Insurance is a basic form of risk management that removes the risks associated with loss of income, reduction in income or an unplanned and unexpected charge on income which will upset the personal financial situation of an individual. Insurance planning is specific to the individual and their situation. The steps in insurance planning include identifying the protection needs and quantifying them, buying the type of insurance that suits the requirement and setting in place a review of insurance needs periodically.
Identify insurance need: Insurance is primarily a tool for protection from financial loss. Identifying insurance needs therefore requires identifying all those situations that can result in a loss of income or an unexpected charge on income. Insurance needs can be broadly categorized as:
- Income replacement needs in the event of risk to the life or earning ability of an asset, which includes the life of an individual as an asset generating income. Life insurance, insurance for the maintenance and replacement of plant and machinery, annuities, are all examples of insurance products that meet this need.
- Income protection needs which protect the available income from an unexpected charge. Health insurance and motor insurance are examples of insurance products that will take over such expenses if they occur, and thereby protect the income from a large outflow.
- Asset protection needs which include the need to protect assets created, from theft or destruction. Household insurance is one such product.
The type of insurance required depends upon the age and stage in the life of the individual. Insurance implies a cost and buying insurance that is not required is a wasteful use of income. A young individual without any dependents may probably need a personal accident insurance policy that will give him an income in the event of him being incapacitated in an accident, more than a life insurance policy. The life insurance policy will replace his income in the event of his death, but since he has no dependents it may not be as relevant at this stage in his life. For an individual with dependents, the primary need is income replacement to support his family in the event of his death and therefore a life insurance policy that does this will be more relevant. The personal accident insurance is usually available as an addition to the life insurance policy.
Estimate the amount of insurance required: The purpose of insurance is to compensate the financial loss suffered from a specified event. It is not to profit or gain from it. The amount of insurance required must be calculated giving due consideration to factors such as the future value of the costs being sought to be replaced, the period for which protection is required and, the ability to bear the cost of insurance. Under-insurance will imply that the beneficiary who is likely to suffer the loss is retaining a portion of the risk with them. Over-insurance would imply that unnecessary costs are being incurred.
Evaluate the type of policies available for their costs and features: Insurance products can be differentiated on the basis of their features such as premium payment, nature of cover provided, structuring of benefits and the like. A product should be chosen based on the features that are applicable to the individual, and not merely on the basis of multiplicity of features. The cost associated with the insurance is an important parameter while evaluating insurance products. Insurance is a long-term commitment and exiting midway is difficult and has financial implications. It is therefore essential to consider the suitability of the product, features and cost before signing on.
Evaluate insurance needs periodically since needs keep changing: Every change in the lifecycle of the individual will warrant a review of the adequacy and coverage provided by insurance. These include change in status from single to married, having children, approaching retirement. Similarly, changes in financial situations and commitment such as income levels, purchase of home, all trigger an insurance review.
Insurance should be bought to cover various risks and that is why you pay the premium. Insurance should never be used as a tool to make money.