Our emphasis lies in picking the insurance product rather than evaluating our insurance needs. The standard practice of financial planning advocates us to first calculate the insurance requirements and then start analyzing the available options before picking the suitable product.
In India, when it comes to life insurance we mostly hear about calculating the insurance requirements using the human life value (HLV) method. HLV takes into consideration only the income of the individual.
By considering only the income, the HLV method makes multiple assumptions that are not tenable over a long term.
One of the assumptions is that today's salary can be used as a reference point for future requirements, and often emergencies that are non-life threatening (eg: job loss, accidents, etc) are not considered, making it more likely to overestimate or underestimate the insurance requirements of the family.
The very purpose of taking an insurance cover is for the family to meet the expenses after the demise of the earning member. Need-based approach, often termed as expense replacement, considers the expense that the family would require to sustain in the absence of the bread winner. It is also important to understand that the family needs readily available cash to pay off the deceased member's medical expenses, funeral expenses, debts, estate settlement cost, emergency fund and final expenses as the inflation rate increases the cost of living also goes up. The family of the deceased should be able to sustain itself in such conditions as well. Hence, it would be prudent to link to the insurance requirement of individuals.
Need-based approach involves paying off the deceased persons' remaining obligations such as auto loan (if the loan is not insured), credit card dues, meeting child's future education needs, etc. It also takes care of the future expense needs of the family. Expense replacement approach is more accurate as it involves a detailed examination of the family's anticipated expenses during various periods after the insured's death. It provides more realistic estimates of life insurance needs.
Nitin Vyakaranam is the founder and chief executive officer, ArthaYantra, an integrated online personal finance company.
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