How much life insurance coverage do you really need?
The purpose of life insurance is to replace a person’s earning capacity. Life insurance products have gone through a transition over the period. Once considered a savings and investment avenue, it is now considered risk reduction and protection for the family. We should all be happy that this positive change is happening, and people are now looking at pure insurance products like term insurance to ensure their lives and secure their families. So, the question of which insurance product to go for is now getting clearer.
The next big question is how much should be the insurance cover. There are different ways to evaluate the amount of life insurance coverage one needs. There has been some thumb rule that says that your life insurance should be multiples of your annual income. While this thumb rule may be good, a better way to evaluate it could be to calculate this amount based on current age, current income, expected growth in income every year, and retirement age.
Let us understand the steps of calculating the insurance coverage along with an example and the reason for that step. We will take the example of Mrs.X who is 30 years old and earning Rs.1.20 Lakh per month.
A note before we go ahead – if you think all of these calculations are overwhelming to you, there is a simple calculator you can use which is made available in step 5. But to understand what details to give and how this works, we urge you to read the entire article. After all, this is a very important aspect of financial planning.
Step 1 – Evaluate Contribution to Family’s Income
Based on the present income of Rs.1.20 Lakh per month calculate how much of this income is for the family. Let us assume it is Rs 1 lakh. So the monthly income that needs to be covered is Rs.1 Lakh as the family will need this money for their regular expenses and savings, if the bread winner of the family is no more.
Step 2 – Calculate Total Income up to retirement
If the retirement age is 55, then for the coming 25 years, the family will expect to receive the income every month from the salary. This income also grows every year, so it is important to consider annual income growth. Usually, one can assume a 5 – 8% annual growth in income depending on the profession and profile. In our case, let us assume an average salary increment of 8% every year. So, up to retirement, the total income earned will be Rs. 9.51 Crore.
Step 3 – Calculate the present value of that income
This step is crucial as we’re aiming to replace the financial loss of ₹9.51 Cr if anything happens to Mrs. X today. If ₹9.51 Cr is the total income she will earn up to retirement, we need to find its present value if invested in a low-risk portfolio generating 7% annually. This ensures that if something were to happen to Mrs X and a claim is made, the claim amount can be invested, allowing the family to withdraw ₹1 Lakh monthly with 8% annual growth. The present value of ₹ 9.51Cr at 7% rate is ₹1.75 Cr, which is the required insurance cover today.
Step 4 – Deduct existing insurance cover, if any, and add outstanding liabilities
Existing insurance cover has to be deducted from the above-calculated insurance amount of Rs.1.75 Cr. If the existing life insurance is Rs.50 Lakhs, then the additional insurance will be Rs. 1.25 Cr (Rs. 1.75 Cr – Rs.0.50 Cr). If there is no present insurance, the required insurance will continue to remain at Rs.1.75 Cr.
Step 5 – Customize as per your requirements
If you want to customize it for your own requirements, here is a link where you can download this Excel link to input your figures and find out what your ideal insurance coverage amount should be.
Life insurance ensures that the family does not suffer financial loss in case of any unforeseen event affecting the income earner. Hence, having adequate and right insurance coverage is extremely important. The more methodically it is calculated, the more effective the insurance will be.
The views and opinions expressed in this blog are those of the author. All content provided is for informational purposes only and should not be taken as professional advice.
