Finer Nuances Of Financial Planning Aspects - II : Insurance Needs Analysis

In last week's post Finer Nuances Of Financial Planning Aspects - I : Setting Goals, I covered the nuances involved in setting, prioritising and quantifying financial goals. At this point we may begin building an asset base to achieve our goals. But before building assets for the future, we must first ensure that our present human capital is adequately secured. Human capital has two main facets to it : 

1.  The income that we earn

2.  The skills and capabilities that would help us preserve and increase our income. 

Protecting present human capital effectively would require the purchase of 3 forms of insurance. These are life, health and disability insurance. 

Life Insurance 

Purchasing term life insurance would help replace our income for our family in our absence. The policy we purchase must be free of any and all riders. The standard amount of term insurance recommended for each earning member is 15 to 20 times annual take home income. But this number may be absurdly high in case of those who have significant monthly incomes. The results derived from this thumb rule may therefore be unrealistic. 

The need for term insurance arises from a dependence on earned income. The degree of dependence on earned income is usually limited to the value of the outstanding financial goals and liabilities of the household. Available assets and term insurance coverage reduce this dependence. A more realistic calculation of term insurance requirements can therefore be given by the formula below : 

Term insurance  coverage required = Current value of all financial goals and outstanding liabilities - Available assets - Available term insurance coverage 

This calculation can be repeated once a year with updated figures for all inputs. It would allow us to account for changes in values of our goals, liabilities, available assets and insurance coverage. Additional coverage may need to be purchased based on the results of each year's calculations. An illustrative example is given in the graphic that follows.

We must ensure that the death benefit from the policy is paid out as a lumpsum. Insurers provide the option of paying out the death benefit in a staggered manner. This is advertised to serve as a source of periodic income for our beneficiaries. But this option must be avoided. The staggered payments are not inflation adjusted. Therefore the actual amounts recieved under a staggered payout option would not have the same purchasing power as a lumpsum received immediately.

Covering earning members in a family with term insurance is a standard practice. But there may also be cases where non earning members in the family need to be insured. Consider the case of a couple with kids where only one parent earns. The other looks after kids on a full time basis. Assume the non earning parent passes away. Now the full time support the kids recieved would have to be replaced. This would obviously come at a significant cost. Insuring the life of the non earning parent would therefore be an effective contingency plan. The death benefit recieved may be used to pay for a full time caretaker for the kids. The death benefit would obviously be a significant amount. This may allow the family to pay for the caretaker over a number of years.

Disability Insurance 

Term insurance covers the risk of death of the breadwinners in the family. But the temporary or permanent disablement of breadwinners can also severely compromise household income. This risk can be covered with disability insurance. But  providing for the risk of disability in India is challenging. There are disability insurance policies available in India. But for various reasons, these policies offer negligible amounts of coverage. The range of risks they cover is also very narrow. For instance, loss of 99% vision in both eyes may not qualify as an insurable risk under such policies. Only 100% loss of vision may be covered. 

Therefore we need to provide for this risk through alternate means. One option could be to create a separate savings reserve for use during a period of disablement. This would require us to maintain a substantial monthly savings rate. Non financial measures to cover this risk include closely monitoring our health, driving at moderate speeds and wearing a seat belt while driving. It must be borne in mind that these measures represent extremely limited solutions to this problem. 

Health Insurance 

Life and disability insurance address the need for income replacement. But it is equally important to protect our current income. This is where health insurance comes in. It protects our income against the risk of paying hefty medical bills by outsourcing them to the insurer. Our health insurance policies must therefore cover us against 2 major costs : 

1. Cost of hospitalisation 

2. Cost of major day care procedures (Dialysis, Chemotherapy and so on) 

All other benefits such as ambulance cover, maternity benefit, AYUSH benefit and so on are not essential to the purpose of health insurance. Therefore such benefits should not be the primary reason why we buy a particular policy. Every individual must have health insurance in their personal capacity. A base policy of Rs 10 lakh and a super top up of Rs 50 to 100 lakh would largely be adequate. But having a health insurance policy does not guarantee immunity against paying medical expenses out of pocket. There are two circumstances where we may need to pay medical expenses out of pocket, even with a health insurance policy. 

The first of these is having to pay non medical expenses. These are ancillary expenses incidental to a period of hospitalisation. These expenses are not covered by most insurers. They usually constitute around 10% of the overall claim amount. We would therefore have to pay them out of our own pocket. Examples of such expenses include costs such as admission charges, vaccination, surgical bandages, hospital gowns and so on. 

The second situation where we may have pay medical bills out of pocket is when cashless settlement of our claim is denied. Cashless settlement of claims is a right of the policyholder. But it is not an obligation of the insurer. So it is well within the rights of the insurer to deny cashless settlement as per the facts of the case. The cashless settlement process is explained below.

Cashless settlement is usually denied when the insurer suspects that the claim is being made for a disease not covered by the policy. It can also be denied if the treatment is taking place in a non network hospital. In such a case we would be obligated to first pay the bills out of pocket and claim reimbursement later. Most top up claims are also handled via reimbursement mode.

There are better chances of cashless settlement if the base and top up policies are from the same insurer. Opting for a super top up policy from the same insurer may also be a reasonable choice. But even this does not guarantee cashless settlement. It is therefore important to have adequate liquid savings over and above the health insurance cover we own. 

Conclusion

Reaching this point in the financial planning process would mean we have meaningful goals in place. We have also identified major sources of risk for each goal and provided for them. This means we can now begin constructing portfolios for each goal. Before constructing portfolios we must settle on an ideal asset allocation strategy for each goal. And this would be the next topic of discussion