Since the last several weeks, Ravi is troubled over his insurance requirements. He is not clear about the exact amount of insurance he requires. Now he is considering of adopting some rule of thumb measures to get an idea about the figure. Using rules of thumb is a simple way to know the cover amount, but Ravi is not completely sure about its effectiveness. He also has a doubt about the benefits that can come out of the entire activity.
Analysis
Various rules of thumb are used in the process of taking insurance. These need to be watched carefully because they are often used by people to determine the required insurance cover. These rules are very simple to use and hence can also be easily understood as far as an individual is concerned.
One of the simplest ways is to take multiple of the income being earned and use it to decide the sum assured. Different figures can arise out of these calculations depending upon the multiple that is concerned. The insurance cover in this case depends upon the income as well as the multiple chosen for the calculation. So a person might say that I would like to get a cover that is 4 times my annual income while someone else would like to take it at 5 times the annual income. In both cases the insurance cover will be different, and hence there will be a change in the premium that is paid and the amount that is actually spent by the individual.
The average multiple taken for calculating insurance is between 4 to 8 times the gross annual income being earned. In the above case, Ravi's gross income is Rs 5 lakh and if the multiple taken is 5 times then his insurance requirement will come to Rs 25 lakh. This represents the sum assured that has to be available for the dependants of Ravi.
For salaried people, this working is represented by the multiple of salary approach. Here, a fixed multiple is applied to the salary being earned. Both the multiple chosen and the salary of the person are important factors as they will help determine the final figure of insurance. Since the salary will keep changing, it becomes essential that the insurance figure be reviewed at a regular interval of time.
A variant of this situation is to consider the income plus the expenses approach. This provides an additional amount of insurance cover. So initially the income calculation is made and if there is an expense that will be incurred then this is added to the total insurance cover required. In case of Ravi, his insurance requirement as per the income method is Rs 25 lakh. Now if we also consider his future expenses as Rs 3 lakh then his total insurance requirement will become Rs 28 lakh. Usually, only normal expenses that have to be incurred are taken into the calculation. Expenses represent spending which will have to be met out of the insurance amount, and hence this is a vital part of the calculation.
The other way in which a rule of thumb is considered is by deciding a certain percentage of the income as the premium to be paid. The percentage figure usually ranges from 3 to 7 per cent. This is a slightly different working from the earlier one because here the amount determines the premium to be paid on the insurance policy. In Ravi's case if he fixes his premium at 6 per cent of the annual income, then for an annual income of Rs 5 lakh, his premium will be Rs 30,000. Depending upon the policy chosen a specific amount of insurance cover will be available for him in such a situation, and this can leave different people with different insurance covers for the same amount of premium.
