entire life of the insured person or up to a specified age. Premium paid is fixed through the entire period.

Variable Insurance Products (VIP) combine insurance and investment but are not unit-linked. The premium paid will have a component for risk cover and another portion which is the investment component.

Unit Linked Insurance Plans (ULIP) combines protection and investment by enabling the policy holder to earn market linked returns by investing a portion of the premium money in various proportions in the equity and debt markets.

Insurance companies offer products to meet specific life cycle needs of the insured such as children’s education, retirement and such.

Retirement Plans or Pension Plans

are normally plans to which contributions are made till

retirement or for a specified period.

Loan Cover Policy

covers the individual’s outstanding home loan amount ..

in case of death of the policy holder.

They come with a minimum guaranteed return. Loan Cover Policy covers the individual’s outstanding home loan amount in case of death of the policy holder.

1. Annuity for Life 2. Joint Life last survivor annuity 3. Annuity guarantee for certain periods 4. Life annuity with return of purchase price 5. Increasing annuity

Riders are add-ons to the basic insurance policy to supplement the insurance cover provided according to the need of the insured.

Some of the popular riders

Double sum assured rider, Critical illness rider, Accident or disability rider, Waiver of premium rider, Guaranteed insurability option rider,

Non-Life insurance

Non-Life insurance provides risk cover from loss or destruction of assets created and to

provide for unexpected, large expenses that can be a drain on the available income of the

individual.

Sum insured is the amount specified in the policy which represents the insurer’s maximum liability for claims made during the policy period.

Term of the insurance is typically 1 year. In some cases, such as health policies, the term may be two years.

Deductible is a term used to denote the portion of the claim that is met by the insured.

Types of Non-Life Insurance Products

Property insurance provides protection against most risks to property such as fire, theft etc.

Health insurance policies reimburse the medical expenses incurred for the policy holder and identified family members who are covered under the policy.

Motor insurance indemnifies the insured in the event of accident caused by the motor vehicle against all sums including claimant’s cost and expenses.

Personal accident insurance covers permanent total and partial disablement or temporary disablement caused by accident.

Critical illness policy provides for a lump sum benefit to be paid if the named insured contracts certain specified diseases such as cancer, heart attack, stroke, kidney failure or multiple sclerosis.

Travel insurance provides medical, financial and other assistance in case of an emergency during international travel. Human life value (HLV) is the value that insurance needs to compensate for if there is a loss to the life, or disability which results in a reduction in the ability to generate income.

Liability Insurance

The purpose of liability insurance is to provide indemnity in respect of damages payable under law for personal injury to third parties or damage to their property.

This legal liability may arise under common law on the basis of negligence or under statutory law on no fault basis i.e. when there is no negligence.

Life Insurance Needs Analysis

Income Replacement Method

Income replacement method of calculating the amount of life insurance a family will need is based on the income that they would have to forego if the insured were to pass away today.

The amount of life insurance cover required depends upon the economic value that can be attached to human life.

This is called the human life value (HLV).

Information Required

1. The information required to calculate HLV based on this method is as follows:

2. The number of years the individual is likely to earn (Retirement age less present age)

3. Average annual earnings during the earning years

4. Amount of personal expenses like taxes, personal costs, insurance premium which is deducted from annual income.

5. The rate at which the income is expected to grow over the earning years

6. The rate of return expected to be earned on the corpus

Example

Raj earns Rs.8 lakhs p.a.

He is 28 years old and would like to retire at age 55.

We need to calculate the insurance he needs.

We will follow the income replacement method.

Let us assume that his income would have gone up each year by 5% and investment would have earned a return of 8%.

Broadly there are two steps in the calculation

Step 1

Calculate the adjusted rate to be used in the calculation of the corpus.

The formula to be used is:

a. ((1+Investment rate)/(1+Increment rate))-1 is the formula to be used

b. Investment rate given is 8%

Increment rate is 5%.

So, the adjusted rate is ((1+8%)/(1+5%))-1= 2.86%.

Step 2

Use the PV function in Excel.

There will be four parts in this

1. Rate: This is the adjusted rate calculated i.e. 2.86%

2. Nper: This is the number of earning years.

Here it is 27 years.

Because of 55 - 28

(Retirement age-Current age)

3. PMT: This is the income in each year starting with Rs.8 lakhs in the first year in this example.

d. The amount calculated is the corpus required to generate the income that Raj would have earned over 27 years.

In this case it is Rs. 1,53,39,470.

Corpus required is PV(2.86%,27,- 800000,,1)

Rs.1,53,39,470

Notice the parameters of the PV function closely.

The calculation considers payment at the beginning of each year.

This is indicated in excel by putting in ‘1’ in the PV function for the argument ‘Type’

Need Based Approach

Need-based method of calculating the human life value estimates the amount of life insurance required based on the amount required to cover their needs and goals in the event of the demise of the earning member.

Information Required

1. The needs and goals that have to be met and their current value

2. Inflation rate applicable

3. The current value of the available investments

4. The rate at which the investments are expected to grow

Questions

1. In Whole Life insurance, the premium varies as the age of the person increases. Yes / No

No

2. Variable Insurance Products are a form of Unit linked insurance products. Yes / No

No

3. Pension Plans of insurance companies come with built in minimum guaranteed return. Yes / No

Yes

4. Raj has a travel insurance and he went to China. He ate noodles and fell sick on the airplane. Does his travel insurance cover the scenario?

Yes

5. HLV stands for _____

Human life value

6. Maturity benefits are those benefits that are available on the death of the policy holder. Yes / No

No. Upon death, it is called Death benefit

7. Money Back Insurance Policies are a type of endowment policies. Yes / No

Yes

8. If the premium due on a policy is not paid, then the policy lapses and no claim is payable on a lapsed policy. Yes / No

Answer is Yes. No claim is allowed on a lapsed policy

9. Variable Insurance Products (VIP) are earlier known as _____________ (ULP)

Universal Life Plans

10 . The ULIP provides both death and maturity benefits to the holder (Yes / No)

Yes

11. IRDA issued license to the following companies. What type of companies are the following:

CDSL Insurance Repository Limited ( CDSL IR ) SHCIL Projects Limited Karvy Insurance repository Limited NSDL Database Management Limited CAMS Repository Services Limited

Answer: Insurance Repositories

Related Lessons

• Introduction to Insurance
• Term Insurance
• Health Insurance
• Unit Linked Insurance Plans (ULIP)
• Reverse Mortgage Plans
• Insurance for the family
• Tracking Insurance data with Excel
• Fully Paid Up Insurance Policy

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