A lot of people go through their entire life without even understanding what life insurance is all about. There may be several reasons for this. The most common being that they would not be informed by the right person of the facts. Even if a person has been likely approached by a person (say insurance agent), there is every chance that you may have got inadequate information so that you could be sold what that person wanted rather than what you may have needed.
Insurance is perhaps the only product where you create an asset against a possible risk. Life insurance is nothing but a provision for providing for the financial future of your family in such a way that your absence does little or no financial harm to your family. The very critical element here is the amount of cover. Your life insurance policy cover should be adequate to provide for your family in your absence. In this article, we will attempt to give you some quick methods to estimate the same and give you some understanding and perspectives on calculating this cover amount.
One cannot pinpoint the exact amount of life insurance one needs. But there are many methods of arriving at a sound estimate for your coverage requirement. Here are a few ideas to let you start thinking...
Universal Thumb Rule:
This is a very simple and straight forward method. Here we would simply use a multiple of say 10 times and consider the gross, pre-tax income of the person being insured. Assuming a gross income of Rs.15 lakhs yearly, the insurance need would come to be of Rs.1.5 cores or between a range of 1.2 crores to 1.8 crores. The reason we use this is that it normally gives us just enough amount to meet the regular household needs for the family. However, a lot depends on the financial situation of the family/person.
Income Replacement Method:
There is another small variation to the universal thumb rule. Here we would consider the number of active earning years remaining, instead of a random number, for the net, post-tax, monthly income instead of the gross income. For example, for a person aged 40, having an in-hand monthly income Rs.100,000 and a retirement age of 60, there would be 20 years of active service left. One can now simply multiply Rs.12 lakhs yearly x 20 times. This will give you a life insurance need of Rs.2.4 crores.
Of course, we can stop here but there are some key parameters ignored here, and we could adjust this figure further to make it more appropriate. One smart way to do that would be to consider the adjusted investment interest rate which is calculated as [ (1+ returns) / (1+ inflation) – 1). This factor will adjust your figure for returns earned on the insurance kitty investment and the inflation over time. The idea is to discount the above figure of 2.4 cores for 20 years with this factor. Assuming 8% returns, 6% inflation, Rs.2.4 crore divided by the adjusted investment interest rate of 1.89% for 20 years [(1+1.89%)^20] would give you a kitty of Rs.1.65 crores which sounds more reasonable.
Withdrawal Ratio Method:
Under this approach, it is assumed that the policy money will be invested and the income/withdrawals from this investment should be sufficient to finance your expenses over the foreseeable future. Note that in the previous method we will consider the entire net income and here we are only considering a part of it which goes towards financing household expenses.
Let us see this with an example. Your monthly expenses are said Rs.50,000 amounting to Rs.6,00,000 yearly. With a withdrawal rate of 4%, the corpus needed would be Rs.1.50 crores (Rs.6,00,000 divided by 4%). The 4% is borrowed from the very popular rule under which people use this 4% to calculate retirement kitty. This can be applied here also. To be on a safer side, the withdrawal rate of 3% would give us Rs.2 crores (Rs.6,00,000 divided by 3%).
The Human Life Value Method:
This is a more detailed method of calculating the life insurance need. Here we consider all important elements like the earning years remaining, the present net income, the estimated income rise, the present liabilities, and the major financial goals the person is expected to achieve during this lifetime. We present the method here not to tempt you to calculate but to at least help you understand the concept.
Step 1: Calculate the present value of net income: In this step, the present value of all future net cash flows is arrived at. To arrive at the net income, we will consider the adjusted investment interest rate as calculated above. One may consider a growing income here while calculating the figures.
Step 2: Add present values of all future life goals: In this step, the present value of all future goals like child education, purchase of a home, marriage for the girl child, etc., is considered. We need to arrive at this figure by dividing each goal amount with the adjusted investment interest rate for the years remaining.
Step 3: Add all the existing loans/liabilities (less) assets: To the above-calculated figure, we need to add all existing loans/liabilities. This would include all home/car loans, credit card bills, personal loans, etc. This figure will be reduced to the extent of any existing assets that you have so that the life insurance need is reduced to that extend.
The above three steps should give you a fairly accurate amount of life insurance needed.
WHAT TO BUY :
We would first urge you to never mix investment with insurance. There are two basic types of life insurance products sold in the market – traditional life insurance policies and the pure term policies. For obvious reasons, the pure term policies are not suggested by many insurance agents to their clients. The general understanding among experts is that the traditional life insurance policies, which promise some returns in addition to the return of premiums paid and life cover, offer sub-optimal returns while offering a low life cover. They are generally costly and in the event of a death, the amount of life cover is often grossly inadequate to meet family needs. The purpose of buying such a policy gets defeated on day one itself.
Pure term policies, on the other hand, are cheap and offer the maximum life cover possible. This matches perfectly to our objective of family well-being in our absence. One can simply ignore the fact that there would be no return of premium amount, just like you do when you pay for say a car insurance premium. Any savings on account of low premiums can be diverted towards mutual funds SIPs to build wealth over time. Thus, this way, you get the best of both worlds – maximum cover from day one and long-term wealth creation through SIPs, if you survive.
CONCLUSION :
There is no perfect way to calculate the value of a person. We do not wish to do that as a human being can never be replaced. The absence of a person, however, does not take away the fact that life has to go on; the survival and fulfilment of the dreams of those left behind are what matters now. The aim of any method is simply to gauge the figure which can make sure that the lives of our loved ones are not compromised due to paucity of finances.
As already discussed, there are many ways and variations in methods of calculating the life insurance need. No one can claim that one method is perfect. The decision rests on us to chose and modify any particular method to suit our needs and requirements. We would strongly suggest that one approaches a qualified insurance advisor or a financial planner to help you make the calculations and arrive at the right figure. We also hope that you assess your present life insurance cover in the context of this article, take adequate life cover as soon as possible and enjoy peace of mind
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