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This is the first step in risk management and also the first step in building a sound financial plan for any individual. Once a person’s risks are covered, he can safely plan for his goals. If risks are not covered and he plans for his goals of life right away, then all of his savings accumulated to meet the goals will get wiped out if any untoward incident occurs.
What is contingency planning? How to go about it?
Contingency planning can well be termed as saving for a rainy day. It is planning for any emergency that might be lurking round the corner. A contingency fund or emergency fund has to be prepared to meet any emergency. Predicting how much would be enough for such situations is always difficult.
How to calculate a contingency plan?
Each one of us prepares a monthly budget wherein we list the items and the expenses against them. From the list of expenses, a person needs to distinguish them as mandatory expenses and voluntary expenses. Mandatory expenses are those that are supposed to be met ‘come what may’. EMIs, insurance premium, grocery and utility bills, etc fall under this category. Voluntary expenses are those which can be avoided during bad times. Going on a vacation, eating out or going for movies fall in this category.
Begin by preparing a cash flow statement. List all the mandatory expenses. Break down mandatory expenses further into fixed mandatory expenses like loan EMIs, insurance premium, rent, etc and variable mandatory expenses like grocery expenses, transportation expenses, electricity bills, phone bills, etc. These are expenses which vary from month to month.
From the exemplary table, the yearly expenditure comes to Rs 3,53,072. Hence, the monthly expenditure equals Rs 29,423. The contingency or emergency fund should consist of amount equal to three months of a person’s mandatory expenses. Hence the amount a person needs to keep aside is Rs 88,269 (Rs 29,423*3).
Why consider three months?
Research has shown that generally three months are enough for an individual to come out of any catastrophe. If a person is retired then he needs to keep aside at least six months of mandatory expenses. So the above figure will come to Rs 1,76,538 (Rs 29,423*6). This amount definitely seems difficult to keep as contingency. This fund can be raised slowly. The fund should be bifurcated in the following manner: Cash In Hand: The amount to be set aside in cash is called as cash in hand. From the above example, the person should keep aside Rs 15,000 as cash in hand. Savings Account: A part of the fund should be kept in a savings account and should be easily accessible through an ATM. From the above example, Rs 20,000 should be
available in a person’s savings account at all time. Liquid Fund/ Bank Fixed Deposit: The balance amount in this case which is Rs 53,269 can either be invested in liquid funds or in a bank fixed deposit. Since a person can also earn returns, it will be safe and easily redeemable. If saving this amount seems difficult, begin by keeping aside small amounts every month. The above amount is for an emergency and not for daily needs. As and when one withdraws the amount from this fund, he must remember to replenish the fund.
Once the first step of contingency planning is covered, move on to the second step - insurance planning. It is the second step of a sound financial plan and risk management. Insurance is planning for any untoward incidents in an individual’s life. Remember to have a life insurance cover for the earning member of the family and a health insurance cover for every member of the family. Once the above two are in place, the risk is covered. A person cannot predict when a crisis might strike but he can at least prepare himself for such unforeseen events.
Thanks to Nirmal Bang Beyond the Market