Income replacement need
Also written Income replacement needs · Replacement of income need
The insurance need that arises from a risk to the earning ability of an asset, including a person and their life, met by life, critical illness, accidental disability and annuity products.
In plain language
The workbook sorts every insurance need into three boxes. This is the first, and the one that comes first in practice too.
An income replacement need arises when the thing that earns the money is at risk. Usually that thing is a person. Death ends the earning. A critical illness or a disabling accident can end it just as completely.
Note the wording the workbook uses. The risk is to the earning ability of an asset, and a person's life is one such asset. A plant or a machine is another.
The products in this box all pay money to stand in for earnings that will not now arrive. Life insurance is the obvious one. So are critical illness insurance, personal accident insurance for disability, and an annuity.
The other two boxes answer different questions. An income protection need is about a bill. An asset protection need is about a thing you own.
How it works
What the category covers. Section 1.7.1(a) lists the products the workbook puts in this box: life insurance, critical illness, accidental disability insurance, cover for the maintenance and replacement of plant and machinery, and annuities. The common feature is a lost or reduced ability to generate income, not a lost object.
Which need comes first depends on the life stage. The workbook is explicit that a young individual with no dependents may need a personal accident disability policy or a critical illness policy more than a life policy, because a life policy replaces income for dependents who do not exist yet. For an individual with dependents, income replacement through a life policy is the primary need.
How long the cover should run — and this is where the figures are. The workbook states the rule and then prices it. An income replacement policy is needed during the earning phase and not after retirement, because there is no income left to replace. Its own quotation, for a person aged 30:
| Cover to age | Term | Annual premium |
|---|---|---|
| 60 | 30 years | Rs 13,800 |
| 70 | 40 years | Rs 16,200 |
The extra ten years of optionality costs Rs 2,400 a year, about 17% more premium. The workbook does not say to buy it. It says the person may find it worthwhile to pay that price for the option to keep renewing past 60.
How much cover. Section 1.7.1(b) sets the boundaries rather than a number: allow for the future value of the costs being replaced, the period protection is needed for, and the ability to bear the premium. Under-insurance means the beneficiary is silently retaining part of the risk. Over-insurance means paying premium for nothing. The actual sizing calculation is the human life value method in Chapter 2.
A worked example
Mr Rathod is 30, married with a one-year-old daughter, and earns Rs 12,00,000 a year. His adviser works through the category before touching a product.
Step 1 — name the need. Two dependents rely on his earning ability. The primary need is income replacement, so a term life policy leads.
Step 2 — pick the tenure. He plans to retire at 60. Using the workbook's own quotation, cover to 60 costs Rs 13,800 a year and cover to 70 costs Rs 16,200 a year.
| Choice | Annual premium | Total over 30 years | What the extra buys |
|---|---|---|---|
| Term to age 60 | Rs 13,800 | Rs 4,14,000 | Cover for every earning year |
| Term to age 70 | Rs 16,200 | Rs 4,86,000 | The option to renew past 60 |
The difference is Rs 2,400 a year, or Rs 72,000 over the 30 years. Strictly, the income replacement need ends at 60, so the cheaper policy answers it in full.
Step 3 — do not stop at the life policy. His earning ability can also be destroyed without him dying. A permanent total disability at 40 would leave twenty earning years unreplaced and a dependent adult to support. That is the same income replacement need, and it calls for accidental disability and critical illness cover sized the same way.
Step 4 — review it. The workbook says cover may even be reduced over time as goals are met. By 55, with the daughter's education funded and the loan repaid, Rs 1.5 crore of cover may be more than the remaining need.
Why NISM asks about it
Chapter 1 (Basics of Insurance), section 1.7.1(a), names the three insurance-need categories and lists this one's products; section 1.7.1(b) gives the tenure rule and the Rs 13,800 against Rs 16,200 term-premium comparison, plus the under-insurance and over-insurance warnings.
Expect a category-matching question (which of these is an income replacement need) and a reasoning question on why an income replacement policy is not needed after retirement. The young-with-no-dependents case is a favourite: the workbook's answer is disability or critical illness cover ahead of life cover.
Common exam traps
- Income replacement is about lost earning ability; income protection is about an unexpected bill. Life, critical illness and disability cover sit in the first box. Health and motor insurance sit in the second.
- A young earner with no dependents may not need a large life cover at all. The workbook says a disability or critical illness policy may matter more, because there is nobody whose income has to be replaced on death.
- The policy is needed during the earning phase, not after retirement. Paying for income replacement cover past the earning years buys an option, not a need — and the workbook prices that option at Rs 2,400 a year on its own example.
- Under-insurance is risk retention in disguise. The beneficiary, not the insurer, carries the uncovered slice.
- Annuities are in this box. Candidates expect only protection products here and miss the annuity, which replaces employment income after it stops.
- The category is not the calculation. Naming the need is section 1.7.1; sizing it is the human life value or needs-based computation in Chapter 2.
Check yourself
1.The workbook classifies insurance needs into three broad categories. Under which category does it place health insurance and motor insurance?
- a)Income replacement needs, because they replace the earning ability of an asset
- b)Asset protection needs, because they protect assets from theft or destruction
- c)Income protection needs, because they take over large, unplanned expenses and so protect the available income from an unexpected charge
- d)Risk retention needs, because the insured bears a deductible on every claim
Show the answer
Answer: (c) Income protection needs, because they take over large, unplanned expenses and so protect the available income from an unexpected charge
The workbook: "Income protection needs protect the available income from an unexpected charge. Health insurance and motor insurance are examples of insurance products that will take over such expenses if they occur, and thereby protect the income from a large and unplanned outflow."
Option A is wrong — income replacement needs arise "in the event of risk to the earning ability of an asset, which includes the life of an individual as well as his earning ability". The workbook's examples are "Life insurance, critical illness and accidental disability insurance ... and annuities".
Option B is wrong — although a car is an asset, the workbook places motor insurance under income protection. Asset protection needs "include the need to protect assets created from theft or destruction. Household insurance is one such product."
Option D is wrong — risk retention is not a category of insurance need at all. It is the alternative to insurance: the consequences of a loss "can either be borne by the person to whom the benefits accrue (risk retention) or they can be transferred to another (risk transfer)."
Why this matters: "The type of insurance required depends upon the age and stage in the life of the individual. Insurance implies a cost and buying insurance that is not required is a wasteful use of income."
Where this is taught
Free preparation for NISM Series X-BRelated terms
- Asset protection needThe need to protect assets already built up from theft or destruction — the third of the workbook's three insurance needs, alongside income replacement and income protection.
- Critical illness insuranceA defined benefit policy that pays a lump sum when the insured is diagnosed with a specified disease such as cancer, heart attack or stroke and survives a minimum period — no payment on death.
- Human Life ValueThe present value of the income a person is expected to earn over their remaining working life that is available for dependents — the upper bound on how much life cover is justified.
- Income protection needThe insurance need that arises when a sudden, unplanned bill would otherwise be met out of income — the category the workbook fills with health insurance and motor insurance.
- Level premiumA term insurance premium that stays the same every year for the whole of the policy term, as distinct from one that increases as the insured gets older.
- Personal accident insuranceA policy paying a defined sum where the insured sustains bodily injury solely and directly from an accident caused by external, violent and visible means — covering three grades of disablement.
- Term insuranceLife cover for a fixed period: if you die during the term your nominee receives the sum assured, and if you survive it nothing is paid back. It is the cheapest way to buy protection.
- Life insuranceThe product family that covers loss of income: temporary loss from disability and permanent loss from death — the first of the three covers in a household insurance plan.
- Maintaining a foreign life policyA person who becomes resident in India need not buy fresh life cover here and may keep an existing overseas policy alive, paying the premiums from foreign income or remitting them from India.