### Right way of Calculating Life Insurance

POSTED BY ON November 12, 2010 11:30 am COMMENTS (6)

I would like to know from all the investors that what is the right way of insurance as per you .

There are two models of calculating it

Model 1 : It takes into consideration all your future earnings . So if you are earning 10 lacs , it would take 10 times of your earning and it would be 1 crore, so it is called human capital value approach

Model 2 : This takes care of your future financial goals and make sure you are insured for the value which is linked to your lifestyle . So if you earn 50 lacs , and your future goals and lifestyle require only 2 crore in total , It would insure you for 2 crore .

Which is the right model do you think for Calculating life insurance .

Take a CASE . If a person ABC earns Rs 20 lacs per annum and his Human life value is Rs 3 crores (Total money he will earn in his life time in today’s value) , however his overall future financial goals etc can be met at Rs 2 crore , What should be his insurance amount . 3 crores (model 1) or Rs 2 crores (Model 2)

Manish

## 6 replies on this article “Right way of Calculating Life Insurance”

1. Saanvi says:

Great information. But now a days, no body is calculating manually,there are so many site like BankBazaar.com ,which are calculating and comparing your life insurance by using online tool, which is good accuracy and time consuming tool.

2. shashank kashettiwar says:

Manish,
With HLV approach there is no possibility of making any mistake in calculating any insurance need.
Your income represents the maximum means of creating wealth or fulfilling aspirations, ambitions or whatever that income may allow us to do. It could be charity, philanthrophy or just throwing away the wealth if wished so!
When we have the need based approach we may make the error of confusing between needs, dreams, aspirations and wishful thinking. Sometimes because of this the cover need may even come out to be even larger than HLV value. Like in the above example which you have considered; where you are adding 2 cr cover for estate need to the 50 laks other basic need cover. This extra wish may not even be possible to be fulfilled from your earnings and wealth created by you if you were alive and lived a normal span of life.

In the HLV approach this mistake cannot be made because you are thinking of the income. And ultimately what is HLV method nothing but the maximum limit of the need based function. Just think of your income being represented by a circle. You cannot spend or create wealth beyond this income. Means any single need or a combinations of any number of needs which can or are to be fulfilled will be digram/polygon whose area always will be lesser than the income circle. This needs diagram will always be lesser than the circle. It is the limit of the needs function.
If the insurance cover created is similar to the income function then all the needs function are automatically provided for. The income function is the superset containing all the elements of different subsets of needs function and all the elements of the needs subsets cannot be larger than the income superset!
The open and closed ended approach: Life is an open ended situation. When I approach it with a needs based approach I may make the mistake of creating closed ended solutions. ( This point would become extremely clear when I put it in the context of child education. I will write on it as a reply to one of queries on child plans tommorow.)

One point you have raised about is the ‘sale’ angle of insurers. You think ibecause of HLV approach the insurance companies make a person to buy insurance unnecessarily. They adopt this approach just to increase their sale. I have three objections to your perspective.

1. It is as if buying more insurance is going to harm an individual. It is not a consumer product. It is a saving instrument or a wealth protection instrument. Being sold more is good for the individual, society and the country as a whole.
2.Basic principle on which insurance mechanism rests is the principle of ‘large numbers’. Larger the persons, more the covers, more correct will be the statistical outcomes. The costs and the premiums could be brought down!
3. As it is insurance is a vague need. Its benefit cannot be felt immediately. It is far ahead , somewhere in the future that I may receive the said benefits from it. So there is a srtong resistance to buy it. It has to be convinced. So even though the insurance companies base it on the HLV, they don’t sell it on it. THEY SELL ON THE NEED BASIS. Thats why all these child plans, mortgage insurance, tax saving approaches and investment approaches to push it. I don’t think pushing HLV approach is going to make their life easy. It would happen exactly opposite.
4)Can we really say LIC is a profiteering, capitalist, bloodsucker company ? We may give such adjectives to private enterprise may be. So do you think the HLV approach will lead to exploitation of a consumer?

shashank

1. Fair enough

I agree with your point that HLV method gives the upper limit of person insurance needs , but still its not clear that HLV method gives accurate insurance need of a person , from your explaination I can conclude that the insurance limit is lower of HLV and need based approach .

Regarding your first point “It is as if buying more insurance is going to harm an individual.” . No I dont think so , its not that it harms him or anything , at the end , he will get a lot of money , may be much more than what he desired or require, however the point I was making when i say “over-insurance” is that a person will be paying much bigger premium which he needs to for a less probabilistic event of his death , so for something which might not happen by all chance, why compromise on one’s current cash flows .

With term insurance , may be I am convinced if a person needing 1 crore takes a insurance of 2 crores , because the premiums are very low , however with endowment policies , it can turn out to be a costly mistakes, but I dont see any example in real life , in all chances most of hte people are under-insured only .

Again , I feel that you are trying to give the HLV approach so much significance and that you are taking it as the ultimate source of truth and making it so supreme that it logical way does not hold any water.

Overall I would like to conclude that It might be a difference of opinion between me and you and the way we are looking at many things like human needs in life and financial planning overall . But that fine as far as we make sure the clients are not underinsured at least . which is the case with both of us I suppose 🙂 .

Anyways , it was a good discussion overall and it adds a new dimension to my understanding .

Manish

3. shashank kashettiwar says:

Very few people have clarity regarding what insurance is all about.

In my trainings and my financial planning call also I tell, you can look at life insurance in two ways; eighter as
– Family’s Financial Security
or – Protecting Your Economic Value

Family’s financial security concept is more akin to the ‘need based approach’ of calculating insurance need. It takes into account your existing wealth also while finding the insurance need. Whatever seems to be shortfall is the insurance cover one needs to buy.

The second approach is to look at your economic value and try to protect the whole of it. This approach is akin to the HLV methodology.

I pose a question: do Mukesh Ambanis, Laxmi Mittals, Rahul Bajajs of the world need life insurance? The answer would be NO if we look at their situation from the first perspective i. e. family’s financial security. Why only for their immediate family, they probably have created financial security for the generations to come! But if you look at insurance from the second perspective, then, yes they do need insurance because their future income is yet to occur.Life Insurance has nothing to do what your present assets are and how you are going to provide for the dependants. Don’t confuse the insurance concept with your existing wealth. As long as a person has economic value he needs insurance.

And what is the harm in having full insurance? Is it going to decrease your wealth or affect achieving of your life’s goal? Is it going to create so much a negative impact that you should try to buy less than the fullsome life insurance? We might be living on only a fraction of our income i.e. we don’t require the whole of money for our present or future needs also. So if your employer says work for lesser salary or no income raise for you, will that be acceptable to you? Definitely no. You will say I smoke a bidi and not a 555 cigarette because that is my choice and it doesn’t mean I wouldn’t do so in future. That is my choice in life. You might be still driving a Indica even though your finances would allow you to buy and ride a Honda City. That is your choice. You might be taking yearly holidays to your native place that doesn’t mean you wouldn’t like to be able to take them to Switzerland if wished so.

So our income not only have a need component but also an aspirational component, an ability display component, a pride component. If you protect the whole of income then there is nothing more than that to protect and worry whether something has been left uncovered, whether I’m going to upgrade or downgrade some of my needs, any unforeseen situational changes affecting my plans and all that. Also if you have money, budget for investing/buying ample insurance then why do you want to be miserly about it and underinsured with the need based approach? Not at all a prudent and sensible policy.

The person insisting on need based approach is like a one who says,” I don’t want to leave behind heavy wealth if I die suddenly but would definitely likely to leave huge wealth behind if I live a normal lifespan.” Horrible logic indeed!

One more important point missed by the need based approach is the one’s duty towards one’s estate. I live, I work , I create an estate like my forefathers have done for me and left an estate for me. Without this estate I would have had lesser choices in life, less comforts and less opportunities also. If I insure myself fully then even if I die untimely my son would have enough choices available because I ‘m living behind wealth which I would have created or left behind if I had worked my normal working life. The Anil and Mukesh Ambanis are just lucky that their father lived a full life and could create weath which has been a springboard for their further rise in life. Can you imagine the situation if Ambani sr had died untimely and not created enough insurance to protect own’n economic value?

The insurance can be looked upon as- 1) Expense 2) Hedging Mechanism or 3) Asset.
It requires very good understanding of the insurance concept and products to understand all these perspectives.

(I can go on describing effect of choosing different multipliers- right from ‘0’ i.e. no insurance to a fullest insurance multiplier allowed by the insurance companies; which is technically the highest allowed even if we wish and can afford to go beyond. Now this is the complete spectrum from nil to complete insurance.
The product choice too could be from low budget term plans to heavy budget moneyback/endowment/ULIP plans and any combination in between these extreme ends in product selection for creating insurance portfolio. Again a complete spectrum of solutions for a particular cover need.)
And what is the optimal solution/combination for a particular person, for a particular life cover and a particular budget can be arrived at. ( I will state my steps of insurance planning in next comment. They are definitely vastly different than what Manish proposes in one of his articles on the same topic)

shashank

1. Shashank

I think you didnt took my approach in right way , When I say need based approach , it say what are your future financial goals , which can include leaving estate for your generations or having some aspirations in life and fulfilling them

So as you said If I want to go on a world tour and it would cost 50 lacs and I want to leave estate of 2 crores to my dependents , I would also put them and have 2.5 crores extra life cover over and above the normal goals in life .

My still disagree with your point “As long as a person has economic value he needs insurance.” , Not sure why ! again , it feels like with this statement we are trying to impose what is general perception created by companies to make their sales happen .

Companies or the creators of these rules know that once they declare these message and spread it that “Anyone earning money or having economic value should have insurance” , its going to make sure there products are sold . Need based analysis is a model which will hamper their sales .

With HLV approach , companies can sell insurance even to Ambanies, but if you consider Need based analysis , it wont help them to make sales, which one do you think will get the most pushed and tought to everyone .

Do you think even with logic and common sense , HLV is the way to go and Need based is non-sense ?

Manish

4. I’ll go with Model 2. We all take insurance to meet our financial goals in our absence. If a person is earning Rs.20 lacs p.a., naturally, he will have other assets & investments also, which can be add liquidate by family members. And he survives, he can obviously fulfill his responsibilities.

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