How much insurance cover we need?

After we saw how to set and track our financial goals, it is important to know whether we are sufficiently covered for life.

There are many methods available to calculate the insurance cover like as simple as multiply the yearly expense by 10 to more complicated one  like real life value. I have learned a more practical approach where the insurance value (I.V) is calculated  based on three factors

1. Real Expense
2. Goals and
3. Liability

Let us take an example:

Personal Profile:

	Name	Age	Income
Self	Arun	30	10,00,000
Spouse	Lavanya	27	-
Kid	Ajay	1	-

Financial Profile:

Annual Expense		7,50,000
Savings		5,00,000
Liablity	Home Loan	25,00,000
Goals	Ajay Education	10,00,000
	Ajay Marriage	6,00,000

Real Expense Calculation:
For every insurance calculation we need to calculate the actual annual expense. Arun has mentioned that he is spending R.s. 7,50,000 annually. In that he is investing around Rs.1,00,000 and paying EMI of Rs.3,00,000 so we need to subtract these values from his annual expense

7,50,000 - 4,00,000 = 3,50,000

assuming that his expense alone out of this total expense is 10%

350000 - 35000 = 3,15,000

Rs.3,15,000 is required by the family every year to meet the personal expense should something happen to Arun.

Expense Corpus calculation to generate Rs.3,15,000 annually  :
Expected Inflation: 6%
Expected Returns: 9% (Should be safe enough in absence of bread winner)

Effective Returns: 9-6 =  4%

Tax Slab : 20%
Pre Tax Annual Requirement : Rs. 3,93,750

Expense Corpus Required = 393750 * 100/4(Effective Return) = Rs. 98,43,750


Life Insurance Calculation:
I.V = Expense Corpus + Goal Value (Today's Value) + Liablity - Net Worth
I.V = 98,43,750 + 16,00,000 +25,00,000 - 5,00,000 = Rs. 1,34,43,750


Which Insurance to Choose?
There are many types of insurance policy available in the market like plain vanilla Term plan, Monthly income plan, Endowment plan and ULIP. As you might know that for the coverage of around 1.3 crores Arun cant afford premium in any of the plan except the term insurance.

The important thing to note is insurance is not investment, it helps your family in case of any eventuality so you should not fall into prey of getting returns from the insurance premium you pay.

I have taken an example to show you how much premium Arun will need to pay in case if he choose a term insurance.

Plan : Aviva i-Life
S.A : 1.3 Crores
Age : 30
Policy Term: 35
Non Smoker

Premium : R.s 10,612 Annually

Some thoughts:

I feel that this method gives me more accurate value of my insurance requirement. However there are some variable components involved in this calculation like

• Expense which may go up or down ( Not based on inflation which we already factored in, but based on the need like kids expense may go up considerably once he joins the school etc). 
• Goal: It may go up once you have another kid or when you have more goals

so it is very much important to do the calculation once in 2 years at-least and  add/reduce your insurance coverage accordingly. To start with I suggest taking 3 term insurance plan for Expense,Goal and Liability respectively and once the goal is achieved are you have no liability stop the insurance of those two. 

Summary:

• Always take term insurance (Online preferable).
• Review the requirements once in 2 years and add/remove covers.
• Never lie while filling the insurance application. In case if you missed or lied anything call them and correct the mistake now itself. Even if they cancel the policy, it is ok rather than living in false belief that your dependents will get the S.A in future. 
• Fill the application by yourself.
• Never let the insurance agent talk.

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Goal-Plan-Action for Finance planning

This is the follow-up post for my previous post "The importance of goal setting in financial planning". I will take the  theme of my previous post and discuss how to achieve it using some of the tools available.

Goal->Plan->Action

Goal Setting:

Let us take an illustrative example of one Mr.T.R aged 28 want to save money for his kids education. His kid Simbu is now 2 years old. He needs to address these following things to come up with the goal

• Name of the Goal  :  Simbu's Education Fund
• How much money he need now:  10,00,000 (He should answer how of much money he needs now if Simbu is joining college today)
• Years till Simbu joins college: 16 years

Plan:

Now Mr.T.R clearly defined all the key parameters of the goal, we need to plan how much money is needed after 16 years.  If we assume that the education expense grow 8% every year,

this calculator clearly shows that Mr.T.R needs Rs.34,259,42 after 16 years to meet the education expense of Mr.Simbu.

(Calculator used: Future Value Calculator)

Now we need to calculate how much money Mr.T.R needs to invest every month for the next 16 years to reach his goal.

I use the "How much should I Save to Reach My Goal? calculator from yahoo finance" assuming 12% returns from the investment which is modest. 

this calculator shows me that Mr.T.R needs to invest Rs.71547 annually (Rs.5962 monthly) to achieve his goal. If he has any savings currently he can also put that in current savings balance.

If we cant invest 71547 now, we can opt for a lesser amount now and increase the investment every year, you can play around with the field annual increase on recommended savings to determine such value.

Action:

Next thing Mr.T.R needs to do is to pickup a 5 star rated equity mutual funds from www.valueresearch.com and start investing Rs.6000 through SIP (Systematic investment plan) for the next 16 years. Mr.T.R should not worry about ups and downs in the market and keep investing in equity. The only advice is that he should review the plan once in every year and switch to other plan if it under performs the category average.

To track the growth I created a spread sheet which looks like this (The funds mentioned are just for illustration and not for recommendation)

Similarly Mr.T.R needs to set goals for Simbu's marriage, Kural's education etc. We will talk about retirement planning sometime later.


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Importance of Goal setting in financial planning

When we talk about personal finance planning, we need to understand the clear difference between the terms "Savings" and "Investment". Even though these two terms are used interchangeably in financial discussions there are certain difference with which we can distinguish these two.

When you say "I am Investing" it means that you are expecting the capital to grow and you are taking a risk but when you say that "I am Saving" it means that you are more conservative and you are looking for your capital protection.  

So what should we do? Save or Invest? What I say is forget about these jargon's and get yourself into reality. It gives us a false prestige when we say that we are investing in stocks rather than PPF, it gives you a geeky image. 

Even if we don't understand the risks, even if we don't understand the stock market we will put our money into it and expect a 200% returns in a year. When we question their motive the simple answer is I want to be rich. Well everyone's ambition is to be rich but how rich is rich? XYZ invest in stocks and wants to be rich so as Warren Buffet invest in stocks and wants to be rich. The only difference is Warren Buffet has goals.

Is Finanical Goal important, yes definitely.

Goal->Plan->Action-> Excitement->Achievement ->Satisfaction

Without goal we are clueless, goal will lead us to plan for it. Some one might keep investing in some assets without any goal and become super rich but i don't travel that way. I need a goal to get motivated to get excited. Otherwise it is like watching Sachin playing in Australia without 100th century in mind. That milestone motivates Sachin, excites him and when he achieve it gives enormous satisfaction.

Investing is not about putting your money continuously in some asset and watch it grow, it is all about booking profit at right time and reaping the benefits. To achieve it you should know when to stop, to know when to stop you need to set goal.

You can set a goal by answering these questions

• Why do you want to save money?
• How much money you need?
• When you need that money?

Some of the goals you can set are

• Children's education - Need 10,000,00 in 2021
• Marriage of your Son/Daughter  - Need 15,000,00 in 2030
• Retirement planning
• Down payment for buying house
• Down payment for buying car
• Foreign trip

Next post we will see how should we plan and track for achieving the goal.

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