Principles of Insurance

• Law of large numbers
• Principle of indemnity
• Uberrimae Fides (Utmost good faith)
• Insurable Interest

Law Of Large Numbers

The law of large numbers basically relies on the principle that the larger the pool, the more predictable the amount of losses will be in a given period. Since not all members of the pool are the same age or in the same health condition, we can assume not all of them will be making a claim at the same time.

Principle of Indemnity:

Insurance is meant to compensate losses. By implication the mechanism of Insurance cannot be used to make profit. This broadly is Principle of indemnity. The amount paid as a claim cannot exceed the amount of loss incurred. Insurance should place the insured in the same financial position after a loss as he enjoyed before it, not better

Uberrimae Fides (latin word for utmost good faith) or Principle of Utmost Good Faith

Each party must disclose every material fact known to him. Disclose all the facts accurately and fully that can affect the risk on Life Assured. Whether requested or not

Material Fact - Any fact which influences the judgment of a prudent insurer in fixing the premium or in determining if he will take the risk

Insurable Interest

Exists when a person stands to lose if the event “insured against” occurs and it must exist at the time of entering into the contract

Following relationship hold Insurable Interest:

• A person has unlimited insurable interest on his own life
• Spouses have insurable interest on each other.
• Father / Mother have insurable interest on their children
• Creditor on the life of Debtor to the extent of debt
• Partners in partnership firm to the extent of their share holding
• Employer on the Employee (Keyman, Employer-Employee)

How much life insurance should you buy?

The primary purpose of Life Insurance is to secure the financial well-being of your loved ones in case of an eventuality. If your family is dependent on your income, or your financial obligations are more than your assets, it is imperative that you consider buying life insurance to protect their future.

Once you have taken a decision to buy, one of the first considerations will be to determine the amount of money you want to leave behind for your dependents, i.e. the Sum Assured value. When you choose an amount, keep in mind that if it is very small, it might not be adequate to meet your family’s future financial needs. Alternatively, if it is very high – more than what you essentially require – the annual premiums will be an unnecessary long-term expense.

One widely followed rule of thumb is to choose a Sum Assured valued at 10-15 times the annual income of the policyholder, plus outstanding debts. Another common way is to multiply the annual salary of the policyholder by the number of years left until retirement. This calculation assumes that not many family members will be financially dependent on the policyholder beyond his retirement age.

However, using such simplified ways to decide the value of your Sum Assured is not recommended. The reality is that a life insurance cover is a function of your expenses and debts, not your income. If your income is high but your expenses are low and/ or you have little or no liabilities, you don’t need as much life cover as someone who earns the same amount as you, but has higher expenses and/ or more liabilities than you do.

Also, since life insurance can be tailored to suit your specific requirements based on your current life stage (number of people who depend on you financially) and financial circumstances (income, expenses and liabilities), it is advisable to spend some time to evaluate your insurance needs carefully. This will help you get a better idea of the amount of life insurance you actually require.

A structured way to do this would be to first account for all your financial obligations – both short-term, and long-term.

• Calculate your living expenses. This will indicate how much money your family will need every month to maintain their current standard of living.
• Approximate the amount you will require to accomplish your financial goals such as education and marriage of your children.
• Consider additional expenses that may arise in the future such as caring for ageing parents.
• Include all your liabilities such as car and home loans, interest, insurance premiums, credit card dues, and other debts, if any.

While adding up these figures, take into consideration that inflation will keep eroding the value of your life cover. A Rs 1 crore Sum Assured may seem adequate right now, but will not exactly protect against future inflation. Therefore, adjust for inflation in your calculations to minimize its impact so that the real value of money is protected.

After you have added all your financial obligations, subtract all the liquid, non-fixed assets you have in the form of bank balance, Fixed Deposits, stocks or Mutual Funds, which can be accessed or redeemed quickly in case of an emergency.

The gap between your financial obligations and your liquid assets is the most accurate estimate of the Sum Assured you should buy.

The end goal of the needs assessment exercise should be to ensure that your insurance policy’s pay-out will adequately provide the much-needed financial protection for your dependent family in your absence.