INSURANCE AND RISK MANAGEMENT

Submitted to
Prof M.Vedavalli

By
Chintamaneni Rajesh
PGDM-Finance
Roll no 258/2014

Calculating how much life insurance you need is one of the most important financial decisions an individual will ever make. It should never be an isolated decision depending only on how much of a premium one can afford.
Having said that, there are many ways in which one can determine how much insurance a person need.

Some of the most popular methods for calculating insurance needs of an individual are
Rule of Thumb
In general, a rule of thumb is a simple guideline that can be easily applied to a situation. In terms of determining a need for life insurance, there are some rules of thumb that you might use to calculate a basic amount of insurance coverage for yourself. The rules of thumb are simplistic and do not consider many of the factors used in other methods of insurance-need determination. They are, however, easy to use and will provide a starting point for your insurance-need evaluation. Below are some common rules of thumb for determining amounts of life insurance coverage.
a. Income Rule
The most basic guideline for determining an insurance requirement is six to eight times your gross annual income. Under this rule, a person earning a gross salary of $60,000 should have between $360,000 and $480,000 of life insurance.
Gross Salary

x6

x8

$60,000

$360,000

$480,000

$80,000

$480,000

$640,000

$100,000

$600,000

$800,000

b. Income Plus Expenses
This rule considers gross annual income along with cash needs at death and any special funding needs, such as private school or college tuition. Under this rule, the insurance requirement is five times gross income plus the total of any mortgage, personal debt, final expenses, and special funding needs, such as college funding. For example, assume the following expenses and debt:

Expense/Cash Need

Amount

Mortgage

$80,000

Personal Debt

$15,000

Estimated Final Expenses

$15,000

Estimated College Expenses

$50,000

Total

$160,000

Using the expenses assumed above, insurance requirements using this rule at various gross salary amounts are as shown:
Gross Salary

Gross Salary x 5

Expenses

Insurance Required:
(Gross Salary x 5) + Expenses

$60,000

$300,000

$160,000

$460,000

$80,000

$400,000

$160,000

$560,000

$100,000

$500,000

$160,000

$660,000

c. Premiums as Percentage of Income
This rule calculates the amount to be spent on premiums instead of the amount of life insurance coverage. Under this rule, 6 percent of the breadwinner's gross income plus an additional 1 percent for each dependent should be spent on life insurance premiums.
Assuming a breadwinner with a nonworking spouse and two dependents, the insurance premium allocations are as shown for various salaries:
Salary

Basic Allocation
6% x Salary

Dependent Allocation
(3 Dependents x 1%) x Salary

Premium Allocation

$60,000

$3,600

$1,800

$5,400

$80,000

$4,800

$2,400

$7,200

$100,000

$6,000

$3,000

$9,000

Under this rule of thumb, you determine the percentage of your income to be spent on life insurance premiums and then buy as much life insurance as you can get for that premium amount. When considering term insurance, the percentage of income allocated for premiums is often calculated at 2% or 3%.
d. Multiples of Salary Method
The multiples of salary method requires the use of a multiples of salary chart and is based on the assumptions that the family has one income provider and that the average family can live adequately on 75% of the income provider's salary. Here's how to calculate the estimated life insurance need:
1. Using the sample chart that follows, find the column showing the age of the nonworking spouse
2. Find the factor on the chart where the nonworking spouse's age intersects with the working spouse's income from the column on the left
3. Multiply the income amount by the multiplier factor from the chart
4. Add the result using the multiplier chart to the estimate of final expenses and debt
See the explanation following the chart for ages and incomes that fall between columns.
Multiples of Salary Chart
Current Age of Nonworking Spouse
Income

25

35

45

55

$15,000

4.5

7.0

8.0

7.5

$20,000

5.5

7.5

8.5

7.5

$25,000

6.5

8.0

8.5

7.5

$30,000

7.0

8.0

8.0

7.0

$40,000

7.5

8.5

8.0

7.0

$50,000

7.5

8.0

7.5

6.5

$70,000

8.0

8.0

7.5

6.5

If the age or income is different than those shown on the chart, it is possible to calculate the amount of insurance needed by using interpolation. For example, if the income is $60,000 and the age of the nonworking spouse is 50, the result can be found using the amounts and ages immediately before and after the actual figures. In this case, take the multipliers for the

ages 45 and 55 with the incomes of $50,000 and $70,000 and use the average, because the actual figures lie halfway between the chart figures. The factors are highlighted as shown:

Multiples of Salary Chart
Current Age of Nonworking Spouse
Income

45

55

$50,000

7.5

6.5

$70,000

7.5

6.5

Average of multipliers = [(7.5 + 7.5 + 6.5 + 6.5) 4]
Multiplier for this income and age = 7.0
Income of $60,000 X 7.0 = estimated starting need of $420,000
Generally, this amount would be adjusted to include final expenses, debt payoffs, and special needs, such as education funds. Using the previously assumed expenses for debt and college funding, the overall insurance need is shown as $580,000.

Expense/Cash Need

Amount

Mortgage

$80,000

Personal Debt

$15,000

Estimated Final Expenses

$15,000

Estimated College Expenses

$50,000

Total

$160,000

Multiplier Result

Estimated Need

$420,00

$580,000

Rules of thumb are simple to calculate and easy to understand. The calculations can be done using a basic calculator. They are useful as a rough starting point and can provide a framework for you to start with in assessing your insurance need. Keep in mind that they are

very general and fail to consider individual circumstances. While the rules of thumb can be a helpful starting point, they fail to consider the needs and circumstances of the individual.
There are no considerations of the ages of the insured or the dependents or whether the family is provided for with one income or two. There are also no adjustments made for special circumstances, such as the expenses associated with a special needs child or the need for liquidity for estate planning.

Human Life Value Method
The human life value concept is a universally adopted approach utilized by underwriters as well as courts when establishing the economic value of a human life.
In life insurance parlance, "Human Life Value" or HLV, represents the amount that ensures a family's standard of living does not get affected if the one who earns for the family dies or is unable to continue earning.
Why should we value human life?
The main contention behind the concept that values human life is that in the event the member of the family which provides regular income dies an untimely death, the earnings lost must be replaced in order for the family to continue on living their lives with as little financial difficulty as possible.
Since the economic value of human life is considered only in relation to the particular person’s dependents (such as a spouse or children) and the lost earnings that must be indemnified for, the human life value approach is suitable to determine the life insurance needs only for families with income-producing members. Hence the other name of the method - income replacement value. This method contrasts the needs approach.
Estimating HLV for the purposes of life insurance
The HLV approach is one of the ways used to determine the amount of life insurance coverage you may need.
Factors considered while calculating human life value:
There are a number of factors involved and some of these are the following:


Age of the insured person.



Gender



Occupation



Target retirement age



Yearly salary



Employment benefits



Financial and personal information on the spouse and children

How the human life value approach works – step by step
1. Get an estimate of the person's average yearly earnings by using current income (also take into consideration future increases in salary).
2. Deduct from the estimated amount in step 1 all living expenses, payments for insurance, and taxes to get the amount that is enough to financially support the family.
Generally, that amount is about 70 percent of the pre-death earnings of the insured person. This amount will largely depend on the financial circumstances surrounding a family. 3. Determine the needed replacement period. That period may be up until the children will have finished college or until retirement of the family's breadwinner.
4. Take into account the rate of return that will be paid on the interest-bearing account in which the insurance company will leave the death benefit.
5. Calculate future income by multiplying the estimated net salary by the number of years. After that use the rate of return from the previous step to get an estimate of the current value of the family's earnings for the desired replacement period.
Although the HLV approach is widely used, it is subject to certain limitations. For one, life is full of unexpected events and changes. These can have significant impact on anyone's financial situation and it becomes difficult to estimate the future earnings of an individual

The Needs Approach
The life insurance needs approach - how does it work?
The needs approach is one of the most accurate methods to determine the amount of life insurance to own. It takes into account all the present and future family needs and calculates directly the amount necessary to meet those needs.
To estimate how much life insurance you need using the needs approach, you should add up all current and potential expenses and then subtract the total amount of existing assets from it.
Cash Needs
These are the immediate lump sum cash needs at death, including administrative and burial expenses, tax liabilities, uninsured medical bills, estate settlement costs and debt liquidation.
Multi-Period Income Needs
The monthly income that the breadwinner's spouse and dependents will need after that person's death.



Readjustment period income needs - a period of one or two years following the insured's death in which the family should receive the same income as when the breadwinner was alive. The readjustment period income provides a cushion period for the spouse to adapt to their new situation.



Children's income needs during their dependency period - when the insured's children are under 18 at the time of that person's death, the family should receive income during the dependency period, i.e. the period between the breadwinner's death until the children reach age 18. The income needed may vary from family to family depending on whether the spouse is on the labor force or plans to remain at home to look after the children.



The surviving spouse's income needs - for a spouse who is under age 60, who has been unemployed for years and whose youngest child has reached 16, the need for income in the case of the family head's death is particularly urgent. This is especially true if the insured dies during the blackout period (the period from the time Social
Security survivor benefits terminate to the time they are resumed).



The spouse's retirement needs - the need for the surviving spouse's adequate retirement should be considered.

Special needs
Any additional family needs that are not covered by any of the above categories. Different funds can be established to cater for these needs, including an education fund, an emergency fund, a mortgage-repayment policy, and other major-debt-repayment policies (for cars or other non-mortgage long-term debt).
The Method that I would prefer and is mostly followed by reputable financial planners for decades is the Needs Analysis Method. Once you determine the amount of life insurance need, just buy the lowest cost insurance plan that's available to you.
You should buy insurance after a thorough calculation of capital (lump sum needs on death such as paying off a loan, daughter's marriage or education) as well as the income needs of your family after you are gone.
One should ask itself: If something were to happen to me, what kind of corpus would my family need to maintain their current lifestyle, to fund my child's education as I had envisaged, retirement income for my wife etc.
Most middle-class individuals have insurance policies in the range of Rs 1,00,000 to Rs 10 lakhs. Some of the wealthier ones have more than this.
The question one need to answer is: How long would Rs10 lakhs suffice?
Keeping that statement in mind one should estimate his insurance needs , so that his loved ones are never short of funds.