The Concept & Advice on Life Insurance

Mr. Gerard Colaco: No insurance in the world is more wrongly sold than life insurance. We will discuss about whether you require it or not, later. First, let us have some ideas on insurance which are based upon the advice of some of the world's best writers on financial planning, insurance and investment.

Life insurance should be purchased only if required and to the extent required.  A. N. Shanbhag is perhaps the best Indian writer on investment and financial planning. This is what he has to say about life insurance:

"There is no substitute for life insurance.
Life insurance is not an investment. 
It is a social and commercial instrument to provide financial security in the event of death of the insured.
If dependents can look after themselves comfortably without the amount insured, life insurance is not needed.

Life insurance is like a life saving drug. If you need it, you must have it irrespective of the cost.  If you do not need it and you take it, it can have very bad side effects on your financial health."

So the first question to be asked is: Do you need life insurance?

The answer is simple. You need life insurance only if you have financial dependants.  If no one is going to be financially affected by your absence, you do not need life insurance.

The next question is: How much life insurance do you need?

The answer is, enough to keep your financial dependants in the lifestyle they are used to, ensure that they are debt-free, and provide for their reasonably foreseeable future needs.  In other words, enough to compensate your dependents for the adverse financial situation caused by your absence.

Let us take a simple example for attempting to calculate how much life insurance a person needs. Suppose there is a family consisting of husband, wife and two very young children. Let us assume that the monthly normal expenditure of this family is Rs 25,000/-. That means a cash requirement of Rs. 3 lakhs per annum, to ensure that the family lives in the lifestyle it is accustomed to.

Now supposing the husband is the sole bread winner of this family. His first concern will be that the family will not have the cash flow of Rs 3 lakhs per annum, in case he should suddenly be removed from the scene. Therefore, he must calculate what size of corpus must be invested in a safe avenue of investment like a bank fixed deposit, to ensure that the family gets Rs 3 lakhs per annum. If a corpus of Rs 43 lakhs is invested in a safe avenue like a bank fixed deposit at an average rate of interest of say 7% p.a., it will provide the family with the required income stream.

However, this does not mean that the husband must rush out and straightaway purchase Rs 43 lakhs worth of insurance. There are some deductions to be made from this corpus. For example, he may already be having financial savings of say Rs 10 lakhs. His wife may have financial resources of her own of another Rs 15 lakhs. Let us say that the value of his retirement benefits, existing insurance policies and other cash flows that will accrue in case of his death amount to another Rs 5 lakhs. This total of Rs 30 lakhs must be deducted from the Rs 43 lakhs corpus envisaged earlier, since it will be available to provide the necessary income stream.

Therefore, there is an uninsured gap of Rs 13 lakhs, that is 43 lakhs minus Rs 30 lakhs.  This is the amount for which life insurance must be taken. We have of course given a very simple example, assuming that this family has already taken care of its housing requirements. You can discuss with your close family members and calculate your own insurance requirements.

Going back to the example under consideration, if when doing your calculations, you find that your total liquid assets are say Rs 45 lakhs, that is more than the corpus of Rs 43 lakhs that would be required to provide income to take care of normal expenditure, then you do not have an uninsured gap and you certainly do not require life insurance.

One final point.  Do not be fooled by advisors who do complicated calculations to arrive at how much life insurance you need.  They will add things like child education, marriage expenses, etc., to inflate the quantum of insurance to be taken.  No one can predict the future, especially the distant future.  The period of vulnerability is one, two, three or a maximum of five years after a death occurs in a family, especially of a breadwinner or important earning member.  Human beings are very resilient by nature and are capable of adjusting to, and dealing with, new, adverse situations, in the medium to long term.  It is in the short-term that they are vulnerable and need the protection of life insurance.

When we talk about expenses based on which to calculate life insurance needs, we generally talk about normal current monthly expenses. There is however definitely no harm in a slight increase in the estimate of these normal expenses. For example, if we are talking about Rs 25,000/-worth of normal monthly expenses, you certainly can provide for Rs 30,000/- normal expenses for the purpose of life insurance requirement calculations.

However, there is no need to substantially inflate these figures or worry about providing for 10 or 20 years hence. No one can predict the future including what shape general circumstances or economic circumstances including inflation is going to take.  The two simple examples are; Twelve years ago, the cost of a telephone call from Mangalore to Bombay was more than 26 rupees per minute.  If anyone had predicted that the cost of this call would come down to less than Rs 1 per minute, he would have been laughed at and dismissed as a madman.  Similarly, if someone had predicted that one day, you would have air tickets of Re 1/- (subject of course to conditions) available in India, no one would have believed the prediction.

There is already a built-in safeguard in taking only normal monthly expenses for insurance calculations.  In practical terms, we have observed that the expenses of a family tend to go down immediately after the death of one of its members. This is because expenses that used to be incurred on that particular person are no longer incurred.

Further, as mentioned earlier, it is impossible to predict future inflation rates and future fund requirements. So long as the rest of the family is adequately insured for health, and to the extent required for life, the best you can do in life insurance is enable a corpus to take care of normal expenses for the next few years, say a maximum of 5 or 6 years.

It is important and most people do not realise it when they buy insurance:  Human beings are extremely resilient. They tend to adjust sooner rather than later to new situations, including existing, adverse situations. The greatest period of vulnerability is generally not more than, one, two or at the most three years from the date of death of the breadwinner.