What approach should you take when you decide your life insurance policy?Check out Naval Goel's advice.
Illustration: Dominic Xavier/Rediff.com
The major role that life insurance plays is in offering the death benefit.
The financial loss after the death of the breadwinner of the family is protected with the help of life insurance.
But you should be careful about your insurance needs.
To know how much insurance you require, you can go through these approaches:
1. Human Life Approach
This approach actually forecasts the income need of the individuals by the expectancy of the remaining life.
It generally uses a discounted rate when the present value of the life is being calculated.
The calculation takes place in the following manner:
- The average annual income of the taxpayer is calculated after deducting the living expenses and taxes.
- Forecast the period of time when the taxpayer is expected working before the retirement.
- Choose the interest rate which is logical and can be discounted with the future earnings.
- Before the expected retirement, the present value can be annually payable by the value of one dollar.
2. Need Approach
This is another approach which is widely used for determining the needs of life insurance.
The needs of the family should be analysed.
If the breadwinner of the family become disabled or dies suddenly, then this need analysis is very important.
This analysis can be calculated by the following factors:
- Income During Dependency Period: You should know the required amount which is necessary for maintaining the present expenses for the household of the dependents and children.
- Income For The Spouse Who Survived: If the spouse is non-working and dependent, the life income for the surviving spouse is also to be calculated.
- Last Fund Of Expenses: The medical expenses and the funeral expenditures are to be included within the last expenses fund.
- Payment Fund Of Mortgage: If the breadwinner deceases, then the ability of paying off the mortgage payments should also be calculated.
- Readjustment Fund: When the family is adjusting with the income losses, the non recurring expenses should also be included.
- Fund For Education: During the financial crisis situation, the fund should be provided in lump sum for the child's education.
Now, how will you determine the amount of life insurance you will require?
1. Calculate The Expenses Of The Family In The Event Of Death: You should consider the final expenses including the outstanding debts.
There may be some debts which automatically retire after death. You should be aware of all those debts.
2. Add Unfunded Goals: If any unfunded goals are present, you should consider them fully.
For example, college funding expenses.
You should consider the expected amount of college expense and subtract the amount which you have already saved.
3. Determine The Amount Required To Fill The Gap Of Cash Flow: For planning your insurance, you should determine the cash flow gap.
Without you, your family's income and expenses can only be protected if you can determine the amount carefully.
There may be some changes when you are gone. You can ask some of the questions yourself:
- Whether your spouse will continue working in the event of death, or s/he will have to start working after your death.
- Will some of the expenses fade away after your death? For example, mortgage payments automatically fades away. Are there other expenses which fade away in the event of death?
- The cash flow gap can only be determined if the future income and expenses can be predicted carefully.
4. Calculate Present Value Of Gap Of Cash Flow: You can use the online calculator for calculating the present value of the cash flow.
As life insurance is required for replacing the income of the deceased, you can also use a conservative approach.
The life expectancy of the beneficiary is to be considered and the proceeds can be invested in the income producing assets.
5. Add The Amount Owed On Mortgage: If your family is not able to pay the amount owed on mortgage, you should possess sufficient amount of life insurance so that the amount gets paid off easily.
6. Subtract The Non-Retirement Investments: If you possess some non-retirement investments, it can supplement the gap of the cash flow.
The post-tax value of the investments can be subtracted. This will help you in determining the amount of your life insurance.
When you are assuming the future expenses, you can assume the savings during the retirement expenses of your spouse.
If the spouse is presently not saving the expenses of the retirement, the need of the life insurance increases naturally.
So whether it's human life or the needs approach, you need to predict the future expenses of the life expectancy of the dependents.
Naval Goel is CEO and Founder, PolicyX.com
