The objective of a life insurance plan is to ensure that after the demise of the insured person (who is typically a family’s bread earner), his family does not suffer financially.
Containing life’s uncertainties is an important part of financial planning. While buying life insurance, people often find it difficult to calculate an adequate sum assured requirement. There are also those people who do not seek life insurance at all, and they thus risk the financial well-being of their families. Finally, there are also those who buy more insurance than may be required. Essentially, the problem is this: how do you accurately calculate your insurance requirement?
Being uninsured, under-insured, over-insured
An uninsured person is exposed to the maximum financial risk due to death. He may not be leaving his dependents adequate financial support. Similarly, if there’s a person whose family’s fund requirement would be Rs 1 crore in the future (while considering inflation and future needs), and if he’s insured for only Rs 50 lakh, his family too is at risk. But if the same person is insured for Rs 1.5 crore, then he is over-insured by Rs 50 lakh, so he may be incurring a higher-than-required premium cost which may otherwise be allocated towards more meaningful pursuits. So the need here is to arrive at an adequate sum assured which is just right for your family’s requirements.
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Let’s check out how to calculate the insurance needs of a person.
Assessing insurance need
While assessing your life insurance need, you should take into account your current income, expenses, future needs, inflation, liabilities, etc. Based on all these factors collectively, you can closely assess your insurance need.
The assessment should help estimate the financial requirements of your family at various stages in life and make adequate financial arrangement for it, considering you won’t be there. So here are some methods to make your calculation easy.
Income Multiple or Thumb Rule Approach
The income thumb rule says you must calculate your insurance need by multiplying your current total income by 10 to 12 times. It means, if your income is Rs. 5 lakh, your life cover should be around Rs. 50 lakh to Rs. 60 lakh.
Method II- Income Replacement Approach
It considers the current income level and the expected remaining years till retirement of the individual to calculate the insurance cover value. For example, if the current income is Rs. 5 lakh and the expected remaining years for retirement is 25 years, then the insurance requirement would be Rs. 1.25 crore. It means Rs. 1.25 crore value of insurance would be required to replace your expected future income.
These two are very simple method, therefore let’s take a look at methods that take a more nuanced understanding of your insurance needs.
Method III- Need Analysis Approach
The need approach focuses on how the needs and goals of the family would be achieved in case the primary income winner were to pass away. Start with estimating your day-to-day, regular requirements and also assess your various life goals. Expenses may include rent, EMIs, insurance premiums, outstanding loan liabilities, healthcare expenses, groceries, utilities, etc. The family goals may include buying a home, funding the children’s higher education and marriage, creating a retirement corpus, etc.
Next, take into account the impact of inflation of some of these expenses. For example, if an average wedding costs Rs. 10 lakh today, assuming an average cost inflation rate of 7%, it will cost Rs. 20 lakh in 10 years. You can estimate when each of these expenses will be due. For example, your child who is five years old now may marry at the age of 27, leaving you 22 years to create a wedding fund. Assuming 7% cost inflation, you’ll need Rs. 44 lakh in 22 years for your child’s wedding. This is how you can calculate each of these requirements.
Next, you should take stock of your existing investments: your bank FDs, RDs, postal saving schemes, properties, rental income, shares and any regular or irregular source of income. Add to this any existing life cover you may have.
Now, you are ready with estimation of expenses with inflation adjustment, current investment, income, and existing insurance. Subtract your income, investments and existing life insurance from the sum total, inflation-adjusted expenses and goals. The result that you get after subtracting is your insurance requirement. But if the result is negative, you may not require additional insurance to cover your risks as your existing setup may be adequate.
Let’s understand the calculation of insurance need with the help of an illustration.
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The assumption: individual’s liability: Rs. 5 lakh, total investments: Rs. 5 lakh, existing life insurance: Rs. 10 lakh, fund requirement (present value) for child’s marriage: Rs. 15 lakh, higher education: Rs. 10 lakh, regular expenses: Rs 3 lakh per annum.
Formulae of Future Value (FV)= PV (1+ (R)) ^n; Where, Inflation Rate= n; Present Value= PV; R= Inflation rate
|Estimation of Inflation Adjusted Goal amount|
|Higher education of child|
|PV= Rs 10 Lac; n= 10 years; R= 7%|
|A||Future Value (FV)||PV (1+R/100) ^n|
= 19.67 lakh
|PV= Rs 15 Lac; n= 15 years; R= 7%|
= 41.39 lakh
|PV= Rs 3 Lac; n= 15 years; R=7%|
= 8.3 lakh
|Total Inflation adjusted Regular Expense and Goal amount (A+B+C)||Rs 69.36 lakh|
|Calculation of Insurance Requirement|
|a||Inflation adjusted Regular expenses and goal||Rs 69.36 lakh|
|b||Liability||Rs 5 lakh|
|a+b||Rs 74.36 lakh|
|Less||Present investment||Rs 5 lakh|
|Less||Existing insurance cover||Rs 10 lakh|
|Net insurance cover required||Rs 59.36 lakh|
Apart from the calculations discussed above, there are a few more things to be considered while calculating the insurance requirement. If the spouse is also an earning member, the insurance need would reduce to an extent. Family history of critical illness must be kept in mind while determining the tenure and amount of insurance cover.
Once you are ready with the insurance need and tenure, you can select the best life insurance product as per your requirement. For substantial insurance covers at low premium costs, term plans are the best way forward.
(The writer is CEO, BankBazaar.com)