cfp-e book (1)

CFP Module 1

1. 7Financial Planning HandbookPDP
Chapter 1

2. 8 Financial Planning Handbook PDP
Introduction to Financial Planning
T
he Indian youth never had it so good. On the consumption side, the choice of goods and services
available is unprecedented. And, as far as income is concerned, given the booming economy and its
ever improving prospects, opportunities have never been better! So the youth are earning a lot and
spending a lot as well. It is definitely a happy situation to be in.
In times like these, when everything seems to be going right for so many people, there is a tendency to
ignore that one great habit –saving money. The rationale is simple-since the future looks great from here,
why set aside money for the future needs and contingencies. But in our view, this is an ideal time to save
money as surplus monies are high. Rather than spending this money on a product that you don’t really
need, you would do well to invest in the future for some later date critical need.
In this book of financial planning, we discuss this and a lot more, including investment avenues available.
We also discuss the concept of spending wisely and creating wealth in a systematic way.
Happy Investing!
Financial decisions are critical decisions, which decide how comfortably we end up monetarily in life.
Poorly planned financial decisions can cause, at best, great anxiety and at worst lead to bankruptcy,
whereas well thought-out decisions can lead to a prosperous lifestyle.
The complexities of our financial circumstances are many and we need to take a careful well thought-out
solution to such problems. The concerns could be many. Some of them are:
How can I grow and protect my financial wealth?
How can I pay and manage my debt?
How much should I save to be able to pay for my children’s education?
How can I maximize the tax benefits which can be availed of?
How can I save enough to be able to retire comfortably and maintain the current lifestyle?
How can I maximize what my heirs will inherit?
Definition:
Financial Planning is the process of identifying a person’s financial goals, evaluating existing resources
and designing the financial strategies that help the person to achieve those goals.
The key basic steps toward reaching this end as a financial advisor are:
Organizing your client’s financial data.
Assisting your client in goal setting.
Financial Analysis for the client.
Developing appropriate strategies.
Evaluating and choosing the best option amongst the various strategies.
Coordinating and implementation of the planned decisions.

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What is Financial Planning?
Financial planning is the process of meeting your life goals through the proper management of your
finances. Life goals can include buying a home, savings for your child’s education, planning for your
retirement or estate planning.
This process consists of six basic steps. Using these broad six steps, you can work out where you are
now, what you may need in the future and what you must do to reach your goal.
The process involves gathering relevant financial information, setting life goals, examining your current
financial status and coming up with a strategy for a plan on how you can meet with your goals, and map
the gap.
The Benefits of Financial Planning
Financial Planning helps you give direction and meaning to your client’s financial decisions. It allows him to
understand how each financial decision affects other areas of finance. For example, buying a particular
investment product may help your client to pay off his mortgage faster or may delay his retirement significantly.
By viewing each financial decision as a part of a whole, you may help your client consider the long term and
the short term effects on his life goals. You will help them feel more secure and more adaptable to life
changes, once they can measure that they are moving closer to the realization of their goals.
Best Practices When Approaching Financial Planning
Set measurable goals.
Understand the effect your financial decisions have on other financial issues.
Revaluate your financial plan periodically.
Start now. Do not assume that financial planning is for when you are older.
Start with what you have got. Do not assume that financial planning is for the wealthy.
Take charge. You are in control of the financial planning process.
Look at the bigger picture. Financial planning is more than retirement planning or tax planning.
Do not confuse financial planning with investing.
Do not expect unrealistic returns on the investments.
Do not wait for a money crisis to begin financial planning.
How Do You Make Financial Planning Work For Your Clients.
To achieve your goals of making a complete financial plan for your client, you have to be completely in
sync with his financial needs and his responsibilities. This can be best achieved by following the processes:
Set measurable goals.
Set specific targets of what your client wants to achieve with a specific time line. For example, instead of
saying that he wants to be comfortable when he retires, or that he wants to send his children to good schools,
he should be able to quantify what “comfortable” and “good” means. He will have to as specific as “I need
Rs.100000pm income post retirement for 25 years from the age of 60, considering the anticipated inflation
rate at 5%. These plans may have to be changed keeping in view the market scenario or a changed need.
Understand the effect of each financial decision.
Make the client realize that each financial decision that he takes will affect several other areas of his life.
For example, an investment decision may have tax consequences that are harmful to his estate plans or
a decision on the retirement plans may affect his retirement goals. If he has invested in real estate and

4. 10 Financial Planning Handbook PDP
would like this investment to provide for his retirement income that he has to realize that real estate
investment would invite long term capital gains tax which can reduce the post tax returns and keep
margins for this deduction.
Re-evaluate the financial situation periodically.
Financial planning is a dynamic process. These goals may change over the years due to changes in
lifestyle or circumstances such as an inheritance, marriage, birth, house purchase or change in job
status. Revisiting these goals periodically is very important to keep track of how much our client is on
course, both from a long term perspective and a short term perspective.
Start planning soon.
Explain to the client consequences of waiting and how any delay in financial planning affects the whole
big picture that he has in mind for himself and his family. Developing good habits like saving, budgeting,
investing and regularly reviewing one’s finances early in life, makes one better prepared to meet changes
and handle emergencies. If one starts investing Rs. 500, one can expect to have Rs.58 Lakhs at age 60.
Remember that every Rs.500 that you can save from the age of 21 can get you Rs. 58 Lakhs towards
your retirement, but if you start at age 41, you will get only Rs.5 Lakh.
Be realistic in terms of expectations.
Financial planning is a commonsensical approach to managing one’s finances to reach one’s life goals.
It is a life long process. There are certain extraneous factors like inflation, changes in macro economic
policies or interest rates that may affect one’s financial results.

5. 11Financial Planning HandbookPDP
Chapter Review

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Chapter 2

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Assessing your current wealth
Taking Stock
T
he first step in assessing your current wealth is determining your net worth. It is the starting point for
financial planning. It provides an indication of your capacity to achieve your financial goals. Your net
worth can be ascertained by drawing up a personal balance sheet, as shown in
Worksheet 2. 1. The process consists of three steps:
1. List the items of value that you own. These are your assets.
2. List the amounts that you owe to others. These form your liabilities.
3. Subtract your liabilities from your assets; the difference is your net worth.
This relationship is shown below:
Items of Value - Amounts Owed = Net Worth
Definition:
Your assets are the things that you own. You probably own assets that have many different forms,
including cash, investments, personal property, real estate etc.
Assets possess value. Value can be of different types. The most basic measure of value is cost i.e. the
amount of money you spent in acquiring the asset. However, usually cost is not a very accurate meaure
of value. This is because, over time, the market value of an asset changes significantly from its original
cost. For example, your house may have cost Rs. 10 Lakhs ten years back. But today it is likely to sell for
much more. In case of such assets, market value or the amount someone would be reasonably willing to
pay for it in today’s marketplace is a much more accurate estimate of the value. However, collector’s
items like art pieces and antiques have an emotional value which may be significantly different from their
market value or cost.
In the Balance Sheet or the Statement of Net Worth, the assets are arranged in order of liquidity. The
most liquid assets are listed at the top of the list and include cash, bank accounts, and money market
mutual funds.
Definition:
Liquidity is a measure of the ease with which an asset can be converted into cash or cash equivalents.
The easier an asset is to convert into cash, the more liquid it is. Cash is the most liquid asset.
The cash surrender values of your whole life insurance policies and annuities can be determined by
contacting your insurance company.
The value of cars can be obtained from agencies which buy and sell used cars.
Household furniture, clothing, and personal effects should be more conservatively valued so as not to
overstate their value. It should be remembered that in an actual sale of these items, you are likely to get
far less than the estimated values.

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Your home is likely to be your largest asset, so its value should not be over- or under-stated. The figure
that you should use is the current market value; that is, the amount that someone would be willing to pay
for your house. Do remember that the cost of the property is not an accurate indicator of its value if you
have owned your house for a long period of time. The most recent selling prices of houses similar to
yours in your area are a good indicator of the likely market value of your house. Real estate brokers can
also provide you with an estimate of the value of your house.
Note
There is another school of thought, which proposes that the value of a self-occupied house should not be
considered in the net worth statement because one cannot really sell the house to raise resources. This
approach is also worthy because it is the more conservative of the two.
Liabilities
Definition:
Your liabilities are amounts that you currently owe (i.e., your financial obligations). The sum of your
liabilities is what you must pay today to overcome debt.
Begin by listing your most current debts, such as utility bills, telephone bills, and others.
Next, list the balances outstanding on your credit card debts and loans. For most people, a home loan is
their largest single debt outstanding. The amount to include is not the original amount of the loan but the
current outstanding balance. The current outstanding balance of the loan can be obtained directly from
the lender.
Add up all the amounts owed to others and to get the total of your liabilities.
Net Worth
Definition:
Your net worth is the difference between the totals of your assets and liabilities. In other words, if you
sold all your assets for the values stated and paid off all your debts, the amount left over would be
your net worth. The net worth of a person is a measure of a person’s financial position as of the date
of the personal balance sheet.

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Steps:
List all items of value starting with cash, investment assets, the current value of your house, and
possessions.
List and total all liabilities.
Subtract total liabilities from total assets.
Notes:
Assets
Determining the value of your stocks, bonds, and mutual funds is easy. The prices can be found in
newspapers or on financial websites.
WORKSHEET 2.1 How to determine your net worth
A. Assets Amount (in Rupees)
Cash
Bank Accounts
Fixed Deposits
Cash surrender value of life insurance
Cash surrender value of annuities
Market value of investments
Mutual funds
Stocks
Bonds
Others
Market value of house/real estate
Investment property
Vehicle(s)
Household furniture/appliances
Jewelry/precious metals
Collectibles
Loan receivables
Others
Total Assets
B. Liabilities
Credit card balances
Bills outstanding
Outstanding loan balances
Taxes due
Others
Total liabilities
Net worth [assets minus liabilities (A-B)]

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Why Is Determining Net Worth Important?
Determining your net worth is the first step in financial planning and assessing your financial wealth. Net
worth is a tool for comparing the changes in your financial position over a period of time. An increase in
net worth over a period of time is a favorable trend, and a decrease in net worth is a reduction in wealth.
There are a number of ways to increase net worth:
Appreciation of assets (for example, a rise in the value of stocks, bonds, mutual funds, and real
estate).
Reducing liabilities.
Increasing income, such as through salary and wage increases as well as growth in investment
income.
Reducing the amount spent on living expenses.
The importance of increasing net worth is obvious. It is important to remember that addition of assets
may not always increase your net worth. This is especially true for depreciating assets, such as cars,
computers, electronic equipments etc.
Investment assets like shares could also lose substantial part of their value.
Creating a personal balance sheet will assist you in tracking your personal wealth over time and enable
you to see relationships among the balance sheet items. The relationship between liquid current assets
and current liabilities indicates the relative ease or difficulty in paying upcoming debts. This evaluation
ratio is the current ratio and is determined as follows:
Current Ratio = Current Assets ÷ Current Liabilities
For example, if a person has Rs. 10 Lakhs in liquid current assets and Rs. 5 Lakhs in current liabilities,
the current ratio is 2. This means that for every Rs. 1 in current debts, there is Rs. 2 in liquid assets.
Generally, most current debts are repaid from liquid current assets such as cash, savings accounts etc.
In the event of unemployment or insufficient liquid current assets to cover current debt, longer-term
investment assets would need to be liquidated to pay off the debt.
The other significant relationship between balance sheet items is the debt ratio, which is total liabilities
divided by net worth:
Debt Ratio = Total Liabilities ÷ Net Worth
For example, if a person has Rs. 1 Lakh as total liabilities and a net worth of Rs. 2,00,000, the debt ratio
is 0.5.
We need to make the Cashflow statement and the Income and Expenditure Statement, to assess changes
in networth.

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Chapter Review
Exercise
1. Mukesh bought a flat for 12 Lakhs, worth 20 Lakhs today. He has no loan repayments i.e. EMIs due
on his flat. He has FDs worth Rs. 2 Lakhs and cash of 30,000 in his account, jointly held with his
wife. He has mutual funds worth 1.5 Lakhs and stocks worth 1.5 Lakhs. Ritesh, an old colleague of
his, has taken a loan from him for Rs. 50,000, for which he pays him 10,000 every month. His wife,
Geeta is fond of diamond jewellery and owns up to 3 Lakhs of diamond jewels.
Mukesh bought a car for 4 Lakhs, 3 years ago. He has a tax liability of Rs. 35k per year. He has no
other outstanding bills pending, except for telephone and electricity bills to the tune of Rs. 5,000 .
A] What is his net worth?
B] Can you think of ways of increasing his net worth?
C] What is his current ratio and debt ratio?

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Chapter 3

13. 19Financial Planning HandbookPDP
The Income and Expense Statement and
the Cashflow Statement
Y
our Income and Expense Statement reports income earned and spent during a specified period,
while the Cashflow Statement presents a record of all the cash inflows and outflows during a particular
time period.
The difference between the two is that the cashflow statement records only the actual cash inflows and
outflows. It does not include amounts spent or earned on credit. On the other hand the income and
expense statement records all types of income and expenses.
These statements make it easy to see where your money is being spent. Many people complain that
they earn large sums of money, but they never have anything left over. Recording their expenditures is
a first step to taking control of their financial affairs. Because earnings and living expenses also influence
net worth, these statements also show that change.
The income statement shows actual income and expenditures over a period of time, whereas a balance
sheet or Statement of Net Worth shows financial position at a single point in time.
There are three steps to creating an income statement, as shown in Worksheet 3.1.
List all income received during the time period.
List all expenditures made during the time period.
Determine the surplus/deficit of income over expenditures.
Step 1: List All Sources of Income
List all sources of income for the period of the income statement. Income from salary is generally
received after deducting tax at source (TDS).
The main source of income for most people comes in the form of salaries, wages, self-employment
income, and commissions. Other sources of income include bonuses, interest, dividends, rent, gain on
the sale of assets, and gifts and inheritances. All sources of income should be included in order to make
the income statement complete and accurate.
Step 2: List All Expenditures
Expenditures show where cash flows have been spent. Major categories of expenditures should be listed. It
is not necessary to account for every penny spent. By reviewing cheque-book records and credit card statements
and recording the cash payments, you can easily develop categories of expenditures. By adding the payments
made in each category, you will have a fairly accurate account of where your money has gone.
Certain expenditures are fixed; that is, they remain the same each month or year. Examples of such
expenses are rent, mortgage payments, life insurance premiums, and equated monthly instalments of
loans. These are called Fixed expenditures.

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Certain expenses change from month to month, such as food, clothing, medical expenses; telephone
and utility payments; household operating expenses; contributions; and recreational expenses. These
are called Variable expenditures.
Both Fixed and Variable expenses can be either Discretionary or Non-Discretionary Expenses.
Discretionary Expenses: Eating outside, Excess Consumarisation, Changing models of mobile every 3
months etc.
Non-Discretionary Expenses: House Maintenance Charges, Grocery Expenses, Medical Expenses,
Electricity Charges where you cannot really do any curtailments.
Step 3: Determine whether there is a Surplus or Deficit of Net Cash Flow
When income exceeds expenditures, there is a surplus. When expenditures exceed income, there is a
deficit. Funds to cover a deficit can come from withdrawal from savings or by taking a loan, both of which
decrease net worth.
A surplus represents an increase to net worth if the amount is used to increase savings, invest it wisely
to acquire additional assets, and/or pay off debt.
Note:
Cash surplus increases net worth while a deficit decreases it.

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What can the Income and Expense Statement/Cashflow Statement tell you?
The income and expense statement is an important tool which helps in understanding current spending
patterns and formulating a budget.
If your expenses exceed your income, you have a negative bottom line or a "net loss." That is, you are
depleting your net worth, a situation that sometimes requires prompt attention. If you have a substantial
surplus, it means that your net worth is growing.
You can divide total expenses by total income to learn what percent of income you are spending into
Discretionary and Non Discretionary Expenses. This shall give the indication of what amount is utilized
and what amount is being wasted. Compare this to previous periods to learn if your ability to grow your net
worth is improving.
Income is difficult to increase in the short term. Longer-term income can be increased by establishing
yourself in your profession, finding a better-paying job, or changing careers. The latter alternative should
be deliberated carefully before any moves are made.
Expenditures are also difficult to reduce, but variable (Discretionary) expenditures are easier to cut than
(Non Discretionary)fixed expenditures. For example, it may be easier to reduce recreation, summer
vacation, and/or entertainment expenses than necessary living expenses, such as food, loan payments
and utility expenses.
By going through the process of compiling an income statement, you can see where money has been
spent and where you need to reduce expenditures, if necessary. The income statement is not only an
important tool in helping to understand current spending patterns, it also assists in formulating a budget.

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Chapter Review
Exercise
1. Anil lives in a flat, which he purchased 10 years ago for Rs. 10 Lakhs. There is a loan outstanding
for Rs. 3 Lakhs left. The monthly EMIs, which Anil pays towards the loan, is Rs. 4000 pm. His wife
has jewellery worth Rs. 2 Lakhs.He has a car, which he purchased for 3 Lakhs, four years ago. He
pays a monthly EMI of Rs. 2000 for his car loan. His life insurance and pension funds cost him Rs.
4000 pm. He earns Rs. 40000 pm. His car requires petrol worth Rs. 3000 pm. The grocery bill adds
up to Rs. 8000 pm. His wife, Mina likes to eat out. They spend Rs. 2000 on entertainment every
month. His mobile bill and utilities come to Rs. 6000 pm. His credit card bill is Rs. 2000 pm.Anil
earns interest income up to Rs. 400 pm.He has no other source of income.
Prepare his income and expense statement. Is there a surplus or a deficit? State the discretionary
and non-discretionary income. What is the percentage of discretionary and non-discretionary expenses
to the income?
2. Mukesh, a student had withdrawn Rs.3000 on 1
st
May’07. By the 10
th
of May, he had only Rs. 100
in his wallet. Intrigued as to where he spent all his money, he decided that for the following month,
he would maintain a note of all his cash outflows and inflows.
One June 1’07, Mukesh withdrew Rs. 3000 from ICICI Bank. On the 1
st
, he had travel and eating
expenses of Rs. 150. On the 2
nd
, he bought some fruits worth Rs. 45 and had conveyance of Rs.
50. On the 4
th
and the 5
th
, he had miscellaneous expenses of Rs. 500. On the 7
th
of June, he realized
that the rains will start soon and that he needed both a pair of rainy shoe and a bag. He purchased
the office bag at Rs. 700 and the shoes cost him Rs.900. He hunted out his old umbrella that had
served him well for the last 2 rainy seasons.
How does Mukesh’s cash inflow-outflow statement look like? Does Mukesh have a surplus or a
deficit? Is he better off in June than in May?

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Chapter 4

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Budgeting
What is budgeting?
Budgeting is a process for tracking, planning, and controlling the inflow and outflow of income.
How does the budgeting process work?
The budgeting process begins with gathering the data that makes up your financial history. Next, you use
this information to do a cash flow analysis. You will calculate your net cash flow, which tells you whether
cash is coming in faster than it’s going out, or vice versa. Then you will determine your net worth. Having
a snapshot of your present financial situation, you’ll then define your financial objectives and create a
spending plan to achieve them. Finally, you will periodically check your progress against the plan and
make adjustments as needed.
How to Formulate a Budget?
A budget is a plan for how you intend to spend your money during the coming month or year. It is an
integrated statement based on details of your income statement and balance sheet for the past month or
year. The budget expresses what you would like to achieve in terms of spending and savings in the future.
A budget can assist you in determining whether:
You are living within your income limits
Your current spending patterns are satisfactory
You are saving and investing sufficient amounts to satisfy your financial goals
You need to make changes in order to satisfy your financial goals
A suggested budget format is shown in Worksheet 4.1. You can also make budgets using personal
finance software programs.
More specifically, a budget can be drawn up in six steps:
Estimate your future net income for the period of the budget.
Determine your expected expenditures during the period of the budget.

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Determine what you expect to spend to fund your personal goals.
Determine whether there is a surplus or a deficit.
Record your actual income and expenditures.
Evaluate whether changes in spending and saving are necessary.
Step 1: Estimate Your Future Income
Estimating income is self-explanatory but seldom easy to implement. It is the process of combining
everything you know or sense what is likely to affect your income for a specific future period, then using
it to forecast income. Some sources of income are naturally much more difficult to forecast than others.
One way to arive at an estimate is to combine prior period income with anticipated changes to estimate
your future income.
When there are multiple income sources, it is necessary to first estimate each one, and then add the
individual estimates to derive total estimated income for the period being considered. Common income
sources include all anticipated receipts of money, such as future salary, estimated profits (or losses,
which are deductions from income) from a business, bonuses, commissions, interest, dividends, rent,
gains, tax refunds, loans, and other sources of income.
Some of the factors that can increase (or decrease) future levels of income are:
Bonuses
Business upturn/downturn
Commissions and royalties
Cost-of-living adjustments
Disability
Dividends
Gifts
Health condition
Inheritance
Interest rate changes
Investment gains/losses
Job promotion
Personal property sale
Salary increase/decrease
Change in tax bracket
Tax refunds
Remember
When estimating income that is highly variable, the estimate should be conservative. Being surprised by
an income surplus is far more pleasant than having an unexpected income shortfall. In fact, the latter can
cost even more if you need to rely on credit to cover the shortage. Being conservative by underestimating
budgeted income is prudent so as to avoid overspending.Use the reasonableness test to avoid unrealistic
estimates.

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Step 2: Determine Your Expected Expenditures
The second step is to estimate all expenditures during the period of the budget. Estimating expenses is
similar to estimating income. Both are equally important and use a prior period’s information as their
starting point. Naturally, some expenses are more difficult than others to predict and therefore require
estimation. Unlike income, expenses can arise from tremendously diverse sources, estimating expenses
is more complex and requires greater effort to do well.
Estimating expenses is central to the budgeting process, because it is the first step in controlling the
outflow of household income. Forecasting expenses is also directly related to achieving financial goals.
Only by knowing what your expenses are likely to be, can you plan for meeting financial goals.
The following steps are involved in estimating expenses for a future period:
Review prior period expenses and determine which will recur in the forthcoming period
Determine what new expense items are anticipated
Estimate the amount of each expense for the period
Add individual estimated expenses to obtain total estimated expenses
Whether estimating expenses or income, you should always estimate conservatively. Being surprised by
lower than expected expenses is far more pleasant than experiencing a spending deficit. If you need to
borrow funds to cover a spending deficit, you’ll be spending even more. Use the reasonableness test to
avoid unrealistic estimates.
Expenses can come from many directions, so be careful not to overlook any that could be significant.
Expenses that are uncommon and nonrecurring are the most difficult to predict, yet are frequently the
cause of budget chaos.
Certain expenditures such as rent, mortgage, and car loan payments are fixed in amount and do not vary
from month to month, whereas other expenditures such as food, clothing, and utilities vary in amount
from month to month. Anticipating these variable expenditures with accuracy may be difficult. The purpose
of budgeting is not to bind you so much that you cannot maneuver. On the contrary, its purpose is to
provide you with flexibility in your financial planning so you can achieve your financial goals.
Step 3: Determine Your Financial Goals
In order to set aside money for your financial future, you need to estimate the expenditures that go
toward your savings and investments. Financial goals vary from person to person over time. Some
sample financial goals maybe:
Saving for an emergency fund
Increasing savings and investments
Buying a new car
Paying off a loan
Buying a house
Saving to fund children’s education
Providing retirement income
Some of these are short-term goals while others are longer term. It is often easier to concentrate on the
short-term goals and neglect longer-term goals. By assigning priorities to each of the goals and quantifying
their cost, you can determine the amount of savings needed to fund them.

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The table below shows an example of prioritizing of goals:
1. Column 2 shows the estimated amount of money needed to fund each goal.
2. Column 3 lists each goal’s priority. For example, buying new furniture is the lowest of the family’s
priorities.
3. Column 4 shows when the expenditures will be needed. For example, a new car to be purchased in
12 months; fund children’s education in 15 years (180 months); retirement in 24 years (288 months);
and new furniture to be bought in six months.
4. Column 5 shows the amount that will be needed every month to finance each goal. It is calculated as
follows:
Monthly Amount = Estimated Cost ÷ Time Needed
For example: Monthly amount required for a new car = 600000
÷÷÷÷÷12 = 50000
Since setting appropriate financial goals forms the foundation of any budget, we will look at the process
of setting budget goals in detail in the next chapter.
Step 4: Determine whether there is a Surplus or a Deficit
If budgeted amounts for income exceed expenditures, there is a surplus. Expenditures and the amounts
needed to fund personal goals added together equal the total expected expenditures. It is a good idea to
incorporate goals into a budget so that monthly or periodic income is set aside to address them.
When projected income exceeds projected expenditures, there will be additional amounts of cash, which
can then be added to savings/investment plans or used to pay down liabilities.
When projected expenditures exceed projected income, there is a deficit. This means additional amounts
will have to be withdrawn from savings/investment plans to pay for these additional expenditures. In
such a case, it may be necessary to review projected expenditures and reduce some of them, or look for
ways to increase projected income.
Step 5: Record Actual Income and Expenditures for the Period Budgeted
Actual amounts earned and spent are not always the same as those projected. By recording the actual
amounts and comparing them with the budgeted amounts, you can immediately see the differences,
called variances. Spending more than a budgeted amount for one item can be offset by spending less
than the budgeted amount for another item.
Similarly, if actual income exceeds actual expenditures, there is a surplus, which means additional cash.
The opposite is a deficit, which means that cash will have to be withdrawn from cash savings or other
assets in order to pay for the deficit spending.
Step 6: Evaluate Whether Changes in the Budget Are Necessary
If there are large variances, or your surplus/deficit is not what you would like, you need to analyze your
budget. Examine the variances and study where the amounts spent are greater than the budgeted amounts.

23. 29Financial Planning HandbookPDP
For example, if your actual phone bills are consistently greater than the amounts budgeted, then you
need to either reduce your phone usage, if possible, or increase the amount budgeted for this item. When
you increase planned spending, you will need to find items where you can make corresponding cuts to
compensate for the increases. If you don’t, the amounts set aside for personal goals or savings will be
reduced.
There are certain expenditures over which you have some degree of control. These are your discretionary
or variable expenditures, such as entertainment and miscellaneous expenses. Entertainment and food
are the most common areas of overspending, particularly when they involve eating out at restaurants.
By contrast, non-discretionary fixed expenditures such as rent, loan payments, taxes, and insurance
premiums cannot be easily trimmed without consequences. You may need to prioritize your expenditures
to see which are necessary and which can wait.
The purpose of a budget is to help you plan the use of your resources so that you can fund your goals and
set aside more of your money to savings. Following your budget will help you achieve what you want
most from your resources.
Establishing appropriate financial goals is the foundation on which a budget is built. We will look at the
process of setting goals in more detail in the next chapter.

24. 30 Financial Planning Handbook PDP
Exercise
1. Priti is a 30-year-old young professional. Her net salary is Rs. 50,000 pm. She is expecting a bonus
of Rs. 30,000 in the next 6 months. Her car loan outflow is Rs. 6,000 pm. The rent is Rs.15,000 pm.
She spends on food and clothing Rs. 9,000 pm.She invests all her surplus funds in retirement
schemes, so far. She invests Rs.10,000 pm on pension annuity fund. She wants to save money to
enjoy a holiday with her parents and take them on a world tour. She will have to have Rs. 6 Lakhs
for this trip. She has monthly medical and miscellaneous expenses for her parents to the tune of
Rs. 5,000 pm. Her salary is expected to go up by Rs. 5,000 net of tax, in 2 months time.
Prepare a budget for Priti.
Should she invest in any other instruments as well? What could they be? Discuss.
2. Nitish is a 40year old, working with Elder Pharma Ltd. He lives with his wife, child and elderly
parent. In the year 2007-2008, he expects interest from his Fixed Deposits to amount to Rs. 20,000.
He has invested in mutual funds to the tune of Rs. 2 Lakhs, the value of which all together is Rs. 2.5
Lakhs. He has received tax-free dividends of Rs. 10,000, in the year. His agricultural income
comes from the land in his village. He received Rs. 1 Lakh this year as agricultural income. He is
quite generous with the people who look after his farm, and they are faithful farmers who have been
associated with his family for more than 40 years, now.
He lives in a self-occupied house, where the EMIs are Rs. 15,000 pm. His salary is Rs. 8 Lakh pa.
His monthly expenses to look after the house inclusive of groceries, utility bills, car maintenance,
and children’s education comes to Rs. 30,000 pm. Medicines and miscellaneous purchases come
to approximately Rs. 10,000 pm. His insurance payment is Rs. 5,000 pm. He wants to set up an
emergency corpus of Rs. 2 Lakhs and set aside Rs. 10,000 pm as retirement funds. There is an
anticipated expense to cover the leakage in the house to the tune of Rs. 50,000. This leak has to be
fixed before the monsoon begins, which is in another 2 months time.
Prepare a worksheet and analyze his expenditure pattern to determine if his future goals can be
achieved.
3. Naik, who is living in Mumbai decided to look into his finances one saturday afternoon. He had not
had a look at them in a long time for now. It was decided that it was high time that he took out some
time for stocktaking regularly. He and his wife Renu, sat down to discuss and enumerate all their
respective responsibilities and priorities. Renu said that she had a family wedding coming up and
there were some gifts to be purchased on an immediate basis. Her brother’s wedding was fixed up
and she wanted to buy a gift worth Rs. 8,000 for him.
Their son would require tuition fees to be paid to Aggrawal classes. Aggrawal Classes charged Rs.
20,000, a year which was due to be paid in 2 months time. Mr. Naik had a commitment to pay EMIs
for his home loan for which the monthly outflow was to the tune of Rs. 12,000 pm. Looking at their
long-term plan, they wanted to save Rs. 5 Lakhs for their child’s education, Rs.8 Lakhs for his
wedding and Rs. 50 Lakhs as a corpus for their retirement. Mr. Naik is due to retire in 5 years time.
He earns Rs. 60,000 pm, after taxes.
Identify the short term and the long-term goals, their priority and the time needed to fulfill the goals
and their monthly cost. Determine if there is a surplus or a deficit to fulfill these goals.

25. 31Financial Planning HandbookPDP
Chapter Review

26. 32 Financial Planning Handbook PDP
Chapter 5

27. 33Financial Planning HandbookPDP
Setting Budget Goals
What are budget goals?
T
hink of your budget goals as your financial wish list and your spending plan as a way to make those
wishes a reality. Without clear budget goals, your financial life may remain in disarray. Like any other
goals in life, your budget goals help you turn your wish list into an action plan.
Your budget goals also help you take the drudgery out of following the budget because now, when you
give up any immediate desire, you know that you are one step closer to something you really want. For
example, when you give up having dinner in a nice restaurant, you know that you are closer to being able
to buy a dream car next year. With clear goals in sight, you can chart your course of action and change
your direction when needed.
Step 1 : Start by listing your goals
Setting your budget goals requires forecasting your future needs and dreams. Involve every member of
your family and discuss each possible goal with them. Have a brainstorming session with your entire
family and ask each member to make a list of three to five of their possible needs and dreams as
individuals and as a family. At this stage, keep in mind that you want to list all of your goals and dreams.
Examining them and prioritizing them will come later. Strive to be as specific and unambiguous as
possible so that they become easier to plan. For example, instead of listing a goal of “taking a family
vacation somewhere within next five years,” list “taking a vacation in the Himalayas next summer.” Once
each member has made the list, go over all the goals and see if you want to make any changes before
you incorporate them into your budget.
Step 2 : Categorize your goals
Divide up your goals, according to how long it will take to meet each goal, into three categories:
Short-term goals (less than a year)
Medium-term goals (one to five years)
Long-term goals (more than five years)

28. 34 Financial Planning Handbook PDP
Short-term goals are your immediate needs and wants, such as buying a music system next month or
buying a new car next year. Since these goals are, by definition, less than a year from being realized,
they are relatively easy to estimate and plan.
Medium-term goals are things that you and your family want to achieve during the next five years, such
as taking a vacation or renovating your home. These goals require more planning and careful estimation
of their costs.
Long-term goals extend well into the future, such as planning for your retirement or for your child’s
education. These goals require the most planning, including estimating the cost, forecasting your income,
and estimating the growth of your investments. You may need expert help to plan for these goals.
Step 3 : Estimate the cost of each goal
Find out how much it costs today. Before you assign priority to your goals, it is important to determine
the cost of each goal. The greater the cost of a goal, the more alternative goals must be sacrificed in
order to achieve that goal.
Step 4 : Project the future cost
For your short-term goals, inflation is not a big factor, but for your medium- and long-term goals, you need
to factor in the inflation so that you have a more accurate estimate of their costs. Inflation can be a very
tricky issue in dealing with long-term goals. Even a relatively modest inflation rate can increase the cost
of your goal by 2 to 3 times over a 20-year period. However, there is no need to panic, since time is also
your ally. If invested properly, the money you will be saving toward that goal can also grow at a rate that
will outpace inflation.
To calculate the future cost of your goals, you need to determine the rate of inflation that will apply to
each particular goal. Often, prices change in different industries at different rates. For example, the real
estate prices in your area may rise at a different rate than college education costs.
There are two ways to estimate the rate of inflation for your goal. You may observe current and past
inflation rates and make some assumptions as to the rate of inflation for the period of your goal. Or you
may find out what experts are predicting in the industry in which you are interested. For example, if your
goal is to buy a new car, find out the rate of inflation for the auto industry by reading the financial
newspapers. By finding out what it costs today and factoring in the rate of inflation, you can now project
the cost of all of your goals in the future. It is crucial that your estimate be as accurate as possible,
especially for your long-term goals.
Step 5 : Calculate how much you need to set aside each period
Once you have some idea about the future cost of your goals, your next step is to determine how much
you should put aside each period to meet all your goals. Keep in mind that you may not need to assign
a separate savings or investment account for each goal as long as you have a method to keep a record
of your goals. You may want to have a separate investment strategy, however, for your short- and long-
term goals.
For your short-term goals, it is easy to estimate the cost, the amount you will need to set aside each
month, and your projected income during that time. Divide the cost by the number of months until you
need to meet your goal. You then know the amount of money you need to put aside each month for your
goal. For example, if you want to buy a music system in six months and it costs Rs. 30,000, you need to
put aside Rs. 5,000 a month for the next six months.

29. 35Financial Planning HandbookPDP
For your medium- and long-term goals, the process can get complicated, since you also need to take into
account the interest you will earn on your savings. Computer programs are available to calculate your
monthly requirement for your future goals, taking into account interest earnings. You may also project
the amount of interest your money will earn at a specific rate of return. Subtract this amount from the
future cost of your goal to find out how much more you need to save to meet your long-term goals.
Example
If you are saving for your child’s college education and you will need that money in 10 years, you first find
out the amount of money you will need, taking into account the rate of inflation. Say, for example, you will
need Rs. 6,00,000 for the first year of college. Now, calculate the amount of money you will need to save
each month, taking into account the estimated rate of return on your savings or investments.
Once you have calculated this number for all of your goals, you get an amount that you will need to save
every month. Then you need to evaluate your goals in order of their priority so that you can channel your
savings in the right direction.
Step 6 : Prioritize your goals
Once you have a list of all your goals and the estimated amount needed for each goal, prioritize those
dreams. Unfortunately, for most families and individuals, it is not possible to realize all goals, which is
why setting priorities is essential.
Review your goals and give each a number that reflects its priority. For instance, a number one would
mean the goal is extremely important to you. Like shown in the table below saving for your retirement,
saving for your child’s education, or saving for a down payment of a house could be priority one for you.
Goals with a number two are somewhat important to you, such as taking a vacation or replacing your car.
A number three reflects any goal that is more of a wish than a need, such as buying a vacation home.
After assigning priorities your list might look like as shown below:
Your first focus will be on the goals marked with a number one. Calculate the amount of money you will
need to put aside each month to meet these goals. Do the same for goals with priority number two,
followed by those for number three. You can then write your goal schedule.
Goal Priority
Saving for Retirement 1
New Car 2
Saving for child’s education 1
Taking a vacation 2
Buying a music system 3
Buying a vacation home 3

30. 36 Financial Planning Handbook PDP
Step 7 : Create a schedule for meeting your goals
List all your goals according to their priority. Then write down the amount of money needed, when you will
need it, and how many installments you will need to meet your goals. Here is what your goal schedule
might look like:
This table will give you a picture of how much money you need to save every month to achieve all your
goals. The table will also give you an idea of your investment options, since your personal time line
affects your choice.
With the clear picture of your goals, their priority, the amount of money you need, and the amount of monthly
savings to attain those goals, you can move to the next step - developing a spending plan for your budget.

31. 37Financial Planning HandbookPDP
Chapter Review
Exercise
Sayantani had the following goals that she wanted to fulfill.
She wanted to take up higher education in a city which is full of growth prospects, ie Mumbai.
She is already a graduate, but she wanted to pursue a career in mass media for two years.
She wanted to learn music, side by side, with a famous music teacher who is renowned for his
tutelage and his performances. This has been a dream for her since a long time. It was one of
the factors which made her consider Mumbai as the first choice. This teacher was expensive
and charged Rs. 500 per hour. She had to take atleast ten classes in a month.
She had to throw a party for her friends since she was soon leaving town. This would cost her
Rs. 500.
She wanted to own a scooty for ease in commute. This would cost her Rs. 30000 upfront.
Sayantani, was to go and stay with her uncle while she was studying, but she would have to
allocate some funds for renting a place, because she knew that it was a burden on him as well.
So after two years, she would have to spend Rs. 3000 pm on her rent.
She had to repay her educational loan, which she had taken to complete her education. This
loan was repayable six months after she graduated. She had taken a Rs. 1lakh loan.
She had to send back Rs. 1000 pm to her parents for the education of her siblings. Though her
parents were not asking her for it, she knew that it was her duty to support them financially.
She had an expense of Rs. 1000 immediately for clothes and other necessities since she was
leaving out of town.
She was hoping that she could start out as a media reporter for a TV channel since this was something
which she thought she was good at. The pay currently for any of these jobs as a media reporter was
about Rs. 10000 pm, and in the next two years would be Rs.12000 - 13000.
Prioritize, prepare a goal schedule and write down a plan as to how she should allocate her funds after
she starts working.
Start with yourself. Create a goal-list, Cost attached to it, prioritise it as make a schedule. For each of
you this will be the start of dealing with your own Financial planning.

32. 38 Financial Planning Handbook PDP
Chapter 6

33. 39Financial Planning HandbookPDP
Developing a Spending Plan
What is a spending plan?
Y
our spending plan is your active strategy for getting where you want to go. Think of your spending
plan as a road map that helps you reach your goals. Your spending plan provides a sense of
direction and puts you in charge of how your money is spent on a weekly, monthly, and yearly basis.
What are the steps to develop a spending plan?
It takes significant time and commitment to develop a spending plan that is right for you and your family.
The steps are:
Step 1 : Record all your expenses
In order to develop a spending plan that is appropriate for your lifestyle, you need to understand your own
spending habits. First, start recording all your expenses – every single rupee that you spend - for at least
a month. You may record all your expenses in a notebook or use your computer. However you do it, it is
important to remember that you include all expenses, no matter how trivial. You will find that just recording
all your expenses may allow you to focus your attention on how, where, and how much money you are
spending. Categorize it into heads like rent, food, clothing, transportation, any other expenses. These
will include phone, mobile phones, unexpected household purchases, utilities maintainance, memberships,
life and other insurances, entertainment, travel etc.
After recording and prioritizing, take the following steps.
Step 2 : Identify out-of-pattern expenses
Once you have created categories and listed all your expenses for a month, your next step is to identify
your out-of-pattern expenses. There are many expenses such as insurance payments, festival gifts, or
taxes that occur annually, semiannually, or quarterly. Identify all of your out-of-pattern expenses. Add all
your out-of-pattern expenses on a yearly basis and divide them into 12 so that you have a clear idea of
how much you need on a monthly basis for your spending plan.

34. 40 Financial Planning Handbook PDP
Step 3 : Estimate your income
If you are getting a regular salary, estimating your income is easy. Write down your monthly income
minus income tax and any other automatic deductions. Add other income such as dividends, interest,
and rent. Make sure you include all types of income.
If your income is irregular, you will have to start with the premise that your total income is somewhat
predictable, but your payments come at uneven intervals. Look at your income over the last two years
and project your income for the next 12 months. Divide that number by 12 and consider that to be your
monthly income. Plan your spending with that income in mind. During months that you earn more than
average, save the extra earnings for the months when you earn less.
Step 4 : Develop your plan
Now you are ready to create a spending plan based on your income and your expenses. Here are some
guidelines that experts suggest.
Suggested spending plan percentages of your gross income:
Look at your records and see how your spending is distributed in terms of percentage of your income.
You can see how your own spending habits compare with the guidelines above. You may choose to
follow these guidelines closely, or you may decide to make changes so that the overall spending plan
reflects your lifestyle. For example, if you love to travel, your transportation budget may be larger than
the suggested average. To compensate for that extra spending, you will have to reduce some of your
other expense categories. Also, keep your goals and priorities in mind and adjust your spending plan
accordingly. For instance, if you are not saving any money right now but you want to save 10 percent of
your income for retirement, find out from which categories the money will come.
Implementing and Monitoring Your Spending Plan:
Once you have identified your budget goals and created a spending plan to meet them, you are ready to
put your plan into action. Before you begin, though, here are some tips to avoid common mistakes.
Tips to Implement and Monitor your Spending Plan
Involve the entire family.
Implementing and monitoring your budget plan requires commitment as well as discipline from the entire
family. Make sure that they are all in agreement and understand your plan. The better you all work as a
team, the greater the chances for success.
Be disciplined.
To get long-term benefits, your budget should become a way of life. Jot down all the expenses, item by
item, day by day, in your diary. If you are using your computer, make sure you enter all the expenses at

35. 41Financial Planning HandbookPDP
the end of the day or at the end of the week. Don’t wait until the end of the month because, by then, you
will have so many entries that you are likely to give up.
Keep it simple.
Keep monitoring simple. Divide your expenses into fixed, variable, and discretionary categories. Monitor
your variable and discretionary expenses, such as clothing money or eating out, once you have assigned
your fixed expenses.
Use different credit cards.
Track different categories by using different credit cards. Dedicate one credit card for clothing purchases
so that you don’t need to write down your expenses every time you buy any clothes. Instead, your credit
card statements will itemize your clothing expenses for you. Use an oil company card when you fill up
your car’s fuel tank.
Caution
If you’re going to use multiple credit cards to help track your expenses, make sure that you aren’t
paying high annual fees for each of these cards.
Be careful not to fall into the trap of using credit to pay for everyday expenses and not paying off your
outstanding balance each month. If you do this, it will seem like you are spending less, but your debt
will continue to increase.
Fine tune as you go.
Keep in mind that implementing a spending plan requires fine tuning of your estimates and your expenses
as you go along. You will get better as time progresses. Don’t give up too quickly if you feel it is not
working.

36. 42 Financial Planning Handbook PDP
Chapter Review
Exercise
1. Nishant had joined TCS on the 1
st
of July’07. He had come to Bombay from Nagpur. In the first
month, he took a vehicle loan, so that his commute is faster and convenient. He had to allocate Rs.
6000pm for this outflow. Initially, during the first few days, he had to spend Rs. 15000 from his
pocket for stay and food expenses until he rented a place and made arrangements for food. He
made clothing purchases for Rs. 6000, just before he joined his organization. The petrol costs were
amounting to Rs.1000pm. His mobile monthly expense came to Rs.2000pm. He spent Rs. 2000
initially on gifts and entertainment. His monthly expenses for food and rent were up to Rs.12000pm.
He wanted to plan to save money for his sister’s college education, as soon as possible. His
monthly salary was Rs. 25000pm. The corpus required for education was Rs. 2 Lakhs.
Record Nishant’s expenses and develop a plan to save money for his goals.

37. 43Financial Planning HandbookPDP
Chapter 7

38. 44 Financial Planning Handbook PDP
Time Value of Money
T
he time value of money is one of the most important concepts in personal finance decision-making.
Money does not have the same value over time due to the fact that it earns interest. Consequently,
a rupee today is not the same as a rupee in the future.
Investing that rupee today yields an amount greater than the rupee in the future because of the interest or
return that the investment generates. The interest rate or the rate of return is the link between the present
and future value of money.
The impact of the time value of money is dependent on the following three factors:
The amount of money
The annual rate of interest
The length of time
Another way to look at the time value of money is to view it as an opportunity cost. Spending rather than
saving means lost interest. What you could have earned on that money has been lost. It therefore
becomes important to know the interest rate on all your savings and investments to determine whether
you should be saving or spending your money.
Simple Interest
The most basic method of calculating interest is the simple interest method. The other, more common
method, of calculating interest is the compound interest method.
Definition:
Interest is the cost charged or payment made for the use of money.
The simple interest method calculates interest on the principal only, without any compounding. In other
words, the interest earned is not used to earn further interest.
The elements used to determine simple interest are the principal, the rate of interest, and the length of
time that the principal is invested or borrowed. The formula for simple interest is as follows:
Interest = Principal Amount ×Annual Interest Rate ×Time Period
or
I =P × R × T

39. 45Financial Planning HandbookPDP
For example, Rs. 2,000 deposited for two years at an interest rate of 5 percent per annum would earn
Rs. 200 in simple interest (Rs. 2,000 x 0.05 x 2). The total amount received at the end of two years would
be the principal amount plus the interest, or Rs. 2,200.
If the amount is deposited for less than one year, then the time period is divided accordingly. For
example if Rs. 2,000 is deposited for a period of 9 months at an interest rate of 5%, then the amount of
interest is calculated as below:
Interest = Rs. 2,000 x 0.05 x (9/12)
= Rs. 75
Compound Interest
Compound interest differs from simple interest in that interest is paid not only on the principal but also on
the accumulated interest, assuming that the interest is left to accumulate. The greater the number of
periods for which interest is calculated, the greater is the accumulation of interest earned on interest plus
interest earned on the principal.
The formula for compound interest is expressed as follows:
Future Value = Principal (1 + Interest Rate)
n
or
FV = P (1 + i)
n
where
FV = Total future value (principal plus total compound interest)
P = Principal (amount invested)
i = Interest rate per year or annual percentage rate
n = The number of periods at the interest rate
Example:
To illustrate the difference between simple and compound interest, assume that Rs. 100 is invested at
an interest rate of 5 percent per year for five years and the interest is not withdrawn. If compounded
annually, the compound interest earned would be Rs. 27.63, while the simple interest earned would be
Rs. 25, as shown in the figure.

40. 46 Financial Planning Handbook PDP
The principal amount of Rs. 100 is used to determine the interest in the simple interest method, whereas
compound interest uses the principal plus the accumulated interest from the previous year to calculate
the interest for the next year. Thus, when given a choice between investing in a simple interest or
compound interest account, you should choose compound interest, assuming risk and all other factors
are the same.
You can see that the difference between the compound interest and simple interest figures is quite
significant if the amount is invested for a period of only five years. This difference grows quite rapidly as
rate of interest increases. Consider this example:
Compounding Effect as ROI increases:
Impact of Inflation
Definition
Inflation is the tendency of prices to rise over time.
Learnings
Through this example, you will see that as time goes by, the expenses will only increase, by the order of
inflation. It is safer to ensure that you are geared up for it today.
Inflation erodes the value of your financial assets. For example, suppose you are able to fulfil all your
household needs for Rs. 10,000 currently. If the rate inflation is 4% p.a., it means that the same household
goods will cost Rs. 10,400 next year. As we have seen the impact of compound interest, this would
mean that in about 18 years the cost of all goods will be twice their current cost.
What this means is that a rupee today is more valuable than a rupee in the future. Also it implies that all
investments that you make should earn you a return that is in excess of the rate of inflation.

41. 47Financial Planning HandbookPDP
The concept of time value of money is therefore important to understand for making the apprpriate
investment choices. For instance, investment products that offer payments spread over many years are
often far less attractive than they seem at first glance. Likewise, investment products that return money
to you sooner offer better returns than those that defer payments till late.
The time value of money is a double-edged sword. It benefits you by increasing the size of your savings
but at the same time inflation will decrease the value of your holdings.
Chapter Review

42. 48 Financial Planning Handbook PDP
Chapter 8

43. 49Financial Planning HandbookPDP
The Financial Planner's Toolkit
A
s a financial planner, you will be doing a lot of mathematical calculations for your clients. Doing
these calculations for a large number of years is very tricky and difficult if you do not use the correct
tools. It is recommended that you use either computer spreadsheet software like MS Excel or a financial
calculator to do these calculations.
Basic Concepts of Time Value of Money
Money today is more valuable than money in future. This is because when you forego spending money
at present, you can earn interest on it. Interest can be considered to be the rent for money. When you
give your house to somebody to live in, you get some money as rent. Similarly, when you deposit your
money with somebody, you get interest as rent.
Interest is expressed as a rate or percentage. The amount of interest that you receive is determined by
multiplying the time for which you deposit the money with the rate of interest and with the amount of
money that you deposit. So the future value of your money is calculated as below:
Future Value = Original Amount Deposited + Interest on the original amount
The original amount that you deposit is referred to as the Principal. Since it is the amount that you have
at present, it is also known as the Present Value.
Therfore the generalized formula for calculating interest is:
FV = PV + PV x R x T
Or FV = PV(1+R)T
Where,
FV = Future Value
PV = Present Value
R = Rate of Interest
T = Time period
Interest can be calculated in two ways:
Simple Interest
This is when interest is calculated on the principal amount only.
SI = PV x R x T
Where,
SI = Simple Interest
R = Rate of Interest
T = Time period

44. 50 Financial Planning Handbook PDP
Compound Interest
This is when the earned interest is also deposited alongwith the principal and you also receive interest on
interest. To illustrate, if you deposit Rs. 100 for 2 years at an interest rate of 8% p.a., then after one year,
the interest you will earn would be:
100 x 8% = Rs. 8
For the next year, you will not only earn interest on Rs. 100 but also on the interest that you earned in the
first year Rs. 8 i.e. you will earn interest on Rs. 108.
108 x 8% = Rs. 8.64
The generalized formula for calculating future value at compound interest can be stated as below:
FV = PV(1+ R)
T
Let us now look at various scenarios where you may be required to calculate present value and future value.
A Single Cash Flow
Future Value of a Single Cash Flow
The future value of a single cash flow with simple interest is given by:
FV = PV(1+r)t
Where,
FV = Future Value
PV = Present Value
r = Rate of Interest
t = Time period
The future value of a single cash flow with compound interest is given by:
FV =PV (1+r)
t
Where,
FV = Future Value
PV = Present Value
r = Rate of Interest
t = Time period
MS Excel
The Excel FV function can be used to find out the future value of a single cash flow. The FV function is:
= FV(RATE,NPER,PMT,PV,TYPE)
Where,
RATE is the interest rate for the period;
NPER is the number of periods;
PMT is the equal payment or annuity each period;
PV is the present value of the initial payment; and
TYPE indicates the timing of the cash flow, occuring either in the beginning or at the end of the period.

45. 51Financial Planning HandbookPDP
The PMT and TYPE parameters are used while dealing with annuities.
Note:
The initial payment is a cash outflow, while the future value is a cash inflow for the investors. Accordingly,
we need to treat the initial payment as ‘negative’ in value.
Financial Calculator
Use [] [] to select “Set:”, and then press [EXE]
Press [2] to select “End”
Use [] [] to select “n”, input 8, and then press [EXE]
Use [] [] to select “I%”, input 12, and then press [EXE]
Use [] [] to select “P/Y”, input 1, and then press [EXE]
Use [] [] to select “PV”, input –22,000, and then press [EXE]
Use [] [] to select “FV”
Press [SOLVE] to perform the calculation
Present Value of a Single Cash Flow
The present value of a single cash flow is given by:
PV = FV / (1+r)
t
Where,
FV = Future Value
PV = Present Value
r = Rate of Interest
t = Time period
MS Excel
We can find the present value of a single cash flow in Excel by using the built-in PV function:
= PV (RATE, NPER, PMT, FV, TYPE)
Suppose that a firm deposits Rs. 22,000 for eight
years at 12 per cent rate of interest. How much would
this sum accumulate to at the end of the eight year?
F
8
= PV x (1+i)
n
= 22,000 x (1+0.12)
8
= Rs. 54,471.19
In column B7 we write the formula:
=FV (B4,B3,0,-B2,0). FV of Rs. 54,471.19 is the same
as calculated above.

46. 52 Financial Planning Handbook PDP
Suppose that an investor wants to find out the
present value of Rs. 25,000 to be received after
13 years. Her interest rate is 9 per cent.
We enter in column B5 the formula:
= PV (B4,B3,0,-B2,0).
We enter negative sign for FV; that is –B2. This
is done to avoid getting the negative value for
PV.
You can also find the present value by directly
using the formula
PV = FV x
l
(l + i)
n
The function is similar to FV function except the change in places for PV and FV. We use the values of
parameters as given in the following illustration:
Financial Calculator
Use [] [] to select (1) “Set:”, and then press [EXE]
Press [2] to select “End”
Use [] [] to select (2) “n”, input 13, and then press [EXE]
Use [] [] to select (3) “I%”, input 9, and then press [EXE]
Use [] [] to select “P/Y”, input 1, and then press [EXE]
Use [] [] to select (6) “FV”, input 25,000, and then press [EXE]
Use [] [] to select “PV”
Press [SOLVE] to perform the calculation
Future Value of an Annuity
An Annuity represents a series of equal payments (or receipts) occurring over a specified number of
equidistant periods.
Ordinary Annuity
Payments or receipts occur at the end of each period.

47. 53Financial Planning HandbookPDP
Annuity Due
Payments or receipts occur at the beginning of each period.
The future value of an ordinary annuity is given by:
Where
FVA = Future Value of Annuity
A = Annual Payment Amount
i = interest
n = number of years
The future value of an annuity due is given by:
FVADn = FVAn (1+i)
Where
FVADn = Future Value of Annuity Due
FVAn = Future Value of Annuity
A = Annual Payment Amount
i = interest
n = number of years

48. 54 Financial Planning Handbook PDP
MS Excel
The Excel FV function for an annuity is the same as for a single cash flow. Here, we are given value for
PMT instead of PV. We will set a value with negative sign for PMT (annuity) and a zero value for PV. We
use the values for the parameters as given in the following illustration:
Financial Calculator
Use [] [] to select (1) “Set:”, and then press [EXE]
Press [2] to select “End”
Use [] [] to select (2) “n”, input 6, and then press [EXE]
Use [] [] to select (3) “I%”, input 3, and then press [EXE]
Use [] [] to select “P/Y”, input 1, and then press [EXE]
Suppose that a firm deposits Rs. 3,000 at the
end of each year for six years at 3 per cent rate
of interest. How much would this annuity
accumulate at the end of the sixth year?
F
6
= 3,000 (FVA
6, 0.03
) = 3,000 x 6.4684 = Rs.
19,405.23
In column C6 we write the formula:
= FV (B5,B4,-B3, 0, 0). FV of Rs. 19,405.23 is
the same as in the illustration.
Instead of the built-in Excel function, we can
also directly use the formula below to find the
future value:
We can enter the formula and find the future
value. We will get the same result.

49. 55Financial Planning HandbookPDP
Use [] [] to select (4) “PV”, input 0, and then press [EXE]
Use [] [] to select (5) “PMT”, input –3,000, and then press [EXE]
Use [] [] to select “FV”
Press [SOLVE] to perform the calculation
Annuity of a Future Value (Sinking Fund)
In the previous example, we had seen that Rs. 3,000 deposited for a period of 6 years at 3% accumulates
to Rs. 19,405. However, if we wish to calculate the opposite – that is the value of annual payments that
will accumulate to Rs. 19,405 in 6 years at 3%, then the formula is given by:
Where
FVA = Future Value of Annuity
A = Annual Payment Amount
i = interest
n = number of years
MS Excel
The Excel function for finding an annuity for a given future amount is as follows:
= PMT (RATE, NPER, PV, FV, TYPE)
We use the values for the parameters as given in the following illustration:
Suppose that a firm earns Rs. 19,405 at the end
of for five years at 6 per cent rate of interest.
What is the annuity (PMT) of this value?
In column B6 we write the formula:
= FV (B5,B4,B2,-B3,0).
Note that we input both FV and PV and enter
negative sign for PMT. The value of PMT is Rs.
3,442.38.
Instead of the built-in Excel function, we can enter
formula:
and find the value of the sinking fund (annuity).
We will get the same result.

50. 56 Financial Planning Handbook PDP
Financial Calculator
Use [] [] to select (1) “Set:”, and then press [EXE]
Press [2] to select “End”
Use [] [] to select (2) “n”, input 5, and then press [EXE]
Use [] [] to select (3) “I%”, input 6, and then press [EXE]
Use [] [] to select “P/Y”, input 1, and then press [EXE]
Use [] [] to select (4) “PV”, input 0, and then press [EXE]
Use [] [] to select (6) “FV”, input –19,405, and then press [EXE]
Use [] [] to select “PMT”
Press [SOLVE] to perform the calculation
Shridhar invests Rs. 1 Lakh at the end of each year, in the retirement fund corpus. LICL has promised a
return of 10% pa. How much has his retirement corpus grown to in 20 years time.
Present Value of an Annuity
The present value of an ordinary annuity is given by:
Where
PVA = Present Value of Annuity
A = Annual Payment Amount
i = interest

51. 57Financial Planning HandbookPDP
The present value of an annuity due is given by:
PVAD
n
= PVA
n
(1+i)
Where
PVAD
n
= Present Value of an Annuity Due
PVA
n
= Present Value of Annuity
A = Annual Payment Amount
I = interest
n = number of years
MS Excel
The Excel PV function for an annuity is the same as for a single cash flow. Here we have to put in the
value for PMT instead of FV:
Suppose that an investor wants to find out
the present value of an annuity of Rs. 10,000
to be received for 5 years. The interest rate
is 9 per cent.
We enter in column B5 the formula:
= PV (B4,B3,-B2,0,0).
We enter negative sign for FV; that is –B2.
This is done to avoid getting the negative
value for PV.
You can also find the present value by
directly using the formula:

52. 58 Financial Planning Handbook PDP
Financial Calculator
Use [] [] to select (1) “Set:”, and then press [EXE]
Press [2] to select “End”
Use [] [] to select (2) “n”, input 5, and then press [EXE]
Use [] [] to select (3) “I%”, input 9, and then press [EXE]
Use [] [] to select “P/Y”, input 1, and then press [EXE]
Use [] [] to select (5) “PMT”, input –10,000, and then press [EXE]
Use [] [] to select “PV”
Press [SOLVE] to perform the calculation
Perpetuity
A perpetuity is an infinite annuity. In a perpetuity, the annual cash flows continue forever. The present
value of a perpetuity is given by:
PV = a/r
Where
PV = Present Value
a = Annual Payment Amount
r = interest rate
The concept of perpetuity finds application in case of stock valuation. Stocks are valued at present value
of their expected earnings. For example, suppose a company is expected to earn Rs. 5 every year. If the
discount rate is 10% then the value of the stock would be:
Price of Stock = PV of earnings = 5/0.10 = Rs. 50
Growing Perpetuity
The present value of a perpetuity that grows at a constant rate of g% is given by:
PV = a/(r-g)

53. 59Financial Planning HandbookPDP
Where
PV = Present Value
a = Annual Payment Amount
r = interest rate
g = growth rate of annual payments
To illustrate, a company expects to earn Rs. 5 per share in this year and expects its earnings per share (eps)
to grow at a rate of 6% every year. If the discount rate is 10%, then the current price of the share would be:
Price = 5 / (10-6) = 5/0.04 = Rs. 125
This formula also enables us to understand the PE Ratio in terms of the growth rate of earnings.
PE Ratio = Price per share / Earnings per share
Or
Where
P
0
= Current Stock Price
e
0
= Current Earnings per share
g = earnings growth rate
r = discount rate
Different Periods of Compounding
The future value depends a lot on the way the interest is compounded. Interest may be compounded
once a year or more frequently like semi-annually, quarterly, monthly or even daily. In such cases, the
future value is given by:

54. 60 Financial Planning Handbook PDP
Where
FV
n
= Future Value after n periods
r = rate of interest per period
n = number of periods
m = number of times of compounding per period
PV
0
= Present Value at start of period 0
Exercise:
Let us see the effect of compounding at different periodicity:
Comparison of different compounding periods for Rs. 1000 invested for 2 Years at an annual interest rate
of 12%.
Annual FV
2
= 1,000(1+ [.12/1])
(1)(2
= 1,254.40
Semi FV
2
= 1,000(1+ [.12/2])
(2)(2)
= 1,262.48
Qrtly FV
2
= 1,000(1+ [.12/4])
(4)(2)
= 1,266.77
Monthly FV
2
= 1,000(1+ [.12/12])
(12)(2)
= 1,269.73
Daily FV
2
= 1,000(1+[.12/365])
(365)(2)
= 1,271.20
Therefore, you can see that although the stated rate of interest is 12% in each case, the results are
significantly different. The stated rate is also known as Annual Percentage Rate, APR. The Effective
Annual Rate, EAR, is the rate if there was compounding only once per period; it is true effective rate.
The relation between APR and EAR is given by:
If the compounding period is made infinitely small, it is known as continuous compounding. The EAR for
continuous compounding is given by:
Yield or IRR Calculation
MS Excel
Excel has built-in functions for calculating the yield or IRR of an annuity and uneven cash flows. The
Excel function to find the yield or IRR of an annuity is:
= RATE (NPER, PMT, PV, FV, TYPE, GUESS)
GUESS is a first guess rate. It is optional; you can specify your formula without it.

55. 61Financial Planning HandbookPDP
The Excel built-in function IRR calculates the yield or IRR of uneven cash flows:
IRR (VALUES, GUESS)
The values for the cash flows should be in a sequence, starting from the cash outflow.
GUESS is a first guess rate (arbitrary) and it is optional. In the worksheet, we have entered the cash
flows of an investment project. In column B4 we enter the formula: = IRR (B3:G3) to find yield (IRR).
Note that all cash flows in year 0 to year 5 have been created in that sequence. The yield (IRR) is
27.43 per cent.
You can also use the built-in function, NPV, in Excel to calculate the net present value of an investment
with uneven cash flows. Assume in the present example that the discount rate is 20
per cent. You can enter in column B5 the NPV formula: = NPV (0.20, C3:G3) +B3. The net present
value is Rs. 21,850. If you do not enter +B3 for the value of the initial cash outflow, you will get the
present value of cash inflows (from year 1 through year 5), and not the net present value.
In column C6 we enter the formula: = RATE (C5,
C4, C2, 0, 0, 0.10). The last value 0.10 is the
guess rate, which you may omit to specify. For
investment with an outlay of Rs. 20,000 and
earning an annuity of Rs. 5,000 for 8 years, the
yield is 18.62 per cent.
Financial Calculator
Use [] [] to select (3) “I%”, input 20, and then press [EXE].
Use [] [] to select “Csh=D.Editor x”, and then press [EXE].
This displays the DataEditor. Only the x-column is used for calculation. Any values in the y-column and
FREQ-column are not used.
-40,000 [EXE] (CF0).
15,000 [EXE] (CF0).
25,000 [EXE] (CF0).
30,000 [EXE] (CF0).
17,000 [EXE] (CF0).
16,000 [EXE] (CF0).
Press [ESC] to return to the value input screen.
Use [á] [â] to select “NPV: Solve”.
Press [SOLVE] to perform the calculation.
Use [á] [â] to select “IRR: Solve”.
Press [SOLVE] to perform the calculation.
Impact of Tax and Inflation
In the previous examples, we have considered the rate of interest without adjusting for tax or inflation. In
real life both of these factors reduce the real rate of return that an investor gets.

56. 62 Financial Planning Handbook PDP
Exercise
1. Naina is 22 years old. She has recently started her work. Naina is working with an educational
institute and she has been trained to counsel students. Day in and day out, she talks to young
people about the careers and goals and where they want to be in life. This set her thinking in terms
of her future.
Her aspiration levels increased and she herself wanted to study further. She knew her potential and she
was getting educated on the job market and her areas of interest. After doing the initial research, she
concluded that she wanted to study abroad. However, as is well known, a 22 year old doesn’t have a
lot of money in her kitty. Also she knew that her parents could not take the burden of such a loan. She
decided that she would need to plan for fulfilling this dream of hers. She calculated the amount to be
Rs. 15 Lakhs. She wanted to have saved up Rs. 15 Lakhs in 8 years time. The average market return
is about 10%pa. How much would she need to invest to get Rs. 15 Lakhs in 8 years?
Also, if Naina invests in yearly installments rather than a one time proposition, how much will she
have to invest each year, so that she will have Rs. 15 Lakhs corpus at the end of 8 years at a 10%
rate of return.
2. Let us assume that an investor invests Rs. 1000 at 12% for a period of one year. Let us assume
inflation to be 6% and the tax rate to be 30%. The real return that the investor gets is calculated as
below:
Therefore the formula for finding the real rate of return is:
Real Rate = I(1-T) – R
Where
I = interest rate received
T = tax rate
R = rate of inflation
Amount Invested Rs. 1000
Rate of Interest 12%
Time Period 1 year
Interest received Rs. 120
Tax Rate 30%
Amount payable as tax Rs. 36
Amount after tax Rs. 84
Inflation Rate 6%
Amount Lost due to Inflation Rs. 60
Interest after tax adjusted for inflation Rs. 24
Effective Rate 2.4%

57. 63Financial Planning HandbookPDP
Chapter 9

58. 64 Financial Planning Handbook PDP
Protecting your wealth
O
nce you have made an assessment of your current financial situation and decided on your financial
goals, it is time to develop and deploy strategies to achieve them.
Risk Mitigation
A business / financial proposition becomes risky, when one cannot predict the outcome of a decision.
However, by careful analysis and preparation the risk can be mitigated.
Protection
Asset protection or wealth protection essentially means safeguarding its financial value.
Let us see a corporate example to understand both sides of a coin :
Example
An IT company, primarily in software development has been affected by the strengthening of the rupee.
The earnings of the company has dipped. To protect itself from future fluctuations in exchange rate, it
quickly decides to diversify to closely related areas of business that it is already into. Besides doing
software development initiative, they have quickly spread their boundaries with a view to reducing their
risk and protecting their incomes.
Decrease outflow
This is a more passive conservative way by which wealth could be protected. Suppose you have Rs.
10,000 as your budget for the month. You can blow it up in a party by spending it once or twice or you
decide to spend not more than Rs. 300 a day and more importantly on the essentials first and
luxurious later.
Increase inflows
This is a more aggressive approach to wealth protection. A good example would be a B.Com student,
simultaneously studying for CA. During the student days, they build on their experience and earn minimally
to support their pocket money.
This way, they armor themselves with a thorough preparation for higher education and have learnt to
manage personal finances.
In the context of financial planning, we are concerned only with pure risks.

59. 65Financial Planning HandbookPDP
Types of Pure Risks
Pure risks that can cause financial insecurity can be categorized as below:
Let us look at these in more detail.
Personal Risks
Personal risks are those risks that directly affect an individual. They cause financial insecurity because
they usually result in reduction or stoppage of income, increase in expenses and depletion of financial
resources. Some of the major personal risks are:
Risk of premature death
Risk of poor health
Risk of temporary or permanent disability
Risk of insufficient income during retirement
Property Risks
Persons owning property face the risk of having that property damaged or destroyed or lost due to
different causes. They cause financial insecurity because they affect the income streams being produced
from usage of the property. They also increase expenses because the damaged/destroyed/lost assets
need to be repaired/replaced. Property risks can cause loss in two major ways:
Direct Loss
Indirect or Consequential Loss
Direct Loss
A direct loss results from physical damage, destruction or theft of property. For example, if your house
is damaged due to earthquake, the amount of loss is known as direct loss.
Indirect or Consequential Loss
An indirect loss results from the consequences of a direct loss. For example, if your house is destroyed
in an earthquake, you may have to live in a rented house till your house is repaired. The rent that you pay
is the indirect loss.
Liability Risks
Liability risks arise from the possibility of being held legally liable for the loss to another person. If a person
commits a mistake or because of negligence, causes bodily harm or injury to another person, a court of law
can order that individual to pay damages to the injured party. Liability risks can be categorized into:

60. 66 Financial Planning Handbook PDP
Statutory Liability eg. Third Party Liability in M.V. Act, I.D. Act, W.C.Act, P.I.
Under Common Law eg. Libel and Slander
Under Contract eg. Contractual Obligations
These liabilities may arise in personal or professional capacity.
Personal Liability
Personal liability arises when a person acts negligently or carelessly during the course of his personal life
and causes harm to another. For example, if you hit a pedestrian with your car due to jumping traffic
lights, you may be asked to bear the treatment expenses and pay damages to the victim.
Professional Liability
Professional liability arises when a person harms another while performing as a professional. For example,
a doctor who causes harm due to a wrong diagnosis can be held professionally liable to pay damages to
the patient.
Liability risks cause financial insecurity because they result in depletion of existing financial resources.
Let us consider, Keshav who is running an industrial unit at Vapi, near Surat. His company manufactures
heavy machinery to handle equipments that are used in construction activities. He has employed a full
time work force of 10 workers and part time contractual workers, another 10 in number. Contractual
workers balance out the cost as well as the requirement needs during peak season.
His work force risks the possibility of permanent or temporary disability while at work. What category of
risk does this fall under?
Solution : This is a professional liability.
Some of the equipment is old and doesn’t function properly. During peak season, to make up for the
capacity, Keshav has to hire additional machinery to cover for the productivity loss due to his old
equipment.
What kind of loss is this?
Solution : This is an Indirect loss.
Chapter Review

61. 67Financial Planning HandbookPDP
Chapter 10

62. 68 Financial Planning Handbook PDP
How can we manage risk?
W
hile risks cannot be eliminated, measures can be taken to reduce the probability and size of loss
caused by risks. This process is known as risk management.
Response to risk
The different methods used for management of risk can be broadly categorized into two categories:
Risk Control
Risk Financing
Risk Control
Risk Control methods are those that try to minimize the losses from risks. These can be of two types:
1. Risk Avoidance
Risk avoidance is accomplished by not engaging in the action that gives rise to risk. Avoiding risk is an
appropriate strategy for high frequency and high severity risks.
While the avoidance of risk is one method of dealing with risk, it has many negative consequences. for
example, you can avoid dying in an air crash by giving up air travel, but it also means giving up the huge
time savings and convenience that air travel offers.
2. Risk Reduction
Risk reduction is achieved through loss prevention and control. For example, the risk of fire can be
reduced by measures like installing fire extinguishing systems and sprinklers, using fire retardant materials
in construction. It is an appropriate strategy for high frequency and low severity risks.
Risk Financing
Risk financing methods are those that pay for losses that actually happen. These can be of two types:
1. Risk Retention
Risk retention is used when the risk is retained. The retention may be voluntary or involuntary. This is an
appropriate strategy for low frequency and low severity risks. For example, the risk of suffering from
common cold can be retained. As a general rule, risks that should be retained are those that lead to
relatively small certain losses. The reason for retention is because there is a cost attached to transfering,
reducing or avoiding risk. It may be more cost effective to retain the risk since its frequency as well as
impact is low.
2. Risk Transfer
Risk transfer is the transfer of risk from one individual to another who is more willing to bear the risk.
Insurance is the most widely used means for reducing risk by transfer. Risk transfer is appropriate for low
frequency and high severity risks.

63. 69Financial Planning HandbookPDP
Risk Management
Let us try to understand these for concepts better through some examples.
Examples
1] Vikram had a run of 7kms from home to his office. There are two routes he can take. One route is
faster, but highly dangerous. It is a main highway and has a record number of accidents. In other words,
the area is accident-prone. The second route typically takes him 15-20 mins more. Since it is an inner
city road, it has less of heavy traffic and this route is considerably safer. Which kind of risk would you
classify this as? What is the best way to deal with it?
Since his travel frequency in that route was twice a day, back and forth from home to office, in case of
any accident, the impact would be fatal, hence it can be classified as high frequency, high severity risk
and best way to deal with it is Risk avoidance.
2] Anand was earning well in his company. His friendliness was unfortunately taken as his vulnerability.
Whenever, any of his friends needed some money, they would invariably ask Anand. Anand could never
say no, and always felt that he should help someone in need. The loan was always given on a returnable
basis, but that never happened. What kind of a financial risk does it entail? How should it be handled?
This can be classified as high frequency, low severity risk hence best way to handle it would be Risk
reduction.
C] Prem was to take an official trip to USA. His wife also wanted to join him, as a personal holiday trip. His
company gave Prem an insurace cover. Should his wife also take an insurance cover? What are the risks that
could arise incase the risk cover is not taken? What is the category of risk and how should it be handled?

64. 70 Financial Planning Handbook PDP
The chance of his wife meeting with an accident is low, however if she does, the severity would be high
hence best way to deal with this is Risk transfer.
D] Laxman and Preet used to go and play together everyday with the other boys of the building. All of
them got together and played cricket in the nearby playground.It is quite possible that one of them gets
hurt while playing.
What is the probability and the risk of such an injury? How should such a risk be handled?
It is a case of low frequency and low severity, hence Risk retention is the best way to deal with it.
Personal Risk Management
The methods discussed above can also be applied to the financial risks to which an individual is exposed.
List of some of these events that have the potential to cause financial loss (whether through increase in
expenses or through decrease in earning potential) are given below:
Death
Disability
Major surgery or hospitalization
Illness
Liability for injuries to others
Burglary of home
Destruction of house and contents
Car accident – major or minor damage to car
Professional Liability, etc.
Steps to handle Personal Management Risk:
Step 1 : List down all the risks.
Step 2 : Rate each event for severity of financial loss. Severity of financial loss can be categorized into:
a. Extremely Severe – an event that is financially devastating, possibly resulting in bankruptcy.
b. Very Severe – an event that has a huge financial impact that can radically change lifestyle of the
affected person.
c. Moderately Severe – an event that has an uncomfortable but manageable financial impact.
d.Not Severe – an event that has very little financial impact, that can be covered by emergency cash
reserves held in liquid form.
Step 3 : Rate each event for probability or frequency of occurrence. Frequency of occurrence can be
categorized into:
a. Extremely Probable/Frequent – an event that is almost certain to happen, or that happens very
frequently.
b. Very Probable/Frequent – an event that is quite likely to happen, or that happens often.
c. Moderately Probable/Frequent – an event that could happen, or that happens infrequently.
d. Not Probable/Infrequent – an event that is unlikely to happen, or that almost never happens.

65. 71Financial Planning HandbookPDP
Step 4 : Plot all events into the four quadrants as per the following rules:
High frequency and High severity Risk Avoidance Quadrant
High frequency and Low severity Risk Reduction Quadrant
Low frequency and High severity Risk Transfer Quadrant
Low frequency and Low severity Risk Retention Quadrant
Step 5 : Compare the recommended methods of handling risks with the ways they are currently handled,
to identify gaps or mismatches in the current risk management strategies.
Create an action plan to plug the identified gaps. Keep in mind that:
Step 6 : The topmost priority must be given to risks that should be avoided or transferred but are being
borne. These risks can completely wreck the financial affairs of a person. Accordingly, they need to be
handled foremost. Next priority should be given to risks that should be reduced but are being currently
borne. These risks should be immediately managed by making lifestyle changes and by putting appropriate
loss control mechanisms in place. If risks that should be borne have been transferred through insurance,
the amount of insurance may be reduced or completely eliminated. The resultant cost savings should be
employed into addressing the other gaps. The most common method of risk transfer is insurance. In the
next chapter, we will discuss the relationship between risk and insurance.
Chapter Review

66. 72 Financial Planning Handbook PDP
Chapter 11

67. 73Financial Planning HandbookPDP
I
nsurance is the most common method used for transferring risks. It transfers the risk from an individual
to a group. It also provides a means for paying for losses. Insurance provides an important means of
preventing risk from interfering with a client’s achieving financial objectives.
How Insurance works?
To understand the concept of insurance, let us imagine a small town with 100 houses. The town is
located in an area where storms of great severity occur frequently.
Each family in the town faces the risk that a storm will destroy their house completely. If the house is
destroyed, the family will have to spend Rs. 50,000 to reconstruct the house. However, at the same
time, it is unlikely that a storm will destroy all the 100 houses simultaneously.
Let’s suppose all the citizens of the town agree to share the losses (if and when they occur) equally, so
that no single family will be forced to bear the entire loss of Rs. 50,000. This means that whenever any
house is destroyed, every family will pay a sum of Rs. 500 to the affected family to rebuild their house.
While the cost of Rs. 50,000 would have been crippling for a single family, the expense of Rs. 500 is
easily affordable.
Thus, the risk is transferred from a single family to the entire village and the loss (when it occurs) is
shared.
In our example, the risk sharing and risk transfer is dependent upon the town people successfully agreeing
to bear the expenses of reconstruction of houses. In the real world, it would be very difficult to reach at
such an agreement and even more difficult to enforce it, because:
Some people might not agree to be part of such an agreement, making it difficult to reach the large
numbers of participants necessary for the scheme to work.
Some people might not pay their share, even though they were part of the agreement.
Someone would need to perform the task of collecting money from the people and providing it to the
affected family.
In the real world, insurance companies act as facilitators and remove the obstacles to risk transfer and
risk sharing. They perform the functions of making agreements, collecting money, calculating losses
and providing payments to affected persons.
Risk and Insurance

68. 74 Financial Planning Handbook PDP
Definition:
Insurance is defined as an economic device whereby the individual can substitute a small definite
cost (the premium) for a large uncertain financial loss (the risk).
In the larger perspective, let us hear what an insider has to say from an expert view point.
Expert View
In an interview Mr.K R Subramanian, COO, ING Vysya Life mentions that in a fiercely competitive
market like life insurance, all players deal in similar products. They use the same Indian mortality
assumptions and pricing. “The only differentiating factor is cost leadership and efficient service. We
have to issue policies faster and make sure that normal insurance applications are processed quickly.”
Subramanian feels that there is a need to build awareness about risk management so that people adopt
good risk minimisation methodology. Insurance is a crucial element of transferring risk. Today’s well-
informed customers want to spend an allotted amount intelligently.
“Insurance has developed to such an extent that it can shift risk from insurance to the capital market by
means of a methodology called alternate risk transfer (ART). This includes catastrophe bonds, for instance
you get a particular return if earthquake hits Japan or you get another value as return if an earthquake
does not hit Japan,” says Subramanian. These are high end investment instruments targeted at very
specific well informed clientele.
Pooling of Risks
To perform the function of insurance and to carry out their own activities, insurance companies need to
collect contributions from individuals. But since losses are unpredictable, how does the insurance company
decide how much to collect from each individual?
The theory of probability deals with random events and postulates that while some events appear to be
a matter of chance, they actually occur with regularity over a large number of trials revealing a measurable
pattern.
To draw an analogy – it is difficult to state with confidence whether the daytime temperature will cross 40° C
on a particular day in Delhi, but if data for the past 15 years is collected, it can be seen that in Delhi, the
daytime temperature exceeds 40° C on most days in May and June. Study of historical data is an important
means to understand probability of occurance. Statistical tools are also employed to this effect.

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This phenomenon is known as the Law of Large Numbers.
Definition:
The law of large Numbers implies that the frequency with which an event happens, reflects the actual
probability of the event occurring more closely if the number of cases involved is larger.
The law of large numbers finds many applications in the field of insurance. The most important of them
is that if the risks faced by a large number of individuals are pooled together, then the probability of the
adverse events actually occurring can be predicted quite accurately. This enables the insurance companies
to predict the losses that will actually occur over a period of time and thereby fix the contributions
payable by each individual.
Insurance companies also employ other statistical techniques like regression analysis, loss distributions,
mortality tables to arrive at the probability of occurrence of a particular event which, in turn, is used to fix
the level of premium contributions.
Characteristics of Insurable Risks
Insurance thus appears to be an elegant solution for transfer of all risks. With relative ease, an individual
can be free of all risks that can cause financial insecurity. However, not all risks are insurable. Insurance
companies do not cover speculative risks. They cannot be expected to absorb risk that a person creates
wilfully in expectation of a profit. The essential characteristics of insurable risks are:
The risk must be a part of a large number of homogeneous units; otherwise the law of large
numbers will not apply – making it difficult to estimate the probability of losses.
The loss due to the risk must be definite and measurable. The insurer must be able to determine
that a loss has occurred and to accurately measure the economic impact of the loss. This is because
insurers can only provide re-imbursement of the financial loss occurred. They cannot always undo
the damage done. For example, a rare painting of say, Picasso, if destroyed, can’t be reconstructed.
The damage or loss due to the risk must be fortuitous or accidental. Insurers cannot be held
responsible to pay for certain (intentionally caused) losses.

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The damage or loss due to the risk must not be catastrophic. Insurance is based on the principle
that the losses of individuals are divided within a group. In a catastrophic loss, each member of the
group suffers a loss and hence, would be unable to bear the losses of others. Therefore, the device
of insurance fails if the loss is big enough to produce such widespread devastation as to wipe out the
total pool of insured homogeneous units.
Benefits and Costs of Insurance to Society
Apart from protecting insured individuals, insurance offers many benefits to the society as a whole. Let
us look at these in more detail.
Indemnification of loss
Insurance restores individuals to their former financial condition after a loss. As a result, it reduces the
amount of disruption that such losses would otherwise cause. Insurance contributes immensely to family
and business stability in the society.
Reduction of anxiety
Insurance reduces the level of anxiety and stress in the society because the insured individuals do not
have to worry about financial insecurity in case of adverse events. Even if such events occur, insurance
reduces worry because the insured know that the insurance they have will pay for the loss.
Source of investment funds
Insurance companies collect premiums in advance of the loss. Thus, they have large amount of
accumulated funds that are used only when losses actually occur. These funds are invested in different
forms and promote capital investment and economic growth.
Loss prevention
Since insurance companies benefit if incidence of loss causing events goes down, they actively promote
best practices for loss prevention amongst insured. Insurance companies employ a wide variety of
personnel who specialize in loss-prevention such as safety engineers and fire prevention experts. Better
safety measures adopted by individuals because of the insurance companies’ activities go a long way in
reducing the losses that would otherwise occur.
Enhancement of credit
Insurance makes a borrower a better credit risk because it acts as collateral to the lender. The lender
knows that in case of any adverse event which causes financial losses or affects the income potential of
the borrower, the insurer will restore the borrower to his former financial position.
Costs of Insurance to society
The major social costs of insurance are:
Cost of doing business
Fradulent Claims
Inflated Claims
Cost of doing business
The administration and sales and marketing costs incurred by the insurers for the purpose of doing
business are also recovered from the persons seeking insurance. As a result, the premium they pay is

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Chapter Review
slightly higher than that required for pure risk cover. This is called expense loading of the premium.
However, these costs are more than justified, considering the many benefits of insurance.
Fradulent Claims
Dishonest policyholders submit fraudulent claims to insurance companies by faking losses. The payment
of such claims increases the cost of insurance for all insureds.
Inflated Claims
Another related cost of insurance is submission of inflated claims by policyholders. While the loss is
actual and accidental, many policyholders inflate the severity of loss so as to profit from insurance. This
again results in higher premiums for all insureds.

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Chapter 12

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The Principles of Insurance
An insurance contract is different from a normal contract.
Let us discuss these in more detail.
The Principle of Utmost Good Faith
In an insurance contract, the true status of the subject matter of the contract is not known to the insurer.
For example, if a person suffering from high blood pressure, chooses not to tell his medical insurance
company about it, there is no way of knowing about it. As a result, the insurance company would be
taking on a higher risk than anticipated.
Therefore, the proposer has an unfair advantage over the insurer since he has greater knowledge about
the subject matter of the contract. For this reason, the law imposes a greater duty on the parties of an
insurance contract than in other commercial contracts. This is called the doctrine of “uberrima fides” or
“utmost good faith.”
This doctrine calls for the proposer to disclose all facts that are material to the risk, whether the insurer
inquires for the facts or not.
Definition:
Utmost Good Faith is defined as a positive duty voluntarily to disclose, accurately and fully, all facts
material to the risk being proposed, whether requested or not.
Definition:
A Material Fact is any fact which would influence the insurer in accepting or declining a risk or in fixing
the premium or terms and conditions of the contract.
Incidental or trivial facts are not considered as material facts.
For example, for insurance of a car, the age of the car is a material fact while the color of the car is a
trivial fact.
Every circumstance is material which would influence the judgment of a prudent insurer in fixing the
premium or determining whether he will take the risk.
Breach of the Duty of Utmost Good Faith
Breaches of the duty of Utmost Good Faith arise due to:
1. Misrepresentation
2. Non-disclosure
Misrepresentation happens when the proposer does not report the facts accurately.
Non-disclosure happens when the proposer omits to report material facts. If the proposer deliberately
hides facts that he knows to be material it is called “Concealment”

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The Principle of Insurable Interest
Any asset is insurable by a person only if damage to that asset results in loss of a legal right or creation
of a legal liability for that person.
For example, you can not insure your neighbor’s car because damage to the car does not result in any
financial or legal implications for you.
Definition:
Insurable interest is the financial interest of the proposer
in such a manner that the proposer stands benefited by
the safety or continuous existence of an asset and
absence of liability and prejudiced by the destruction or
damage of assets or existence of liability.
Example
Suppose a person uses his car to travel to work. Then he is benefited by its safety as it adds convenience
to his life. But if the car meets with an accident then the person would need to get his car repaired, if he
wishes to continue enjoying the comfort of traveling by car.
Subject Matter of Insurance
The subject matter of insurance can be any type of property or any event that may cause a loss or create
a liability. Insurance is taken to offset the loss incurred or to pay for the liability created.
Examples of subject matter of Insurance under different types of policies are:
Creation of Insurable Interest
Ways in which insurable interest arises:
1. By Common Law: When the element of insurable interest is automatically present, it is said to have
arisen through common law. For example, if a person owns a house, he is entitled to insure it.
2. By Contract: In this case, insurable interest arises by virtue of a contract entered into. For example,
normally the landlord is responsible for maintenance of the property but a lease may make a tenant
responsible for maintenance and repairs in the building. Such a contract gives rise to an insurable
interest of the tenant in the building.
3. By Statute: An act of parliament may create an insurable interest by granting some benefit to a
person or imposing some duty.
Type of Insurance Example of subject matter of insurance
Fire Insurance Building, Stock or Machinery
Liability Insurance A person’s legal liability to third party for injury or damage
Life Assurance Life of the insured person

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Application of Insurable Interest
In Life Insurance
Every person has an unlimited insurable interest in his own life. His ability to get himself insured is
restricted only by his ability to pay the applicable premium.
A person also has an automatic insurable interest in the life of his/her spouse.
A person has insurable interest in the life of debtor, but only to the extent of loan outstanding.
In Property Insurance
The absolute owner has insurable interest in the property owned by him/her.
Any person who has partial or joint interest in some property is entitled to insure to the extent of the
full value of the property, rather than just the extent of actual interest. In such cases, he will be
deemed an agent for the balance.
Mortgagees and Mortgagors both have insurable interest. Here, the purchaser’s (or mortgagee) interest
arises because of ownership whereas the mortgagor’s interest arises as a creditor which is limited to
the extent of the amount of loan.
Trustees/ executors/ administrators are legally responsible for the property in their charge. So, they
have insurable interest.
A bailee is a person who legally holds the goods of another e.g. workshops, drycleaners etc. They
have insurable interest as they have the responsibility to take reasonable care of the goods.
Spouses have insurable interest in each other’s property.
In Liability Insurance
A person has insurable interest to the extent of any potential liability which may be incurred by way
of damages or costs. For example, a drug manufacturing company may incur a liability due to ill
effects of a new drug.
In liability insurance, it is not possible to predetermine the extent of interest because there is no way of
knowing how and when one may incur liability and what would be the monetary value of the liability.
In practice, a realistic judgment is made by the insured about the maximum liability that may be
incurred and insurance procured for that amount,unless any relevant statute has fixed some limits.
Assignment
Assignment refers to transfer of title of the policy from one insured to another.
For example, if A sells his car to B, then A ceases to have insurable interest in the car. At the same time,
insurable interest is created for B with the ownership of the car. In such a case, A can transfer the
insurance policy in the favour of B.
Assignment due to Operation of Law
Sometimes, transfer of insurable interest takes place due to operations of law. In such cases, the
insurance is normally transferred in the name of the new insured. For example, if X dies and Y is the legal
heir of X then insurance would be transferred in the favour of Y.
Assignment of Life Assurance Policies
Under a life policy, the assured does not receive the benefit of the policy until it matures. Therefore, the
risk profile for the insurer does not change by change in the assignee. For this reason, life policies are
freely assignable.

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Life insurance policies may be assigned to anyone irrespective of the fact that the assignee has an
insurable interest in the life of the assured. The assignee acquires all the rights and liabilities of the
original assured.
Nomination
A life policy holder may appoint a nominee to receive the policy proceeds becoming payable in the event
of his/ her death during the term of the policy.
Unlike an assignee, nominee does not have any right to sue the insurer, except to receive the policy
proceeds payable to him from the insurer.
The policy holder may change nominee at any point of time without consulting the insurer or the nominee.
In the absence of nomination, the legal heirs of the deceased policy holder need to submit the relevant
documents as a proof of the right to claim under the policy.
Nomination is nothing but a form of assignment of proceeds of the insurance policy.
The Principle of Indemnity
Indemnity is the mechanism by which insurers provide financial compensation in an attempt to make
good the loss suffered by the insured due to the happening of the event insured against.
The effect of indemnity is to place the insured in the same financial position in which he was immediately
before the loss - neither better-off nor worse-off.
Indemnity means to provide compensation to the policyholder in such a way that neither he is benefited
nor does he remain in loss, after a claim under the policy.
Property Insurance
In this case, the amount of indemnity is determined not by the cost of the property but by the value at the
date of the loss and at the place of the loss.
If the value has increased during the currency of the policy, the insured
is entitled to an indemnity on the basis of the increased value. This
rule is, however, subject to policy conditions such as the total sum
insured etc.
In assessing the amount of indemnity, the following are not considered:
Loss of prospective profits
Consequential losses
Sentimental value
Building Insurance
The amount of indemnity is calculated as the cost of repair or reconstruction at the time of the loss. An
allowance for betterment is deducted from the indemnity payable.
To clarify, suppose an old dilapidated house is destroyed in a fire. An
allowance will be deducted from the indemnity amount payable for the
new plumbing, electric wiring and decoration. This is because the new
wiring etc. would be much better than the original. At the time of the
loss, the value of the original wiring etc. would be less due to obsolescence
and wear and tear.

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If the new wiring is also paid for by the insurer, it would leave the insured in a better position than he was
prior to the loss and this would be a violation of the principle of indemnity.
Insurance of Household Goods
Indemnity is based on the cost of replacing at the time of the loss, subject
to deductions for wear and tear.
Two different types of covers are generally available for household goods.
These are:
Indemnity only
New for old
“Indemnity only” policies operate in the same way as other property insurances. The cost of replacement
is paid with deductions for wear and tear.
In the “new for old” type of policies, there is no deduction for wear and tear. Indemnity is calculated at
replacement at current market price. Accordingly, the premium payable in this type of policies is higher
than that in “indemnity only” policies.
Liability Insurance
Amount of indemnity is the amount of any court award or negotiated “out-of-court” settlement plus costs
and expenses arising in connection with the claim.
Factors limiting payment
A number of factors may limit the amount payable under an insurance policy. The most important among
these are:
Sum insured
The total sum insured is the limit of maximum amount recoverable under the policy even if the calculated
amount of indemnity is higher. Indemnity can exceed the sum insured if the policy is not updated for a
long time and in that duration, the value of the property increases.
Exceptions
At times, in marine insurance policies, some loss minimization expenses are paid even in excess of sum
insured.
Depreciation
The value of an asset decreases over time due to constant use. So the amount towards depreciation due
to wear and tear is generally deducted.
Salvage
In case of partial loss, the property may remain in a deteriorated or damaged condition. If the insurance
company has agreed to pay the loss in full, it is entitled to any materials left. If the left over parts are not
deposited with the insurance company, the amount payable is reduced by the value of salvage. This is
common practice in motor insurance policies.

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Average
If at the time of loss, the value of the property insured is more than the sum insured, then the insured
would be considered his own insurer for the difference. Thus, in the event of loss, the amount is shared
between the insurer and the insured in the proportion of sum insured and the amount of underinsurance.
The formula applicable when average is applied for identifying the amount of claim payment would be:
Loss = Amount of Recovery
Sum Insured
Total Value
Therefore, when the average clause operates to reduce the amount payable, the insured is receiving less
than an indemnity. This is because, he is considered his own insurer for a proportion of risk and in that
sense is supposed to “indemnify himself” for the balance.
Excess
An excess is the initial amount of each and every claim that is supposed to be borne by the insured
himself. The objective is to eliminate the small losses which may involve comparatively high administrative
cost for the insurer. Excess is of two types – Voluntary and Compulsory. Voluntary excess is voluntarily
opted for the insured and results in reduction of premium whereas compulsory excess does not result in
any reduction.
Limits
Many policies limit the amounts to be paid for certain events by the wording of the policy itself. For
example, universal health insurance policies often specify a limit of Rs. 15,000 per claim.
Corollaries of Indemnity
There are two corollaries to the principle of indemnity – Subrogation and Contribution.
Subrogation
Definition:
Subrogation is the right of one person (insurer), having indemnified another (insured) under a legal
obligation to do so, to stand in the place of that other (insured) and avail himself (insurer) of all the
rights and remedies of that other, whether already enforced or not.
This principle is corollary to the principle of indemnity in the sense that it prevents the insured to be
benefited by loss after receiving the loss from the insurer as well as the responsible third party. The
insured may recover the loss from another source after receiving the claim from the insurers but that
additional money must be given to the insurers.
Subrogation applies only when there is a contract of indemnity. It is not applicable in life insurance,
personal accident insurance as these are not subject to the principle of strict indemnity.
Extent of Subrogation rights
This principle does not apply only to the insured but also to the insurer as insurers are not entitled to
recover more than what they have paid as claim. Just like the insured, the insurer must also not make
any profit out of an insurance claim.

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Liability under policy =
Sum Insured under the policy
Total Sum Insured
Loss
Contribution
In some cases, more than one policy may be in force on the same subject matter at the time of loss. In
that circumstance, each insurer would need to bear a proportion of loss. This is referred to as Contribution.
Contribution is the right of the insurer to call upon others similarly (but not necessarily equally) liable to
the same insured to share the cost of an indemnity payment. If an insurer has paid the indemnity in full,
he can recover an equitable proportion from other insurers of the risk.
The following features are to be met before the condition of contribution arises:
Two or more policies of indemnity must exist;
The policies must cover the same interest;
The policies must cover a common peril which gives rise to the loss;
The policies must cover a common subject matter; and
Each policy must be liable for loss
It is not necessary for the policies to be identical to each other. There should, however, be an overlap in
such a manner that both policies are liable for payment of indemnity.
Basis of Contribution
Contribution is usually calculated on the basis of ‘Rateable Proportion’. This means that each insurer
contributes towards paying the loss in proportion to the sums insured on the policies.
The amounts payable by each insurer are calculated as per the following formula:
To illustrate: Let us assume that a businessman has insured his warehouse against the peril of fire with
three different insurers for Rs 5 Lakh, Rs 3 Lakh and Rs 2 Lakh. Suppose the warehouse is partly
destroyed due to fire and the amount of loss is assessed at Rs. 2,00,000. Then the amounts payable by
each insurer would be calculated as per the following formula:
Note
Even if the property is underinsured, the insured is considered to be his own insurer for the uninsured
amount. Thus, as per the concept of rateable proportion, the insured is supposed to contribute towards
bearing the loss with respect to the uninsured amount.
Insurer Sum Insured Amount Payable
Company A Rs. 5,00,000 (5,00,000 x 2,00,000)/10,00,000 = Rs. 1,00,000
Company B Rs. 3,00,000 (3,00,000 x 2,00,000)/10,00,000 = Rs. 60,000
Company C Rs. 2,00,000 (2,00,000 x 2,00,000)/10,00,000 = Rs. 40,000
Total Rs. 10,00,000 Rs. 2,00,000

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Proximate Cause
An insurance policy is designed to provide compensation only for losses that are caused by insured
perils. This means that the liability of the insurer arises only if the loss is caused by a peril, which is
covered under the policy.
Therefore, to determine if loss is payable, the following two questions need to be answered:
What is the root cause of the loss?
Is the peril identified above, specifically covered under the insurance policy?
Let us examine each in detail.
What is the root cause of the loss?
Sometimes, the root cause of the loss may be straightforward. For example – two cars may have an
accident on the road.
At other times, it may not be so simple.
For example, suppose a fire breaks out in a building containing a library
but is swiftly brought under control by firemen. However, the water
used by the firemen to control the fire damages the books. In this
case what would be the cause of the damage – fire or water?
In such cases, it becomes necessary to identify the root cause, which is also called the “Proximate
Cause”.
In our previous example, we saw that while the immediate cause of damage was water, the root cause of
damage was fire. This is so because the water would not have been sprayed on the books if the fire had
not broken out.
Therefore, proximate cause means the direct, the most dominant and the most effective cause of the
loss. It is the cause that is most closely and directly connected with the loss.
Definition:
Proximate Cause is the active efficient cause that sets in motion a train of events which bring about
a result, without the intervention of any force started and working independently from a new source.
Proximate in efficiency, not in time
In our previous example, we saw that the chronological chain of events was:
Therefore, the more proximate cause of damage in terms of time was water. However, as per the doctrine
of proximate cause, the time that elapses between cause and result does not matter. We know for sure
that damage by the use of water was caused because of the fire that started in the first place.

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The cause that is considered truly proximate is that which is proximate in efficiency not in time. Therefore,
it is not the latest, but the most direct, dominant, operative and efficient cause that is regarded as
proximate.
Types of Perils
Once the proximate cause is identified, the next step is to determine if the causative peril is covered by
the insurance policy or not.
Insured Perils
These are perils that are covered by the policy as insured. For example, – fire, lightening, theft etc.
Excepted or Excluded Perils
These are perils that are specifically stated as excluded, e.g. war and allied perils.
Uninsured or other Perils
These are perils that are not stated in either inclusion cause or exclusion. For example, smoke and water
may not be excluded or mentioned as insured in a fire policy.
Application in Practice
In practice, losses caused only by insured perils are payable under the policy. Losses where the proximate
cause is an excluded or uninsured peril are not payable.
To entitle an insured to recover, the train of events leading from the insured
peril to the actual financial loss suffered by the insured, must be unbroken.
If the sequence of events from an insured event is broken by a train of
events from an excepted or uninsured peril, then only the loss upto the
break is covered.
Let us look at an example to understand this concept in depth:
Suppose a fire breaks out in a building which is insured against fire but not
against earthquake. About 50% of the building is destroyed in the fire.
Further suppose, that there is an earthquake later in the day and the entire
building is reduced to rubble.
In such a case, only 50% of the building value is payable, since the rest
of the damage was caused by an uninsured peril i.e. earthquake. It is also important to note that the
latter cause (earthquake) of the damage was completely independent of the former cause (fire).

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Chapter Review
Exercise
Mahek, is a doctor. She has always been fascinated about doing high end research in medical
studies. She has recently gotten married. Does she have an insurable interest in her own life and her
husband’s life?
Solution : Yes
She is moving to the USA very soon and she will be practicing as a medical doctor at Illinois. In America,
doctors have to be very careful about liability suits. If there is any patient who feels that the doctor has
medically been incorrect about the diagnosis, or the operational issues or the medication or surgery, then
the patient can sue the doctor and there will be big medical liabilities incurred by the doctor. Is there a
possibility of insurable interest and what kind?
Solution : Yes, it is a professional liability.

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Chapter 13

84. 90 Financial Planning Handbook PDP
The Insurance Contract
I
nsurance policies are based on the law of contracts. Each insurance contract must meet the following
essential requirements
Offer and Acceptance
Consideration
Competent Parties
Common Intention
Legality of Purpose
Let us look at these in more detail.
Essential Requirements of an Insurance Contract
Offer and Acceptance
As with all legal contracts in insurance contracts, there must be an offer and acceptance of its terms. It
should be remembered that in insurance contracts, the person seeking insurance makes the offer. Therefore
he is also referred to as the “Proposer.” It is the insurance company or the insurer which accepts or
declines the offer.
Consideration
‘Consideration’ is the value that each party to the contract provides to the other. Without consideration,
there cannot be any contract. In case of insurance contracts, the consideration for the insured is the
premium payments and the agreement to abide by the terms of the policy. For the insurer, the consideration
is the promise to make payment of the sum insured on occurrence of a specified event.
Competent Parties
Each party to the insurance contract must be legally competent to enter into contract. For the insured,
this means that the proposer should be an adult of sound mind. For the insurer, this means that the
insurer must have a valid license to do insurance business.
Common Intention
Parties to a contract are said to have common intention when they understand the same thing in the
same manner at the same time.
For example, if the proposer intends to take a policy for theft then it should not be misunderstood with
burglary. Burglary entails forced entry into the premises, but that is not the same in case of theft.
Legality of Purpose
The purpose of the insurance contract should be legal. A terrorist cannot insure his weapons against
theft because the object of the contract is not legal and is contrary to the greater public interest.

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Distinct Characteristics of an Insurance Contract
Insurance contracts have distinct legal characteristics that make them different from general contracts.
Some of the distinctive features have already been discussed in the chapter on “Principles of Insurance.”
Other distinctive characteristics of insurance contracts are that they are:
Let us look at these in more detail.
Aleatory Contracts
Aleatory contracts are those where the value exchanged is not equal but depends on an uncertain event.
Depending on the occurrence of a chance event, one party to the contract may receive a value out of
proportion to the value that is given. For example, in case of a motor vehicle insurance contract, an
individual may pay Rs. 5,000 as premium, but collect Rs. 5,00,000 if the car is stolen or destroyed during
the insurance period. Similarly, there may be cases where the insured pays premium but gets absolutely
nothing in return if no event causing any loss occurs.
Unilateral Contracts
Unilateral contracts are those in which only one party makes a legally enforceable promise. In the case
of insurance contracts, only the insurer makes that promise. If the insured does not pay further premiums
after the payment of the first premium, he cannot be legally forced to pay the balance premiums. The
insurer can withhold payment of claims if premiums are not paid but cannot force the insured to pay the
premiums.
On the other hand, if the insured pays the premium, the insurer is under obligation to provide the insurance
promised under the contract. In general contracts, if one party fails to perform, the other party can insist
on performance or sue for damages because of breach of contract.
Conditional Contracts
Conditional contracts are those which place certain restrictions or limitations on one or both parties. In
insurance contracts, the insured must comply with policy conditions if he wants to collect payment for
his claims. In case of non-compliance of the policy conditions, the insurer can refuse payment.
Personal Contracts
An insurance contract is a personal contract. This means that the policy is personal to the insured. With
the exception of life insurance, it may not be assigned to anyone else without the approval of the insurer.
Contract of adhesion
Contracts of adhesion are those that must be accepted in total, with all their terms and conditions. In
insurance contracts, this means that the insured must accept the policy issued by the insurer as it is.
The insured cannot insist on any changes or modifications to the contract.
Meaning of “Insured”
All insurance contracts invariably contain the precise meaning of the word “insured” in the
Definitions section. The contract generally indicates the insured person by name. In some insurance
contracts other parties are also covered even though they may not be named in the policy.
For example, a person may take a motor vehicle policy for the driver and the passengers of the car. This
would mean that any person driving the car and any passenger traveling in the car would be covered
under the insurance policy. It goes without saying that the driver must hold a valid driving license and

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should be driving the vehicle for a legal purpose to be covered under the policy. The conditions for
identifying the insured in case of ‘unnamed policies,’ are also clearly specified in the insurance policy.
Co-Insurance
The same property can be insured with multiple insurers. In such a case whenever a loss occurs, it is
paid by all insurers in the proportion of their respective insurance amounts.
When a person chooses to insure a property for less than its full value, he is considered to be insurer for
self for the uninsured part. Accordingly in case of a loss, the insured has to bear the loss in the same
proportion as the uninsured part bears to the value of the property.
For example, if a property worth Rs. 5 lakhs is insured for only Rs. 4 lakhs, then the insured is considered
to be the insurer for self to the extent of Rs. 1 lakh. In case of a loss causing event where the property
suffers damages to the tune of say Rs. 3 lakhs, the amount payable by the insurance company would be
calculated as below:
Purpose
The purpose of co-insurance is to achieve equity in charging premiums. For example, consider two
adjoining properties valued at Rs. 5 Lakhs each. Suppose the owner of the first property – Mr. A – insures
his property for Rs. 4 Lakhs only while the owner of the second – Mr. B – insures his property for the full
value of Rs. 5 Lakhs. If the premium rate is Rs. 1 per thousand ,then Mr. A pays a premium of Rs. 400
while Mr. B pays a premium of Rs. 500.
Further, suppose both properties suffer damages of Rs. 3 Lakhs. If the principle of co-insurance is not
applied both Mr. A and Mr. B will receive Rs. 3 Lakhs from the insurer. But Mr. B will be paying more
premium to get the same amount as Mr. A. This would be inequitable and implies penalizing individuals
who insure their assets for their true value!
Hence Mr. A shall get
i.e. 80% of the loss which works out Rs 2.40 lakhs only.
=
Amount of Insurance Carried
Value of Property
LossAmount of Recovery
Rs. 4,00,000
Rs. 5,00,000
Rs. 3,00,000= Rs. 2,40,000
or

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Exercise
The bungalow of an actor, Murali is on the seashore. It is furnished with the most exotic collection of
paintings and furniture. Murali has a contract with National Insurance Company, to pay him damages to
the extent of Rs. 5 crores, if there is any damage to the house due to tsunami or fire. He will have to pay
a premium of Rs. 2 Lakhs pa, irrespective of whether the house will ever catch fire or a tsunami will
destroy it.
What characteristic of the contract is explained by this example?
Solution : Such a contract is an example of Aleatory contract.
Due to some unfortunate incident, fire indeed broke out due to some combustible explosives in the
house. The kitchen got destroyed and Murali wanted to press charges against the damages. The claims
department, on receipt of the request, ordered an enquiry. They discovered that there was some combustible
material in the house, which increased the risk of fire. This was not mentioned as a probability when the
insurance was drawn. Thus, NIC can refuse the payment.
What characteristic of the insurance contract does the example exemplify?
Solution : This is a Conditional contract.
Murali for some reason was not too happy with this house. He noticed that a lot of negative things had
happened to his career after moving into this house. So, he decided to bring this property into the market.
There was an industrialist who was looking to buy a second house near the seashore and he liked the
architecture of the house. The deal was struck and the money exchanged hands. But the industrialist
also took a more comprehensive house and property insurance. The insurance, which Murali had purchased,
could not be transferred to the new buyer’s name.
What characteristic of the contract is this?
Solution : This is a Personal contract.

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Chapter Review

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Chapter 14

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Health Insurance
M
edical insurance is a type of insurance where the insurer pays the medical costs of the insured if
the insured becomes sick due to covered causes, or due to accidents
Why does one need health insurance?
Today, health care costs are high, and getting higher by the day. In case of a medical emergency, the
cost of treatment cannot be predicted, and thus can be very well beyond what one can afford. In a
particular year, the cost of medical treatment might be low, but in some other year it could be prohibitively
high. Thus, medical insurance is required to protect oneself against such emergencies as well as
uncertainties.
Example
Suppose “A” is driving back to his home after work on his two-wheeler. He gets hit by a speeding car from
behind and suffers intensive brain injuries. He has to now undergo immediate surgery. He has to bear all
those expenses out of his pocket in case he has not taken any medical insurance.
Who can avail health Insurance?
Medical insurance can be availed by anyone between the age of 5 years and 75 years. The lower and upper
age limits may vary depending on the policy. One can avail of medical insurance for himself only (individual
cover) or for himself and family members like spouse, children and dependant parents (group cover).
Benefits of Health Insurance
Provides cover against sudden illness or accidents that one may encounter
Adequate coverage can prevent sudden cash outflow and can sometimes help by providing capital
for immediate surgeries
Different Types of Medical Expenses
Hospitalization
Surgery
Medicines
Diagnostic procedures and tests
Various types of medical expenses can be incurred by a person. Medical Insurance Policies usually tend
to cover the expenses only on and after hospitalization. So this means that once the hospitalization of
the consumer has taken place, then rest of the expenses like medicine, diagnosis etc are taken care of.
Types of Medical Insurance
There are two major categories of Medical Insurance namely
Indemnity Plan
Managed Care Plan

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Indemnity Plans
These are also referred to as reimbursement plans, and they offer reimbursement against medical expenses,
irrespective of which service provider is used. There are three common practices that are used to determine
the amount of reimbursement in an indemnity plan:
Reimbursement of actual charges : Where the actual cost of medical expenses is reimbursed.
Reimbursement of a percentage of actual charges: Where only a set percentage of the actual
charges is reimbursed. The rest has to be borne by the consumer.
Indemnity: Where a specified amount per day for a predetermined number of days is paid regardless
of the actual cost of care. The reimbursements however, will never be more than the actual expenses.
Example
A person enrols for a Medical Insurance Plan. He opts for coverage of up to 1 lakh rupees. Suppose, he falls
sick and incurs an expense of Rs 10,000 over a period of 5 days. If the insurance company reimburses the full
10,000 rupees to him, this will be an example of indemnity plan with reimbursement of actual charges.
In case the medical insurance company pays him @ Rs 1000 per day, i.e. Rs 5000 in total (since he was
ill for 5 days only) then this would be an example of indemnity plan with indemnity.
In case the medical insurance firm reimburses 80% of his total expenses, i.e. to say Rs 8000, then this
would be an example of indemnity plan with reimbursement of a percentage of actual charges.
Managed Care Plans
These are the plans in which the insurer has a network of selected health care provider i.e. hospitals and
they offer incentives to the insured to encourage this to use the provider in the network.
Need for determining the appropriate coverage
After one decides to enrol for a Medical Insurance, the next task is to decide on the amount of coverage
one should take. The amount of coverage that one enrols for in a policy is an important decision as it
would directly affect the premium he/she needs to pay. More than this, if the coverage is too low, the
benefit of taking the insurance is lost and in case the coverage is too high, cash is wasted.
What are the factors that need to be considered while determining the coverage?
The determination of an appropriate coverage will depend on a number of factors. A few of them are
as follows:
Age
Health history and Present health condition
Profession
Income and Prior Financial Commitments
Options of floater cover
Example of age as a factor
A 23 year old will be less susceptible to disease than a 45 year old, who might run a risk of heart attack,
diabetes or blood pressure.
Example of profession as a factor
A cricket player, or for that matter any sports person, is more likely to suffer injury and thus need medical
assistance. In contrast, a professional would have a lesser chance of needing medical attention.

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Income and Prior Financial Commitments
Income of a person would also determine what amount of coverage he/she can take. Again, if a person
has some prior financial commitments, that would also limit his capacity to pay premiums.
Example
Person A is earning Rs 1 Lakh per annum. Person B is earning Rs 3 Lakh per annum. Both will have
different capacity to pay premium and hence, would take different coverage
Person A earns Rs 1 Lakh per annum but has no prior financial commitments. Person B earns Rs 2
Lakh per annum, but has an education loans worth Rs 1.5 Lakh. This prior commitment would reduce
person B capacity to pay premium and thus, he would take a lower coverage.
Options of floater covers
A person might decide on the amount of coverage based on the concept of floater covers. Floater cover
policy is a policy under which the policy is purchased by a group of members, mostly belonging to the
same family. This policy allocates a total amount for the family rather than for individuals; giving the
advantage of a large cover for the family. This policy is based on the assumption that at any point in
time, all the members of the group would not require the complete amount of cover.
Example
Suppose 3 members of a family purchase Rs. 1 Lakh worth of cover individually. However person A of
the family uses only Rs. 50 thousand of the entire cover, person B doesn’t use the entire 1 Lakh while
person C requires Rs. 1.5 Lakh for his treatment and has to provide the 50 thousand rupees from his
side. This family can take a floater cover policy of a total of Rs. 2 Lakh which is available for all the three
members. As the total sum insured is less than the individual cover, the premium on this policy is lower
and thus the cash outflow is lower.
Personal Accident/Disability Income Insurance
This kind of insurance helps one to plan in case of a sudden accident or permanent disability that can
happen because of it. With the increase in number of vehicles in cities, roads have become a less safe
place and thus the need to invest in such a policy has grown.
Benefits
This policy offers compensation in case of death or bodily injury to the insured person, solely as a
result of an accident, by external, visible and violent means.
The different variations have different coverages ranging from death to comprehensive covers including
death, permanent disablements and temporary total disablements.
An Indian adult up to the age of 70 can cover himself / herself and dependent family members
between the age of 5 and 70 years.
This policy also provides a daily allowance for the tenure of hospitalization.
Some policies of this category also provide for the education of 2 dependent children of the insured
person and a bonus on the total sum insured in case of permanent disability.

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Exercise
Sethi and Malik, both age 35 decide that they should invest some of their savings in a life insurance
policy. Sethi took a term policy for the cover of 25 Lakhs and Malik took an endowment policy with a
similar cover of 25 Lakhs. The expected cost of these benefits, based on the risks of the claims helps
determine the premium. Which one will have a lower premium and why?
Solution : Term will always have a lower premium, so Sethi will pay a lesser premium than Malik. There
is always a claim from an endowment policy irrespective of the person living or dead. After a specified
time, Malik will receive sum assured plus bonuses. However a term assurance claim arises only on
death during the term of the policy. So it is purely a risk cover, Sethi made a smarter choice than Malik.
Chapter Review

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Chapter 15

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Personal Property and Liability Insurance
A
part from risks to life and health, a person is also exposed to risks that may cause damage to his/
her property. These risks can be covered by opting for Personal Property insurance.
Let us look at some of the major property insurance types in more detail.
Householder’s Insurance
A comprehensive householder’s insurance policy covers most of the risks faced by any household. It
protects against natural calamities like flood and earthquake and also man-made disasters like theft and
burglary.
Instead of opting for separate policies for the building and for the contents of the house, the householder
can take up one package policy.
What does it cover?
The householder’s Insurance Policy broadly covers two things – building structure and contents inside the
home.
The Householder’s Insurance Policy comprises of ten sections which includes the insured’s building,
fixtures and fittings, contents inside the house, jewellery and valuables, television sets and VCRs,
bicycles, accompanied baggage as well as personal accident and public liability benefits.
The contents of the home are safeguarded against fire, burglary, accidental breakage or mechanical or
electrical breakage.
Motor Vehicle Insurance
Motor insurance is compulsory in India. It is essential for all motor vehicle owners since it protects them
from legal liabilities that might arise during their vehicle operation.
There are two types of policies available for motor vehicles – third-party liability insurance and
comprehensive insurance policy.
Third-party liability insurance
This covers the insured’s liability to third parties. The owner is protected in the event of death or injury
caused by the vehicle to:
pedestrians, occupants of other vehicles except those within your vehicle
other vehicle’s driver
passengers with whom your vehicle is for hire
The premiums are dependent on the cubic capacity of the car. This cover does not extend to fire and
theft accidents, for which one needs to pay additional premiums.
No vehicle can be used without this insurance cover and use of the vehicle without this insurance cover
is a penal offence.

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Comprehensive motor insurance
The comprehensive motor insurance takes care of additional losses and liabilities along with those
covered in third-party liability insurance.
There are two sections under this policy.
Section I protects the motor vehicle owners from the risks of:
Fire, Explosion, Self-Ignition and Lightning
Riot, Strike, and Malicious act of Terrorism
Transit by road, rail, inland waterway, air, lift or elevator
Earthquake
Accidental External Means
Landslide
Categories of vehicles:
The following categories of vehicles are covered under motor insurance policy:
Private cars: This category includes cars, station wagons, motor vehicles used for social, domestic,
business or professional purposes (excluding those used for the carriage of goods other than samples)
Motor Cycles: This includes motorcycles with or without sidecars, pedal cycles, mechanically assisted
pedal cycles and motor scooters with or without sidecars.
Commercial Vehicles: All vehicles excluding private cars, motor cycles and vehicles running on rails
come under this category.
Determining the value of the vehicle
The value of the vehicle is calculated on the basis of the current showroom price of the vehicle multiplied
by the depreciation rate that is set by the Tariff Advisory Committee at the commencement of each
policy period. This is called IDV (Insured’s Declared Value).
How is premium calculated?
The premium in a Motor Insurance Policy is regulated by the India Motor Tariffs as specified by the Tariff
Advisory Council. It is governed by the following factors:
Type of Vehicle
Age of the vehicle
City of registration
Use of the vehicle
Bonus / Malus System
In case of an accident occurring in a year for which the insured makes a claim, in the very next year the
insurance company increases the premium by way of charging a malus i.e an extra percentage. On the
other hand, when there is no claim lodged during the year, the insurance company grants a discount in
the premium by way of bonus.
No Claim Bonus (NCB) clause is applicable to holders of comprehensive insurance policy. The minimum
bonus is 20 percent and the maximum is 65 percent.

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Other liability insurance
Even if the personal property of an individual is protected through insurance, financial insecurity can
arise if the person commits a legal wrong against a third party and is directed to pay damages or fines to
compensate the aggrieved party. The liability arising from such a situation is covered through liability
insurance.
Let us look at some of the major types of liability insurances in more detail.
Directors’ and Officers’ Liability
Directors’ and Officers’ Liability Insurance policy is specifically tailored for directors and others holding
key positions in an organization. It is meant for those who are in the decision making process. Directors
and officers are bound by duty towards the company, its shareholders, employees, creditors, customers,
competitors, members of the public, government, and other regulatory bodies. The Directors’ and Officers’
Liability Insurance policy covers any financial liabilities imposed upon them.
They might become liable to pay damages arising out of:
Misleading statements
Errors and inaccuracy in financial statement and annual accounts
Lack of judgment and good faith
Unfair allotment of shares
Mis-statement in prospectus
Unauthorized loans or investments
Unfair dismissal of an employee
Unwarranted dividend payment, salaries, or compensation
Failure to obtain competitive bids
Using inside information
Misrepresentation in acquisition agreement for the purchase of another company
Exclusions
The policy does not pay for:
Prior and pending litigation and claims submitted under previous policies
Bodily injury, sickness, disease, emotional distress, death, damage, or destruction of tangible property
including loss
Criminal wrongs
Deliberate, dishonest, or fraudulent acts
Pollution and/ or contamination
Professional Indemnity Policy / Professional liability Insurance
This policy is meant for professionals like doctors to cover liability falling on them due to mistakes and
omissions committed by them while rendering professional service. Though doctors are supposed to be
immaculate in their profession, they are human beings and are prone to errors. As a result, they are
exposed to the risk of claims from clients who have suffered loss due to negligence.

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Who can take cover?
Doctors and registered medical practitioners such as physicians, surgeons, cardiologists,
gynecologists, pediatricians, pathologists etc.
Medical establishments such as hospitals and nursing homes
Engineers and interior decorators
Lawyers and counsels
Chartered accountants, financial accountants, management consultants etc.
What does it cover?
Professional Indemnity Policy covers the claims arising out of:
Bodily injury or death caused by mistakes, negligence, and miscalculation
Legal liability including defense costs incurred while investigation, court cases, and compensation
Exclusion:
The policy only covers civil liability claims. It does not cover:
Any liability arising out of or in connection with any criminal act or act committed in violation of any
law
Acts committed under the influence of drugs
Weight reduction
Plastic surgery
HIV Aids
Radioactivity
Blood Banks
Non-compliance with statutory provisions
Products liability insurance
Safety of a product is of prime importance to the manufacturer and seller. Faulty and defective products
can be harmful to the consumer resulting in death or bodily injury. In such cases, the manufacturer or
seller has to pay huge compensation.
Product liability insurance protects the companies exposed to the above risk by financially assisting
policyholders in such situations.
What does it cover?
The Policy broadly covers the legal liability of the insured, where the insured has to pay damages to the
third party as a consequence of:
Accidental death
Bodily injury or disease
Loss or damage to property
Exclusions
The policy does not cover any liability for:
Product recall
Product guarantee

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Pure financial loss such as loss of goodwill or loss of market
The cost incurred for repairing or reconditioning or modifying the defective part of the product
Deliberate non-compliance with any statutory provision
Fines, penalties, punitive or exemplary damages
General Liability Insurance
This kind of insurance is the main coverage in order to protect the business from injury claims, property
damages and advertising claims. It is also known as Commercial General Liability insurance.
Public liability Insurance
What does it cover?
The policy covers the insured against the legal liability arising out of accidents during the currency of the
policy. Accidents can be caused due to handling of hazardous substances as mentioned in the Public
Liability Insurance Act ,1991.
Exclusions
The policy does not cover liability or costs, which arise out of the following factors:
Earthquake, volcanic eruption, flood, storm, hurricane, tornado, or similar weather conditions
Deliberate or willful non-compliance of statutory warnings
Fines, penalties, and damages
War, invasion, hostilities
Loss of goodwill in the market
Ionizing radiation or contamination by radioactivity from any nuclear fuel or from any nuclear waste
from the combustion of nuclear fuel
Workmen’s compensation insurance
The Workmen’s Compensation Act, 1923, aims to provide workmen and/or their dependents some
relief in case of accidents arising out of and in the course of employment and causing either death or
disablement of workmen.
This insurance policy is essential for all employers who engage “workmen” as defined by the Workmen’s
Compensation Act to cover their liability towards them under statutory and Common Law.
What does it cover?
It covers the employer against any legal liability arising out of accident or fatal injury sustained by his
‘workmen’ during work.
Medical, surgical, and hospitalization expenses including transportation costs are also covered, on
extra payment of premium.
Exclusions
The insurance policy does not pay any claims arising from:
Any injury that does not result in a fatality or disability for 3 days subsequent to the accident
Any injury caused due to:
War or nuclear perils

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Influence of drinks or drugs
Willful removal or disregard of any safety device
Any compensation for diseases mentioned in Part ‘C’ of Workmen’s Compensation Act,1923
Liability towards employees of the contractors of the insured
Occupational diseases unless cover is extended on payment of extra premium
Exercise
Ravi had joined Numark recently as the Director-Marketing. He was given a car and a driver by this
company. The company had taken insurance, which will give compensation for other vehicles’ driver and
pedestrians in case of any untoward accident involving the company car. It is mandatory for all vehicles
to take this policy. The HR manager asked that instead of taking only this cover; why not take a more
complete one. It would also cover the car in case of any loss due to theft of the car. What are the two
types of insurance that is being talked about?
Solution : The two types of insurance are third party insurance, comprehensive motor insurance.
Ravi will be the spokesperson of the company. He is the key person, who works as a representative of the
company. It is important that the company takes a
(Directors and Officers Liability) insurance policy.
Does it cover dishonest, deliberate or fraudulent acts?
Solution : The insurance policy does not cover dishonest, deliberate or fraudulent act.
Numark is a pharmaceutical company. They manufacture generic drugs for diabetes and hypertension.
There are reputed players in the market and well known for quality products. However, they had started
their distribution in South East Asian countries and wanted to expand business. There is one insurance
policy that is definitely recommended. What do you think it is?
Solution : Products liability insurance is recommended.
Numark also runs a chain of clinics across the rural areas. The brothers in partnership thought that this
would be a good way to give back to the community. They started this business about 10 years back and
it has been very successful in treating a lot of patients who would otherwise find it difficult to access
bigger cities where all the facilities are already available.More than it being a business proposition, it
started out being a part of the corporate social responsibility.Since it was managed well, this new associate
venture grew in size and geography.The philosophy was to help all the poor and needy free of cost.The
hospital became well known for its treatment and quality of service. Many people started queing up to get
treated who were not necessarily poor but came from the middle class backgrounds. This low revenue
earning model, an associate of the main business was doing contributing up to 7% profits of the company.
The company hires a lot of doctors, who have just completed their education and want to train under
diverse conditions. The company want their costs to be optimized, yet give quality care. To hire young
doctors who are yet gaining a wider range of experience was one of their ways of doing it. The management
decided that it made legal sense to take up another policy. What policy to do think that would be?
Solution : Numark should take up Professional Indemnity Policy.

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Chapter Review

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Chapter 16

103. 109Financial Planning HandbookPDP
Insurance of Business Risk
P
ersonal financial planning for the business owner requires that the risks affecting his business
should also be covered. No matter how diligent an entrepreneur is, a single crisis can annihilate all
profits and can even ruin the business. Protecting the business with insurance is the key to cover all
financial risks. It ensures that the money invested in the business does not disappear whenever a
catastrophe strikes.
It is the job of the financial planner to study the nature of the business run by his client and spot the
potential exposure to risk. Whereever the financial planner feels the need, he/she should not hesitate to
consult an expert in this area.
Purpose of Business Insurance
Business insurance can be taken for three main purposes:
To protect the business from physical destruction
To keep the business afloat if a key employee dies or becomes disabled
To protect the business assets if someone threatens or sues the business
Let us look at these in more detail.
Building and equipment insurance
This protects the business owner if the facility or equipment is damaged or destroyed.
Valuable papers insurance
This protects the owner if any valuable documentation or business records are lost or destroyed.
Crime insurance
This protects the business in case of theft.
Business interruption insurance
This protects the business by replacing some or all of the operating cash flow if the business is unable
to maintain its normal operations for a period of time due to a covered event.
Benefits of Business Interruption Insurance
It’s an effective tool against a financial crisis.
It helps to insure against the monetary losses which an entrepreneur may encounter while running
his business.
It compensates the owner for the lost money if the company has to evacuate the premises due to the
occurrence of a disaster-related damage such as fire, which is covered under the property insurance
policy.
It covers the profits which the business would have earned if the disaster had not occurred.

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This insurance also covers operating expenses, such as the electricity, which continues even after
the disaster has victimized the business.
Example
A company Morality Investments was in the congested central town of Jallandhar. The civic authorities
were to begin road widening process, after the municipal authorities had agreed to the project widening
exercise. The orders were passed and the process was to begin. The company would have to be closed
and business would be interrupted, when it happened. Luckily, the owner had taken the business interruption
insurance, which helped take the cash flow situation.
Extra expenses insurance
This protects the business by reimbursing extra-ordinary expenses incurred to maintain normal operations
after the occurrence of a covered event.
For small business enterprises, package policies generally provide needed coverages. These policies
usually combine property and liability coverages for the standard risks faced by businesses of the type
being insured.
Key Person Insurance
Key Person Insurance is specifically designed to protect a business in the event of loss of an important
person who makes a remarkable contribution towards the progress of the business.
Who is a key person?
A key person or a key man is the owner, director or any ordinary employee, with special expertise,
without whom the company or the business might suffer heavy losses. Death or permanent disability of
the key person could result in:
Reduction in profit
Loss of significant clientele
Loss of time, money and efforts in recruiting a replacement
Loss of business ideas, projects and ventures
How much key person insurance is enough?
There is fixed formula that determines the value of a key employee. Expected profits, replacement costs
and a compensation-multiple formula are the usual techniques of determining a loss. The following
factors are also taken into consideration to determine the amount of coverage:
Projects that would be lost with the loss of the key employee
Sales generated by the employee
Age of the person
Physical condition of the person
Cost of replacing the individual
Important:
Partnership and proprietorships tend to be much more dependent on one or two key employees as
compared to companies. Therefore, key employee insurance is much more relevant for them.

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Chapter Review

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Chapter 17

107. 113Financial Planning HandbookPDP
Government Regulation of Insurance
A
ll across the world, insurance is a highly regulated industry. The reason for this is that for the
insurance industry to run smoothly, it is essential that the insuring public has complete faith in the
capabilities of the insurers.
This faith is essential because the insuring public pays premiums much in advance and the claims occur
far into the future. If during this period some insurer goes bankrupt and is not able to pay claims of the
insured when they arise, then the entire purpose of insurance would be defeated. Also, if because of
some unscrupulous insurers the faith of the public gets shaken, then the entire insurance industry would
collapse. People would stop buying insurance out of fear. This would lead to dwindling sales and the law
of large numbers would cease to be applicable as insurance companies will be unable to get a large
number of homogenous risks to cover. This in turn would increase the unpredictability and make it
difficult for insurers to charge the correct premia.
If the insurers charge excess premia, then they would reduce the market size even more and if they
charge less, then they themselves may go bankrupt.
As a result, insurers are regulated to:
Maintain insurer solvency
Ensure reasonable rates and premia
Make insurance available to a large number of people
Protect consumers from unreasonable restrictive insurance contracts
Insurance Regulation in India
In India, the insurance industry is regulated under the Insurance Act, 1938.
The Insurance Act, 1938 came into force on 1 July, 1938. This Act consolidates and amends the law
relating to the business of insurance. It applies to both life and general insurance business.
Insurance Regulatory and Development Authority Act, 1999
In addition to the Insurance Act 1938, a separate act called the Insurance Regulatory and Development
Authority Act, 1999 was passed for the creation of an independent regulatory agency to oversee the
insurance industry in India.
Agents and brokers
Agents and brokers form the marketing backbone of any insurance company. They are the face of the
insurance company to the consumer. As a result, they are governed by strict regulations regarding every
aspect of their operation.

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Definition:
An Agent is a person employed to do any act for another, called Principal, as well as to represent him
while dealing with a third person, i.e. prospective or existing client of the Principal.
Who can be an Insurance Agent?
An Insurance Agent is a person engaged by an Insurance Company to:
Solicit or procure new insurance business
Deal with the clients on behalf of the company for continuance, renewal or revival of the policies of
insurance.
According to the Insurance Act, an Insurance Agent has to be licensed under Section 42 of that Act. A
license is granted for a period of 3 years and may be renewed after 3 years or cancelled. An Agent can
start functioning only after obtaining a valid license.
A person can be an agent for one insurance company only, and in case of a composite agent, for one Life
and one Non-life Insurance Company only.
Types of Agents
Broadly, agents are classified into two categories as follows:
General Agent - One who is authorized to act for his principal in all matters in a specified sphere.
Special Agent - One who is authorized to transact a special business, e.g. to buy or sell a particular
product.
Insurance Agent
Insurance agents are a kind of special agents who are authorized to transact insurance business. They
are further subdivided into two categories namely:
Direct Agent
Corporate Agent
Direct Agents
Under direct agents, there are three types of agents:
Life Insurance Agent - One who is licensed to transact life insurance business only.
General Insurance Agent - One who is licensed to transact general insurance business only.
Composite Insurance Agent - One who is licensed to transact both life and non-life insurance business.
Corporate Agent
A corporate agent can be a firm, a company under the Companies Act, a banking company, a regional
rural bank, a cooperative society, a panchayat, a local authority, a non-government organization, a
micro-lending finance organization, or any other organization approved by IRDA.
Essentials to become an Agent
The person must be at least 18 years of age.
Have passed at least the 12th standard or equivalent examination, if he is to be appointed in a place
with a population of one lakh or more.
Have passed 10th standard, if he is to be appointed in a place with population less than one lakh.

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Have undergone the prescribed practical training programme for 100 hours in life or non-life insurance
as the case may be.
Must have cleared the pre-recruitment examination conducted by the Insurance Institute of India or
any other examination body recognized by the IRDA.
In the case of a person wanting to become a composite insurance agent, the applicant should have
completed at least 150 hours practical training in life and general insurance business.
Procedure for becoming an Agent
Training
The applicant has to complete at least one hundred hours practical training from an approved institute in
life or general insurance business as the case may be.
Pre-recruitment Test
The applicant has to pass the pre-recruitment examination in life or general insurance business or both,
as the case may be, conducted by the Insurance Institute of India or any other examination body recognized
by the Authority.
Issuance of License
The designated person on being satisfied with the formalities of the application, grant the license along
with the identity card.
In case of a composite agent, separate identity card should be issued by life and non-life insurance
company.
Authority and Duty of an Agent
Authority of an Agent
An agent can act only to the extent of authority granted to him by the principal.
Pre-requisites to Duties and Functions
In order to perform all the tasks, the agent should be familiar with:
Details of various plans of insurance like covers, premiums, exclusions, conditions, warranties.
The office procedures for various matters including the forms and documents considered necessary.
Disclose all the material facts accurately to help the underwriter make his decision with regard to
acceptance of the proposal, as made.
Commission
Commission is the remuneration which the Agent gets in lieu of his services towards the Insured and the
Insurance company. This is paid by the Insurance company and not the Insured.
Commission should not exceed 15% of the premium.
The terms of appointment of the agent include rates of commission, which may be:
5% for fire, marine and motor business
10% for some classes of miscellaneous business
15% for majority of rural and non-traditional insurance business

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Renewal of License
An application for renewal has to be filed at least 30 days before the expiry of the license.
The procedure for this is exactly the same as for the issuance of fresh license with the following differences:
Training – The Agent has to complete 25 hours practical training in life or general insurance business,
as the case may be, or at least 50 hours practical training in life and general insurance business, in
the case of a composite insurance agent.
Fees – Rs.100/- . However, an additional fee of Rs. 100 is charged in case of late applications, even
if it is made before the date of expiry.
Termination of Agency
An Agency can be terminated in the following circumstances:
Cancellation or non-renewal of the license.
Non-fulfillment of business guarantees.
Legal disqualifications like permanent incapacity, conviction for criminal misappropriation, criminal
breach of trust, cheating or forgery, etc.
Offering rebate for whole or part of commission in violation of Section 41 of Insurance Act.
Insurance Brokers
While an agent represents a single insurance company and can bind the company with his actions, a
broker is an intermediary who solicits insurance business for a number of insurers. Brokers do not have
the authority to bind the insurer. They solicit insurance business and then try to place the risk with one of
the insurers.
A “Direct Broker” is licensed to carry out specified functions in life insurance or general insurance or both
on behalf of his clients.
Code of Conduct
Every insurance broker needs to follow recognized standards of professional conduct and discharge his
functions in the interest of the policyholders.
Remuneration
On Direct General Insurance Business:
No insurance broker can be paid or contracted to be paid by way of remuneration (including royalty or
license fees or administration charges or such other compensation) an amount exceeding:
On tariff products:
10% of the premium on that part of the business, which is compulsorily under any statute
or any law in force.
12.5% of the premium on others.
On non-tariff products:
17.5% of the premium on direct business.
Premium from a single client:
The premium shall not exceed 50% of the total premium of a broker in the first year of business, 40%
of in the second year of business, and 30% from the third year of business.

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Any applicant seeking to become an insurance broker should satisfy the following conditions:
A Direct Broker needs to have a minimum amount of capital of Rs. 50 Lakhs.
The capital in the case of a company limited by shares and a cooperative society, shall be in the
form of equity shares.
The capital in case of other applicants shall be brought in cash.
The applicant shall exclusively carry on the business of an insurance broker as licensed under these
regulations.
Every insurance broker before the commencement of his business, deposits a sum equivalent to
20% of the initial capital in fixed deposit in any scheduled bank.
He cannot release this amount of deposit without the prior permission of the Authority.
Every insurance broker has to maintain a professional indemnity insurance cover throughout the
validity of the period of the license granted to him by the Authority.
Doctrines of waiver and estoppel
The doctrines of waiver and estoppel are concerned with the law of agency. They derive their origin from
the fact that an agent can bind the company with his actions. Due to the application of these doctrines,
the insurer may be forced to pay claims that could have been avoided.
Let us look at these in more detail.
Waiver is the voluntary relinquishment of a known legal right. If the insurer or the agent acting on behalf
of the insurer voluntarily waives a legal right under the contract, it cannot later deny payment of a claim
by the insured on the grounds that such a right was violated.
For example, if an insurer issues a policy despite non-completion of all formalities by the insured, then it
cannot deny payment of a claim at a later date citing this reason.
Estoppel is when a person makes a statement to another, who believes it to be true and acts on that
basis to his detriment, then the person who made the statement cannot deny that such a statement was
made.
For example, if an agent makes a statement to a prospective client that it is not necessary to declare
pre-existing diseases in a health insurance proposal form, then the insurer at a later date cannot deny
payment of claim on the grounds that pre-existing diseases were not disclosed.

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Exercise
Lets take a look at a case study.
Pramod is 24 years old and has lived in Mumbai all his life. He hails from Vaishalinagar which is 50kms north
of Mumbai. He has finished his schooling up to eleventh standard in Mumbai. Whilst at school, he went to an
English medium school, and thus learnt the language well. He could converse with people and his strength
was getting around with people and getting work done. His family circumstances led him to quit school early
on in life. He has tried his hands at many different things. He was an intelligent person, and good at calculations
and basic math. He also felt that he should start some business with the little capital that he had built up over
the years. However, his family needed his support and help. He thought of becoming an insurance agent. He
could easily undertake the 100 hours practical training and had run through and studied the books already. He
wants to specialize in both life and non-life insurance. He also realized that with a bit of effort, he could
become a certified insurance agent and that his dreams would come true.
Can he become an agent in Mumbai? What is his option,given that he wants to become successful in
this area? Will he be considered a direct agent or a corporate agent? What type of an agent does Pramod
aspire to become in terms of areas that he would like to look after?
Solution : No, he cannot become an agent in Mumbai because he has not completed his XII standard,
one option is that he attempts to complete his education, which is of prime importance to him along with
his job, since his family needed the income.
The other option for him is to register at Vaishalinagar, nearby town close to Mumbai and start educating
people about small savings schemes and insurance policies. He could begin a career from the nearby town.
He will be a direct agent. Pramod aspires to become a composite Insurance Agent.
Part II of the case study:
Pramod struggled for a few years, and finally became an insurance agent. Slowly but steadily,he got
better with time. On an average, he sold about 5 or 6 policies with a premium of Rs. 10000 pa in a month.
He made an average of about Rs. 5000 to Rs. 7000pm, which he was quite happy with. He got a good
name in his community of being an honest worker and people often asked for his advice. Infact, he was
always there to help farmers who had already purchased their policies with him with their paper work and
completing the procedures including documentation and form filling exercise in a timely fashion. Infact,
in a few more years, he hired some younger boys to help him with the settlement of claims in case of any
eventuality in any of the locations, which he was handling. Since it was a rural setup, the people did not
know how to file a claim report and provide the company with all the required documentation. He now
planned to include his brother in this business after he completes his education and he wanted to move
on to new areas, which interested him equally.
There was a farmer in the Modak taluka, Vaishalinagar who wanted the policy for himself. He was a fairly
well-to-do farmer. He told Pramod that he had installed a pacemaker a couple of days back, as advised
by the doctor, after a series of medical problems. However, he wanted to know if he should disclose in
his declaration, when he is applying for the policy. What advise should Pramod give the farmer? In how
many years should Pramod renew his license to solicit business as an insurance agent?
Solution: He should advise the farmer to disclose all medical ailments when he is taking the policy. The
farmer should be informed that in case of mis-information, it is likely that a claim may not be settled since the
disclosure was not complete. Ultimately, he will turn out to be the loser in the long run,should such misguided
information be declared in the policy statement. Pramod should renew his license in 3 years.

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Chapter Review

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Chapter 18

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Insurance Companies
News-bytes
T
here are some interesting facts from the insurance company point of view relating to the worst floods
which took place in the history of Mumbai in the last 100 years on 26/7.
Let me share with you what happened in the 26/7/05 rain disaster at Mumbai. All insurance companies
had to take care of their claims during such a tragedy. It was definitely a better situation for all those
people who had taken insurance covers than those who hadn’t. Some newspaper reported that though
the damages were inflated, the insurers were forced to pay because of their commitment.
Generally, with a flood like situation, there are insurance claims made each year, but their surveyors are
more stringent than they were at the time of the major flood disaster like 26/7. Largely, 50% of the claims
come from the retailers and the shopkeepers, and about 40% from the wholesale stockists. The remaining
comes from owners of ground floor flats in low-lying areas. On normal flood days, there are claims from
car owners whose cars get damaged, as well. Typically, the average repair costs are claimed for falls
between Rs. 3000 to Rs. 10000, as quoted by Mahendra Dhruva, president of the Institute of Surveyors,
Valuers and Adjusters.
But, if the cars get submerged in water, then the claims become much heftier. When water seeps in, the
power steering gets damaged which costs Rs. 30000.Damaged upholstery cost anywhere between Rs
5000 to Rs. 20000. So, when deep flooding happens, the car damage claims go up by an average of four
times the normal flooding damages’ amount. The insurer also says that if the damages are below Rs.
3000, then it is better to avoid asking for the claim, since one loses out on valuable bonus points and the
premium amount could rise. Insurance had to shell out monies to the tune of Rs. 5000 crores in damaged
property claims. A senior official from the public sector insurance company mentioned in leading papers
that the company was still recovering, after almost 2 years, from such a huge outflow of funds, due to
indemnity provided during disasters of such a large magnitude.
The above-discussed article drives home two important points. Risk assessment is a major function of
an insurance company and the underwriter identifies this risk and calculates the premium to be paid.
Each situation carries a different risk, which needs to be considered and studied very carefully while
undertaking a policy. The second major point discussed is that insurance companies also need to cover
their risk with a reinsurer to tide over major fall-outs like the New York bombing by Al Qaeda. If this
weren’t the case, a lot of insurance companies would have been wiped out because of the claims that
opened due to 9/11 disaster.
Insurance companies (insurers) act as facilitators between groups of people who share similar risks. In
its simplest form, an insurance company collects premiums from policyholders (insureds), invests those
premiums, compensates for losses and shares some of the surplus with policyholders. Eventually,
insurers give policyholders some sort of a financial reimbursement, either upon the policyholder’s death
or when a policy matures.

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In India, insurance companies can be divided into two categories based on the lines of business they engage in:
Life Insurance Companies: These companies provide insurance for human life. They guarantee a
specific sum of money:
to a designated beneficiary upon the death of the insured, or
to the insured if he/ she lives beyond a certain age
General Insurance or Non-life Insurance Companies: These companies provide insurance for
property and profession/ business related liabilities.
No company can deal in both life and general insurance through a single entity.
Functions/operations of an Insurance Company
The important insurance company operations are:
Rate making
Underwriting
Production
Claims settlement
Reinsurance
Investments
Insurers also engage in other operations like customer service, to handle client queries and transactions;
and other internal departments such as human resources, accounts and administration.
Let us look at the major operations in more detail.
Rate Making
Rate making refers to the pricing of insurance. Insurance pricing differs significantly from the pricing of
other products in the sense that at the time of the sale of the insurance policy, the insurance company
does not know what the actual costs are going to be to service that policy. It is only after the period of
insurance has passed that the insurance company can determine the actual cost.
As a result, insurance companies have to determine their premiums on the basis of probabilistic and
statistical analyses. The person who determines rates and premiums for the insurer is known as the
actuary. Actuaries study past data to arrive at probabilistic figures for loss causing events and determine
the premium to be charged from persons seeking insurance.
Underwriting
An insurance company’s main business is that of underwriting or writing insurance policies. The insurer’s
underwriters identify and calculate the risk of loss from policyholders; establish appropriate premium
rates; and write policies that cover this risk. An insurance company may lose business to competitors if
the underwriter appraises risks too conservatively, or it may have to pay excessive claims if the underwriting
actions are too liberal.
Each insurance company uses its own set of underwriting guidelines in order to determine whether or not
the company should accept a proposal. In life insurance, this decision process sometimes requires that
applicants provide further medical evidence. Applications often are supplemented with medical reports
and reports from actuarial studies.

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The applicant may be required to provide the following information (for life insurance) to enable underwriters
assess mortality risk and determine appropriate premiums:
1. Age
2. Gender
3. Height and weight
4. Health history (and often family health history)
5. The purpose of the insurance (such as for estate planning, or business or for family protection)
6. Marital status and number of children
7. The amount of insurance the applicant already has, and any additional insurance he/she proposes to
buy (as people with far more life insurance than they need tend to be poor insurance risks)
8. Occupation (some are hazardous, and increase the risk of death)
9. Income (to help determine suitability)
10. Smoking or tobacco use (this is an important factor, as smokers have shorter lives)
11. Alcohol (excessive drinking seriously hurts life expectancy)
12. Certain hobbies (such as race car driving, hang-gliding, piloting non-commercial aircraft)
13. Foreign travel (certain foreign travel is risky)
Underwriters then must decide whether to issue the policy and, if so, the appropriate premium to charge.
In making this decision, underwriters serve as the main link between the insurance company and the
insurance agent.
The underwriters can decide to make a counteroffer in which the premiums have been increased, or in
which various exclusions have been stipulated, which restrict the circumstances under which a claim
would be paid. Some companies use automated underwriting systems to encode these rules, and reduce
the amount of manual work in processing proposals.
Life insurance companies each have their own extensive policies and procedure manuals they are supposed
to follow in determining whether or not, to issue an individual, a life insurance policy, and in pricing that
policy.
Most underwriters specialize in one of the three major categories of insurance: life, health, and property
and casualty. Life and health insurance underwriters may further specialize in group or individual policies.
Property and casualty underwriters usually specialize in either commercial or personal insurance and
then by the type of risk insured, as in fire, homeowners’, automobile, marine, or liability insurance, or
workers’ compensation.
Production
In case of insurance companies, the term ‘production’ refers to sales and marketing activities. Life
insurance products are distributed primarily through a direct-selling system or through an agency system.
Direct-selling
In a direct-selling distribution system, the insurer deals individually with customers, through its own
employees. A number of marketing techniques are used including direct response and sales through
company-run agencies.

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Agency
Under an agency system, the insurance company contracts with third parties, or agents, to sell its
policies in exchange for a commission. Agents may be ‘captive’ to a particular insurer, selling only that
insurer’s policies. Agents may also be independent, offering an array of policies from various insurance
companies.
Presently, direct selling through own agents and third party agents is the most common means for
distribution of insurance policies. However, alternative channels such as bancassurance, brokers and
other third party tie-ups are likely to gain prominence.
Claims settlement
The claims division of an insurance company performs the verification of a covered loss, ensures fair
and prompt payment of claims and provides assistance to the insured. The claims process is as below:
Step 1: Claims Reporting
Rules regarding reporting of claims are typically outlined in the policy document. This includes the
following instructions:
Filing claims in a timely fashion
Co-operation in the investigation and providing the company with all relevant information and documents
To authorize the company to handle necessary inspections and assess the extent of damage prior to
any repairs or replacement
The insurance company sends an appropriate claim form (when the loss reporting is made in writing) to
the claimant (policyholder/ beneficiary). The claim form pertains to the type of policy under consideration
and is sent within a reasonable period of time.
This form is prepared either by an individual insurance company or at the national level, by companies or
supervisory authorities. The company also communicates information on how to comply with the terms
of the policy and legitimate requirements of the company.
All claims payable by an insurance company are subject to the production of proof of the claim event.

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For instance, the primary documents for processing a life insurance claim are:
Intimation of the claim event, in writing and in the company’s specified format, signed by the claimant
(beneficiary/ nominee/ assignee/ legal heir). This intimation needs to mention the following:
A statement that the claim event (death/ accidental death/ permanent disability/ critical illness) has
occurred
Details of the policy under which the insured is covered
Date of the claim event
Place of occurrence of the claim event (hospital/ residence etc) and the address of such place
Cause of the claim event with supporting documents
Proof of the claim event with supporting documents (e.g., original death certificate in case of death
claim / hospital reports in case of critical illness claim etc)
Original policy document
Proof of age of the insured, if this has not been previously admitted by the company
Step 2: Receipt of Claims by the Company
The claimant would contact the insurance company’s claims department with the completed form. The
company would acknowledge receipt of the claim form.
If the claim cannot be settled quickly, the insurance company would provide an indicative time to the
claimant.
If it appears that the claim is not covered by the insurance policy, the company sends a notification as
soon as possible to the claimant, explaining why it is not covered.
Step 3: Claim Files and Procedures
The company creates a claim file with the indicative information.
Claim filing number
Policy number
Name of the policyholder / claimant / beneficiary
Summary sheet showing developments / review of the claim
Type of insurance concerned
Opening date of the file
Date of loss
Preparing date
Description of the claim
Information of a claimant
Assessment date
Electronic and/or paper copy of the adjustors and investigators
Identify the adjuster
Estimated cost of damage
Dates and amounts of payments
Date of denial, if applicable
Name of intermediary, if applicable

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Date of file closure
Documents regarding contracts with the policyholder / claimant / beneficiary
Step 4: Claims Assessment
The insurance company assesses the damage and communicates the same through a written estimate.
The insurer sends a copy of the document used to set the amount of compensation to the claimant.
When a final payment or offer of settlement is made, the company explains the following to claimant:
Purpose of payment/ settlement
Basis used for payment/ settlement
The insurance company states explicitly to the claimant the reasons for:
Denial of claim
Offering an amount different from the amount claimed
Step 5: Complaints and Dispute Settlement
When the claimant files a complaint in case of a disagreement on settlement amount or non-fulfillment of
the claim by the insurer:
If the claimant is dissatisfied with the final response that he/ she has been sent by the company, he/ she
can activate an internal appeals process.
The claimant can also appeal to the dispute settlement procedures available outside the company (for
example, the handling of complaints by the supervisory authorities). In case of a dispute, the claimant
should be informed by the company of the existence of these appeal procedures. In some instances, a
claims dispute can result in litigation and is then settled in civil courts.
Reinsurance
Reinsurance is the means by which an insurance company (called the reinsured, ceding company or
cedant) shares the risk of loss with another insurance company (called the reinsurer). The reinsurer is not
directly involved in issuing insurance policies but only assumes a portion of the risk of many insurers.
There are many reasons an insurance company will choose to buy reinsurance. Some of these include:
Risk transfer: The main use of reinsurance is to allow the ceding company to assume risks greater
than its size would otherwise allow, and to protect itself against catastrophic losses. For instance, if
an insurance company can write policies with a maximum coverage of only Rs. 10 million, it can
reinsure (or cede) the amount in excess of Rs. 10 million to reinsurers.
Reinsurance is also particularly useful for an insurance company to protect itself against large catastrophic
losses, such as those arising out of hurricanes or other natural calamities or even terrorist activities.
Income smoothing: Reinsurance can help to make an insurance company’s results more predictable
by absorbing extraordinary losses.
Arbitrage: An insurance company may purchase reinsurance coverage at a rate lower than what it
believes is the true cost for the underlying risk. This is possible in a soft pricing scenario, when both
insurance and reinsurance pricing are relatively low.

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There are two types of reinsurance:
Proportional
Under proportional reinsurance, the reinsurer assumes a stated percent share of each policy the insurer
writes and then shares in the premiums and losses in that same proportion. Premiums and losses are
shared on a pro rata basis
For instance, an insurance company might purchase a 50% proportional reinsurance; in this case they
would share half of all premiums and losses with the reinsurer.
The reinsurance company usually pays a commission on the premiums back to the insurer in order to
compensate them for costs incurred in sourcing and administering the business (usually 20-30%). This
is known as the ceding commission.
Non-proportional (excess of loss)
Non-proportional reinsurance, also known as excess of loss reinsurance, comes into force if the loss
suffered by the insurer exceeds a certain amount, called the retention amount.
An example of this form of reinsurance is where the insurer is prepared to accept a loss of Rs. 10 lakhs
for any loss which may occur and purchases a layer of reinsurance of Rs. 40 lakhs in excess of Rs. 10
lakhs. If a loss of Rs. 30 lakhs occurs, the insurer pays the Rs. 30 lakhs to the insured, and then
recovers Rs. 20 lakhs from its reinsurer.
However, if a loss of Rs. 60 lakhs occurs, the insurer pays the same amount to the insured and then
recovers Rs. 40 lakhs from the reinsurer (the maximum amount reinsured). The insurer can further
protect itself against losses above Rs. 50 lakhs by purchasing a second layer of reinsurance for losses
above that amount.
Reinsurance treaties can either be written on a “continuous” or “term” basis. A “continuous” contract
continues indefinitely, but generally has a “notice” period whereby either party can give its intent to
cancel or amend the treaty.
A “term” agreement has a built-in expiration date. It is common for insurers and reinsurers to have long
term relationships that span many years.
Reinsurance companies themselves also purchase reinsurance and this is known as a retrocession.
They purchase this reinsurance from other reinsurance companies, who are then known as
“retrocessionaires.” The reinsurance company that purchases the reinsurance is known as the “retrocedent.”
Investments
Insurers derive revenues from two main sources: premiums and investment income. Insurers collect
payments in the form of premiums from people who face similar risks. Earned premiums are typically an
insurer’s primary revenue source. At the time of issue of a policy, it is recorded on the insurer’s books as
a “written” premium. Then, over the life of the policy, the premium is “earned,” or recognized as revenue.
A part of the earned premiums are set aside to cover policyholder claims and are transferred to a loss reserve.
The second-largest component of insurer revenues is investment income. This is derived from investing the
funds set aside for loss reserves and from policyholders’ surplus or shareholders’ equity. An insurance
company invests this corpus in a number of investment vehicles such as equity, debt, corporate bonds etc.

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These revenues need to provide for a variety of expenses:
Commission paid to the insurance broker, agent, or salesperson for selling a policy; this is usually
deducted immediately from the collected premium.
The largest expense facing a property-casualty insurer is losses, also referred to as policyholder
claims. Funds are also used to pay claims-related expenses, including insurance adjusters’ fees and
litigation expenses.
Insurers also face expenses related to the underwriting process, such as salaries for actuarial staff.
Like most other companies, insurers incur various other operating expenses and interest costs.
Broadly speaking,
Insurance company income = Underwriting Profit + Investment Income
The combined ratio is a measure of an insurance company’s overall underwriting profitability.
Loss Ratio = Losses due to policyholder claims
Expense Ratio = Salaries of actuarial staff and other underwriting expenses
Example:
Let’s assume the following details for an insurance company
Losses due to policyholder claims = Rs. 1 crore
Expenses = Rs. 50 Lakhs
Net premium written = Rs. 1.5 crore
Combined ratio = (1 + 0.5) / 1.5 * 100 = 100%
Underwriting Profits x Losses
Thus, if an insurance company’s combined ratio is less than 100%, it makes an underwriting profit. If its
combined ratio is more than 100%, the company makes an underwriting loss.
Very few insurance companies globally are able to make significant underwriting profits and many make
losses in their underwriting business. Also, with the impending de-tariffing of non-life insurance business
in India, competition will intensify and premium rates may see a dip, making it difficult to maintain
profitability of the underwriting business.
Therefore, investment income is a key driver of profitability for most insurers. The company can make a
profit irrespective of underwriting losses, if its investment income is higher. Investment decisions at an
insurance company are made very prudently, with significant investments in risk-free government bonds
or other low risk-low return investments. Investments often have to be made within the limits set by the
regulatory authority for various vehicles.

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Chapter Review

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Chapter 19

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Growing your Net Worth
Are you lucky?
L
et me draw out an important and a relevant scenario for you. Read on as we discuss an important
issue. Most of us who have bought a house, should consider ourselves lucky. Why?
The double whammy of rising real estate prices and increasing interest rates is threatening to put homes
out of reach of most first time buyers. Here’s the worrying statistic, brought out by HDFC- in 2004, the
average home owner could buy a house at a price that was equal to 4.4 years of his annual income.
Today that figure has been pushed to 5.1 times, meaning that he will need more than five year’s income
to buy the same house despite an increase in his own income during the intervening period.
EMIs
Even worse, the equated monthly installment (EMI) that he’s required to pay has shot up from 42% of the
monthly income to more than 67%. More than the rising prices, it is the hike in EMI’s that could end up
making homes unaffordable. In 1995, almost 35% of the home loan applicants to HDFC had an annual
income of around Rs. 1.2 Lakhs. Since most of the people who came from that bracket, that’s the figure
that was assumed to be the homebuyer’s income. Coming to the 2000s, the average salary increase
from 1995 to 2007 amounted to 13.2% annually based on data across a cross section of industries.
Infact the year 2004, was the best year to buy a house, since the price to income multiple touched a
lowest of 4.4 and EMI as a percentage of the income, touched a record low of 42%.
Then the tide began to change. Home prices rose faster than incomes and the interest rates have shot up
faster. The latter is worrying since the banks usually ensure that the EMIs does not exceed 40% of the
borrower’s monthly income. Under exceptional cases, it can go up to 50%.
In a scenario today, where the EMIs have gone up to 67% of the monthly income, the banks will simply
not loan enough money to make the purchase. To make the EMIs more reasonable, the prospective
buyer will have to pay more than 30% of the cost of the house on his own. But bankers also mention that
young people don’t have that kind of money saved up.
So we notice that the gap is widening.
Speaking of asset classes, real estate in terms of buying a home for occupancy is the single most
important agenda in a person’s lifetime. It is not for nothing that they say that buying a house and
marrying off a daughter well, are the two primemost concerns of a father. So plan ahead of time.
A house is only one asset class. There are many others. The wide range of investment options available
today also makes for a difficult, yet important investment decision. Terms like fixed deposits, bonds,
debentures, stocks, mutual funds etc, present a complicated puzzle, which a layman finds difficult to
understand. It is extremely difficult to identify a single investment that will perform well in a particular
year. Given this difficulty, investing in just one security—or one type of security— is risky. Therefore,
putting all your eggs (money) in just one basket (investment) may result in a large gain or a large loss.

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It is here that the importance of asset allocation really emerges. Simply put, asset allocation, as the
name suggests, involves determining the right balance or mix of your investments into various categories
called asset classes or vehicles. Asset allocation is probably the most important decision and may
account for more than 90 % of the return of the portfolio.
What are asset classes?
Broadly speaking, the main investment categories (also known as asset classes) are the following:
Stocks
These are one of the riskier asset classes and represent an ownership or equity position in a corporation.
A stockholder can lay claim to a proportionate share in the corporation’s assets and profits and is
often paid dividends when the company makes money. Stock share prices will rise as the corporation
grows and there is greater demand for its stocks.
The idea is to buy stock when the company is still small, hold onto it for a number of years while the
company grows and becomes financially stronger. Then, sell it for a profit once the stock price has
risen as a result of new demand.
Bonds
A bond is a debt instrument issued for a period of one year or more.
This is a more conservative investment.
Bonds raise capital for the issuer by borrowing money from investors. With a bond note, the issuer is
basically promising to repay the principal along with interest on a specified date, also known as the
maturity date.
The government, states, cities, corporations and many other types of institutions sell bonds.
Mutual Funds
This is managed by an investment company that invests money belonging to a large number of
shareholders in various assets.
The primary advantage to investing in a mutual fund is that you automatically achieve a diversified
portfolio that is managed by professionals whose advice and expertise you might not otherwise be
able to afford.
Cash Equivalents
Cash equivalents are safe, short-term, very liquid investments that are, as the name suggests,
equivalents to cash.
Cash equivalents are excellent savings vehicles for short-term goals.
Real Estate
This may be defined as land and anything permanently fixed to it, including buildings, sheds, and other
items attached to the structure.
Unlike other investments, real estate is dramatically affected by the condition of the immediate area
where the property is located. With the exception of a global recession, real estate is affected
primarily by local factors.
The downside is that more time to sustain this investment is required. The maintenance and
management of the property will fall on the owner’s shoulders.

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Commodities
In India, commodities as an asset class has delivered strong returns in the last two years with prices of
commodities across segments bullion, metals, agricultural products, crude, chemicals at multi-year highs.
Commodities generally outperform other asset classes in an expansionary phase and deliver extra-
ordinary returns within short periods.
Commodities exhibit low correlation to equity and fixed income instruments and, therefore, provide a
natural hedge to the portfolio. Commodities, thus, provide a balancing and sobering effect on the
portfolio.
The outlook for commodities is positive given that the uptrend in the demand for a wide range of
commodities, driven by the high industrial growth in China and India, is likely to continue after having
spoken of different asset classes.
Comparison between two different asset classes
Let us consider the trend to see how the returns from sensex have performed against the various metals,
leading to a discussion on the importance of broadening of one’s portfolio.
Consider the last one and half years. If you compare the rally between the period of 6th February, 2006
and 6th July, 2007, this period saw the benchmark sensex moving up from 10000 to 15000 mark. The
average return from an equity investment was around 50% while the return from the precious metals like
gold and silver was as little as 4.5% and close to 25% respectively.
Bright prospects of the overall Indian growth story, coupled with comfortable liquidity flow make the
equity markets soar, while a lull in the demand of precious metals has given investors lesser returns in
other asset classes. Besides the rupee’s appreciation has also spoiled the party for gold investors in the
bullion market. Investors in both the metals have not realized the gain due to the rupee’s rise. Large and
small traders are equally shying away from piling up the stock, fearing further losses in case the strong
rupee rally continues.
In the international market, the investment inflows into gold have slowed down in the last 6 months. This
leads one to understand that a person should always invest in different asset classes and broaden the
portfolio, so that not all the eggs are put in one basket.
An investment in the real estate market, on an average in the equivalent time period, though it is too
short to make a judgment call on real estate investment for less than 10 year periods, have shown a
return of 20%.
To conclude the equity market has given the largest returns.
Comparison of returns between the different sectors in one asset class - STOCKS
We move to the next step of details. We are now getting into the analysis of equity returns sector wise.
The reason for bringing this discussion here is that this kind of analysis will become common everyday
parlance for a financial planner. This is also the language of money channel-CNBC. It will become
ASSET(Sensex vs. heavy metals) 6 FEB’06 TODAY 6 JULY’07 RETURN %
Sensex 10000 15000 50
Gold 8208 8582 4.56
Silver 13721 17150 24.99
Aluminium 115.5 111.9 - 3.12

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important and relevant while making presentations and having discussions with the clients.The financial
planner will know how the returns can be mapped with the markets and it will be an enriching experience
for him to know more about the returns from different instruments available .Now we can analyze the
sectoral changes in the equity market in the last one year. You can also see how the % growth of return
from the individual sectors has slowed down in the past one year.
If you see the growth between early 2004 and mid-2006 was mainly because of re-rating of India as an
emerging market. This meant that there was a strong rally across all the sectors. Now the last one-year
has seen that the re-rating phenomenon has passed, and the growth is more specific to certain sectors.
Some of the sectors like the FMCG were undervalued at that time and thus returned 194% in this two-
year period. However, with the major correction in May-June’06, the sector has been lagging far behind.
IT, Oil and sun-rise sectors like media and telecom have performed better, while the rest have witnessed
poorer returns than the benchmark, and returned lesser than the May’06 levels.
Based on the above mentioned discussions, let us look at Neeraj’s example correlating it to the two
different tables shown above.
If Neeraj had invested in the metals sector in 2006 an amount of Rs. 50000, and stuck on to it, he would
be at a loss today, after 1.5 years, which comes to a negative of 13% on Rs. 50000 ie. Rs.6500. This is
called an aggressive approach to investing.
While if the same amount, Rs. 50000 had been invested in an fixed deposit, he would have earned an
interest of 12% cumulative, at 8% pa rate of return. Neeraj would have earned Rs.6000.This is a
conservative approach to investing
Ideally, if he had invested 50% of his total money, ie Rs. 25000 in Fixed Deposit (FDs) and the rest of the
25% into two different stocks in two different industries each, lets us see how his investment works out
for him.
Lets say, he had invested Rs. 12500 in technology stocks, and the other Rs. 12500 in metal stocks . The
overall portfolio of Rs 50000 would now be divided into 3 different investments. His FDs at 12% would
have given him, on Rs. 25000 ie. Rs. 3000. The 12500 in Aluminium based metal company would have
yielded of negative of 13%, which is a loss of Rs. 1625. The rest of the investment of Rs. 12500 in an IT
company would have yielded him at profit of 50%, ie 6250. So his overall income would have been Rs.
7625. This is definitely a better return than both a profit of Rs. 6000, or a loss of 6500.
SECTORS MAY’06-APRIL’07 (%) AUG’04-MAY’06 (%)
TECH 49.56 187.33
INFOTECH 26.66 162.69
OIL AND GAS 19.05 121.34
SENSEX 12.05 150.56
CAPITAL GOODS 9.46 304.96
HEALTHCARE -1.19 94.11
METALS -12.91 207.05
AUTO -13.96 208.04
FMCG -17.88 194.37

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As a general rule, asset classes, give different rates of return over different periods of time. To run
through the troughs and the peaks, we can use a conservative yet a smart approach methodology called
asset allocation, as Neeraj finally understood the hard way.
What is the basic idea behind asset allocation?
The main idea behind asset allocation is that you can balance risk and return in your portfolio by spreading
your investment amount among different types of assets, such as stocks, bonds, and cash equivalents.
This is how it works:
Different types of assets carry different levels of risk and potential for return, and typically don’t
respond to market forces in the same way at the same time.
When the return of one asset type is declining, the return of another may be growing (though there
are no guarantees).
If you diversify by owning a variety of assets, a downturn in a single holding won’t necessarily spell
disaster for your entire portfolio.
Asset Allocation means Diversification of Risk
In the 1950s, Nobel Laureate Harry Markowitz revolutionized the financial markets by showing that
owning a diversified portfolio of stocks could lead to higher returns with less risk than owning any individual
stock. Since then, it has been a commonly accepted fact that Asset allocation is a way to control risk in
your portfolio. The risk is controlled because different asset classes in a well-balanced portfolio will react
differently to changes in market conditions such as inflation, rising or falling interest rates, market
sectors coming into or falling out of favor, a recession, etc. The following are the benefits diversification
of risk or asset allocation:
Diversification across asset classes balances investments with higher levels of safety with those
that have higher levels of growth.
Spreading a portfolio’s investment risk across several types of investments can help smooth out the
ups and downs of investing.
There are different asset classes like equities, bonds, real estate, cash and even foreign investments (to
a limited extent) available to Resident Indian investors now. It has been a well established fact that
Asset allocation has been primarily responsible for portfolio performance more than even stock selection
and timing issues. Asset allocation is the key to portfolio returns and hence, it is of paramount importance.
An asset allocation decision involves deciding the percentage of investable funds to be placed in stocks,
bonds and cash equivalents. It is the most important investment decision made by investors because it
is the basic determinant of the return and risk taken. This is a result of holding a well-diversified portfolio,
which we know is the primary lesson of portfolio management.
Thus, asset allocation serves the purpose of diversification among different asset classes and
diversification among different securities within an asset class.
The returns of a well-diversified portfolio within a given asset class are highly correlated with the returns
of the asset class itself. In other words, the returns on a stock portfolio will depend on the market returns
to a great extent. No stock is expected to give phenomenal returns when the market returns are low or
negative. Within an asset class, diversified portfolios will tend to produce similar returns over time.
However, different asset classes are likely to produce results that are quite dissimilar. Therefore, differences
in asset allocation will be the key factor, over time, causing differences in portfolio performance.

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Factors to consider in making the asset allocation decision include the investor’s return requirements
(current income versus future income), the investor’s risk tolerance, and the time horizon. This is done in
conjunction with the investment manager’s expectations about the capital markets and about individual
assets.
According to some analysis, asset allocation is closely related to the age of an investor. This involves
the so-called life-cycle theory of asset allocation. This makes intuitive sense because the needs and
financial positions of workers in their 50s should differ, on average, from those who are starting out in
their 20s. According to the life-cycle theory, for example, as individuals approach retirement, they become
more risk averse and hence, they should allocate fewer amounts in percentage terms to equity and
equity related instruments in their portfolio.
Asset Class Risk
Risk in the context of investments has different meanings for different people. To the common investor,
risk means the probability that he may lose his capital or suffer loss on the investment. To the analyst,
it is the chance that the investment vehicle may not deliver the required or expected returns and thus not
fulfill the financial goals. It is also well established through research over long periods that equity as an
asset class, international as well as domestic, is the most volatile of asset classes. In equities, the
range of returns as well as the potential for capital loss is the greatest, especially in the short term.
While equity may be riskier asset class, it also has the potential to earn superior returns over long term.
It is also well established that over the long term equities, foreign as well as domestic, have delivered
returns much higher than other classes of financial assets. Hence, equities will find a place in every
body’s portfolio but the extent could vary depending on the risk profile, age, need for higher returns, time
frame, etc.
It is important to note that asset allocation should not be confused with simple diversification. Remember,
the more narrowly focused your investments, the less diversified you are. And that can leave your
portfolio more vulnerable to sudden swings in value and increase your risk for significant losses. Here is
an example to illustrate the difference:
Example
Suppose Mr Sharma diversifies risk by owning 10 or even 50 different stocks. He really hasn’t done
anything to control risk in his portfolio if those stocks all come from only one or two different industries
in the same sector. Those stocks will often react to market conditions in a similar way—they will generally
all either go up or down after a given market event. This means buying 12 internet or tech stocks will not
give Mr. Sharma optimal diversification; instead he needs to buy stocks of different sizes and from
various sectors.
Approaches to Asset Allocation
Establishing an appropriate asset mix is a dynamic process, and it plays a key role in determining your
portfolio’s risk and return. As such, your portfolio’s asset mix should reflect your goals at any point in
time. There are a few different strategies of establishing asset allocation and here we outline some of
them and examine their basic management approaches.
Strategic Asset Allocation
Strategic asset allocation refers to the long term or benchmark asset allocation to each asset class in an
investment portfolio. This involves setting a long-term investment policy, establishing weightings for

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various asset classes, and making few changes over the short run unless there is a specific change in
the investor’s objectives. The following are its benefits:
Tactical Asset Allocation
Tactical asset allocation can be described as a moderately active strategy, since the overall strategic
asset mix his flexibility to switch over to short-term oppotunities when desired profits are expected. Over
the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, you may find it
necessary to occasionally engage in short-term, tactical deviations from the mix in order to capitalize on
unusual or exceptional investment opportunities.
This flexibility adds a component of market timing to the portfolio, allowing you to participate in
economic conditions that are more favorable for one asset class than for others.
This strategy demands some discipline, as you must first be able to recognize when short-term
opportunities have run their course, and then rebalance the portfolio to the long-term asset position.
What factors have to be kept in mind during asset allocation?
There are all sorts of investment recommendations continually flowing from the financial press. The key
question is: Are they suitable for you? It’s important to be informed about asset allocation so as to avoid
the “one size fits all” approach that many investors end up accepting. Asset allocation is the cornerstone
of good investing. Each investment must be part of an overall asset allocation plan. And this plan must
not be generic (one-size-fits-all), but rather must be tailored to your specific needs.
Regardless of the approach you take, be sure that an asset allocation takes into account your financial
profile to the extent feasible. Asset allocation can be an active process in varying degrees or strictly
passive in nature. Whether an investor chooses a precise asset allocation strategy or a combination of
different strategies depends on that investor’s goals, age, investment time-frame and risk tolerance.
Investors should keep these considerations in mind:
Investors should arrive upon the most suitable Asset Allocation Plan.
Investors should not focus exclusively on “market value”.
Investors should not dwell upon comparisons of one’s own unique portfolio with Market Averages.
Investors should not expect “performance” during specific time intervals as this investment plan is
expected to perform over a long period of time.
1. Investor’s goals
To help you determine the mix of investment options that may be appropriate for your investment goals,
ask yourself the following questions:
What are my investment goals?
How much time do I have to reach these goals?
How much can I afford to invest regularly?
How much do my assets need to grow to reach my goals?
How much investment risk am I willing to take to reach my goals?
Diversification is essential for successful investors who have multiple goals with different time horizons.
For example, a 30-year-old unmarried investor is likely to need a different investment mix than a 50-year-
old with two children heading off to college in the next few years. If you are retired, protecting your
principal becomes increasingly important as opposed to growing your investments.

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Sample Aggressive Asset Allocation
An aggressive asset allocation is most suitable for investors with a long-term investment horizon (for
example, 10 years or longer), who tolerate risk well, and whose primary goal is growing their investments.
Sample Moderate Asset Allocation
A moderate asset allocation is most suitable for investors with a medium-term investment horizon (for
example, 10 years or longer), who tolerate risk moderately well, and whose primary investment goal is a
moderate level of growth.

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Sample Conservative Asset Allocation
A conservative asset allocation is most suitable for investors with a short-term investment horizon (for
example, less than 10 years), whose risk tolerance is low, and whose primary investment goals are
generating income and protecting against inflation.
2. Age
Why does age play a crucial role in portfolio building?
Risk appetite reduces with increasing age and responsibilities.
As you grow older, your income levels keep moving northwards but your savings keep moving
southwards. This is because your needs and expenses keep rising along with inflation.
Asset allocation till the age of 40
During the early part of your career (till the age of 40 years), the primary objective of an individual is to
invest in basic necessities for living like mobile phone, car, flat, and the list goes on. Your investments
are restricted to statutory investments most of the times to save tax. Investments into provident fund,
insurance policies and deposits are standard investments in this age group. Investment into equities and
equity mutual funds gradually catch-up. Ideally investments into equities with long-term investment
horizon help in giving a fillip to portfolio return.
Asset allocation from 40 years-50 years
After 40 years of age, capital appreciation remains an important objective for individuals. Therefore, a
more conservative asset allocation with higher tilt towards fixed-income bonds and postal schemes start
happening. Exposure to equities creates balance and help in increasing portfolio returns.
Asset allocation after the age of 50
After 50 years of age, close to retirement, one will probably be more concerned with a steady income at
low risk. Increasingly, at this age, a sizable component of savings is used up for children’s marriage and
in educating them. After retirement, the focus is on a steady income to meet day-to-day needs. With a
limited medical cover at this age and no forthcoming regular income, the investments made in the span

134. 140 Financial Planning Handbook PDP
of 40-50 years of age starts bearing fruit. Equity exposure remains minimal and at times more for balancing
the inflationary pressure.
3. Investment Timeframe
Your Investment Timeframe is how long you will be invested until you need to start pulling money out of
your investment portfolio. The longer you have, the more risk an investor can afford to take. A person
who needs access to his investment funds in 5 years will have a much different looking portfolio than a
person who is going to retire in 35 years.
4. Risk Tolerance
This can be defined as your comfort with the potential for investment loss in exchange for a potentially
greater return. Recent market volatility has made it more important than ever to consider the relationship
between risk and return when investing. Risk tolerance is a measure of your willingness to accept
investment risk in exchange for higher potential returns. Risk is the uncertainty of earning your investment
returns and is measured by the volatility of investment.
When you invest, the weight you give to each of these two desires is commonly known as your risk
tolerance. Knowing your risk tolerance will help you identify your investment profile and decide how to
allocate your assets.
For example, if you’re an aggressive investor, you’re likely willing to accept the risk of losing some of
your investment capital (that means a negative rate of return) in exchange for earning higher potential
returns. A conservative on the other hand, is less willing to accept risk, even for higher potential returns.
Capital is a top priority for conservative investors. As a result, they tend to favor conservative investments
such as certificate of deposit, money market accounts and government bonds.
Your risk tolerance depends on many things, including:
Your goals and time frames. You most likely have several goals—such as your children’s education,
a vacation home or an early retirement. You may be willing to take more risk with some goals than
with others, depending on your time horizon for each goal.
Personality. Some people are simply more predisposed to take lesser or greater risk.
Income and asset base. The larger your income and asset base, the more risk you may be willing to
take, again depending on your time frame. Some investors with a large asset base, however, may
choose a more conservative approach, knowing they don’t need to take on additional risk to meet
their goals.
Portfolio Rebalancing
Once an asset allocation plan is finalized, then securities are chosen for investments and the investment
process is completed. Thereafter, the portfolio of investments comprising of debt, equity, etc. should be
monitored on a periodic basis. The frequency of review could be once in six months or even once a year.
A higher frequency is generally not necessary for a long term investment plan but sometimes, some
economic developments may necessitate an urgent review.
One of the most important factors that will have a big influence of the performance of the portfolio is the
interest rate (which generally moves with inflation). Whenever large scale and protracted interest rate
movements are expected, then a rebalancing will become absolutely essential. In a rising interest rate
scenario, corporate profitabilites will suffer and consequently, stock prices will fall. Bond prices dip to
adjust to the current yields of the market. Reducing equity exposure of the portfolio may become necessary

135. 141Financial Planning HandbookPDP
and moving from long-term debt swiftly into short term or from fixed rate long-term debt funds to floating
rate and short term debts could also become necessary. If economic slow down is seen through falling
growth rates, then portfolio rebalancing will become necessary again. These economic factors are
external factors that will have to be taken into account as their long- term impact on the portfolios will be
severe and hence suitable rebalancing will have to be done. It should simultaneously be remembered
that these are turn around situations and these happen over long term.
There can be some internal family developments also that may make portfolio rebalancing necessary. A
portfolio is built to meet certain financial objectives; not all objectives are met at the same time. One
after the other the financial goals get completed, over a period of time, as the investor gets older and
older. Some of the common objectives are buying a bigger home, buying a new car, education of
children, marriage of children, retirement capital etc. As these objectives are fulfilled, the return requirements
may come down and it may be necessary to switch to less aggressive asset allocation plan – reducing
the exposure to equities and increasing the exposure to debt may be made.
It is an established fact that a rebalancing strategy cannot increase expected return but on the contrary,
rebalancing costs definitely reduce expected returns.
The best rule of thumb of rebalancing is to look at the overall stock/bond ratio quarterly, since it is the
primary determinant of expected returns, and examine individual equity asset classes once a year or
so. Rebalance only when asset classes, and particularly, the equity/fixed ratio, gets out of balance far
enough to produce a significant expected difference in returns.
A portfolio revision may become necessary because of government policy changes, economic factors of
growth rate, budget and fiscal deficits, inflation and interest rates, strength of domestic currency, etc.
While implementing the investment plan, certain securities were bought based on their and the overall
economic fundamentals. These factors may change over time; fortunes of companies also fluctuate,
generally in line with the overall economy but some times on their own as well. For example, a strong
domestic currency may not be good for export oriented companies but will benefit import dependant
companies. A lower interest rate on loans may not be good news for banks and financial institutions but
good news for consumer durables, automobiles and housing sector as the same spurs demand. While a
“Buy and Hold” strategy is fine, it makes sense to observe crucial economic factors that may specifically
affect some of the securities held and it would be prudent at time to switch out of these securities and
move into others.
To conclude, asset allocation is a fundamental investing principle because it helps investors maximize
profits while minimizing risk. The different asset allocation strategies described earlier can help any
investor do this regardless of his risk tolerance and investment goals. In turn, choosing an appropriate
asset allocation strategy and conducting periodic reviews will ensure you maintain your long-term
investment goals and reach your desired return at the lowest amount of risk possible. The best way to
acquire and accumulate wealth is to develop a strategy, and stick with it. Review your holdings every
year, and make adjustments to keep the percentages where you want them to be.

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Chapter Review

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Chapter 20

138. 144 Financial Planning Handbook PDP
What is Investment?
I
nvestment refers to a commitment of funds to one or more assets that will be held over some future
time period. It is important to understand the difference between savings and investments. Anything
not consumed today and saved for future use can be considered as savings. Almost all of us save money. In
fact, we are a nation of savers where the domestic savings is a high percentage of Gross Domestic Product
– sometimes as high as 26-27%. It is important to channel these savings into productive investment avenues.
Almost all individuals have wealth of some kind, ranging from the value of their services in the workplace to
tangible assets to monetary assets. For our purposes, investment will mean a measurable asset retained in
order to increase one’s personal wealth. A financial asset is one that generates income and contributes to
accumulation and growth of wealth over a period of time. The two elements in investments are generation of
income on a periodic basis and/or growth in value over a period of time.
Investment Scenario in India
A pick-up in investment, reflecting the high business optimism, not only strengthened industrial performance
but also reinforced the growth outlook itself. The rally in Gross Domestic Capital formation (GDCF) that
had commenced in 2002-03 continued and as a proportion of GDP, it reached a high of 30.1 per cent in
2004-05. Stock market index returns of 11 per cent in 2004 followed by 36 per cent in 2005 provide a
good measure of investor sentiments. There have been ups and down in the cycle, however, the movement
and growth has been positive.
The increasing trend in gross domestic savings, which provided most of the resources for investment, as
a proportion of GDP observed since 2001-02 continued with the savings ratio rising from 26.5 per cent in
2002-03 to 28.9 per cent in 2003-04 and further to 29.1 per cent in 2004-05.
India, a nation of savers
India is a nation of savers and the domestic savings is a very high percentage of GDP. It is shocking to note
that more than 45% of domestic savings is invested in bank deposits and only about 2/3% in equity and
equity related investments. This clearly shows that while as a nation we are very good savers, we are very
poor investors because it is equally important for the savers to invest in avenues that fetch decent returns
after considering factors like inflation, taxation, etc. Bank deposits not only offer lower returns but they are
hardly tax efficient and thus do not serve the cause of earning high post tax and net of inflation returns. In
developed countries, the proportion of savings being diverted to equity and equity related instruments is in the
region of 20-25% of GDP while around 20% of savings are parked in bank deposits.
A Financial Planner
Some investors have failed to recognize that the less obvious, but potentially more damaging, is the risk
of diminished income staying completely invested in low yielding fixed income securities or bank
deposits.The financial planner should ensure that investors take a hard look at the fixed income components
of their portfolios and rethink this strategy in the context of a more comprehensive, long-term objective,
understanding where the clients come from, the priorities in their life and the challenges they face in a
Fundamentals of Investment Planning

139. 145Financial Planning HandbookPDP
rapidly changing investment horizon. Succeeding in career, planning children’s education, marriages,
and having more than enough for an enjoyable retirement are some of the objectives most people aim at.
The financial planner in India, hence, has a very important role to play. The planner’s job in India is more
challenging because of the Indian mind set and the aversion to risk. It will be part of his job to educate his
clients on concepts of risks and returns and their relationship.
Investment Fundamentals
Some of the fundamental rules of investments are:
Start Early
Invest Regularly
Ensure Higher Returns on Your Investments
Let us study the effects of good investing principals through two examples.
1. Prem started investing money to the tune of Rs. 6000 pm diligently. He began this discipline at the age
of 21 years of age. He was earning a rate of interest of 12% compounded each year. While his friend,
Poonam started investing money to the tune of Rs. 10000 pm. She was also doing this very religiously.
She also earned 12% compounded. She started the process of doing the investments month on month,
after the age of 30. What are the total sums adding up to at the age of 50 years of age?
2. A second example of starting early to fulfill your dreams is shown below.
According to the College Board, college costs for the 2006–2007 school year are roughly Rs145,000
for four years at a private school and Rs.71,000 at a public school.
Two couples need to save Rs.150,000 for college expenses, but begin investing at different times.
Priti and Subodh begin investing the year their daughter is born, making monthly investments of
Rs.311 to reach their goal. Nirvan and Juhi start investing when their son is eight years old, making
monthly investment of Rs.815 to reach their goal.
Assume an 8% return per year compounded monthly and that the child enters college at age 18. This
example does not represent any specific investment
As you can see from the table the cost of waiting for Nirvan and Juhi it’s Rs.30,624. Priti and Subodh
benefited from eight more years of compounded growth than Nirvan and Juhi, which means Priti and
Subodh put in less money to reach their goal.

140. 146 Financial Planning Handbook PDP
Chapter Review