Life Insurance coverage: How much do you need to buy?
Life Insurance purchase decision is often regarded as an intricate process. From choosing the right insurer to determining the adequate sum assured, needs to be handled wisely. The sum assured or the life insurance coverage needs to be adequate to ensure that your dependents lead a smooth life even when you are no more around.
Also read: 15 important terms that you should know before buying Life Insurance
Now you may wonder “How much term insurance cover would be sufficient?”How to calculate the exact amount of sum assured?”What factors need to be accounted for such a calculation?”
The thumb rule says the sum assured should be 10-12 times your annual income. If your annual income is Rs 5 lakh, then you need an insurance cover to the tune of Rs 55 lakh. But here it needs to be emphasised that this is a crude method of calculation of life insurance cover. You need to estimate scientifically the correct life insurance amount that will shield your family from financial troubles and pay off the liabilities in case of your death. The amount of adequate sum assured depends on many factors like your annual income, the quantum of assets, the extent of liabilities, the number of dependents, the existence of additional social security, income of spouse, monthly expenditure, nature of occupation, expected age of retirement, etc. The two extensively used methods to calculate the amount of life insurance cover are Human Life Value Approach and Expense Approach.
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Human Life Value Approach
This method is based on the contribution that you, as a breadwinner, would make to your household over the entire productive years. It considers insurance as a tool which would help in income replacement which was being provided by the breadwinner before his death. In this approach, you need to find out the present value of net insurance coverage amount that would replace your share of contribution to the household. For calculating the Present value of insurance cover, you need a discounting rate, tenure and the quantum of income that should be replaced.
Following steps illustrate the calculation of Present Value (PV) of Insurance Coverage:
Step 1. Firstly, your net contribution is arrived at by deducting your personal expenditure from your annual income.
Step 2. Your productive years will be obtained by subtracting your current age from expected age of retirement.
Step 3. Discounting rate means a rate at which your net contribution will be discounted to arrive at human life value. It is reached with the help of Expected average income growth rate and your expected average annual return on investment.
Discounting rate= [{(1+ Expected average annual return on investment)/(1+ Expected average income growth rate)}-1]*100
Step 4. The Present value of insurance coverage or the human life value is calculated with the help of your annual income, the productive years and a discounting rate.
PV= Net contribution of the assured * PVFAn,i
Step 5. The Present Value of insurance cover or the human life value is then increased by outstanding liabilities and reduced by existing assets and investments to arrive at Net life insurance coverage.
The following table illustrates the Insurance Cover amount calculated using the Human Life Value Approach.
Based on Human Life value approach, you would need an insurance cover of Rs 56 lakh when your net contribution is Rs 4 lakh and 20 years are left for your retirement. The discounting rate is inversely related to the estimated Human Life Value. A higher discounting rate would lead to a fall in the estimated human life value and vice-versa. Moreover, as the rate of income growth increases, it results in the requirement of a higher amount of insurance cover to take care of future needs.
Expense Approach
The Expense Approach assumes that upon the demise of the breadwinner, the family members may face difficulty in meeting the household expenditure. Hence, the amount of insurance coverage should be such that the family need not forego their present standard of living even after the death of the assured. It, thus, delves extensively on the annual expenditure made by the household to find out the present value of insurance coverage requirements of a family. For calculating the Present Value of insurance cover, you need a discounting rate, tenure and the Annual expenditure of the household.
Following steps illustrate the calculation of Present Value of Insurance Coverage:
Step 1. Determine the Annual expenditure of the household.
Step 2. The years for which the insurance coverage may be provided for is the difference between the life expectancy of the dependent and present age of the dependent.
Step 3. Discounting rate means inflation-adjusted return at which the Annual expenditure of the household will be discounted to arrive at the Present Value of Insurance Coverage. It is obtained with the help of Prevailing rate of inflation and your expected average annual return on investment.
Discounting rate= [{(1+ Expected average annual return on investment)/(1+ Prevailing rate of inflation)}-1]*100
Step 4. The Present value of insurance coverage is calculated with the help of the Annual expenditure of the household, the years to provide for and a discounting rate.
PV= Annual expenditure of the household* PVFAn,i
Step 5. The Present Value of insurance cover is then increased by outstanding liabilities and reduced by existing assets and investments to arrive at Net life insurance coverage.
Thus, you get net additional insurance cover that you may purchase to ensure your family continues with the current level of expenditure even when you are no more with them.
The following table illustrates the Insurance Cover amount calculated using the Expense Approach. It assumes the case of a family of two i.e. husband and wife wherein only the husband is the breadwinner.
Based on Expense approach, you would need an insurance cover of nearly Rs 65 lakh when your current annual household expenditure is Rs 3 lakh, and you have to provide for this over a period of 45 years, assuming the life expectancy of your dependent to be 80 years. The level of annual expenditure, the number of dependents and inflation is directly related to the amount of insurance coverage. The greater number of dependents would increase the level of annual spending. The higher the level of household expenditure, higher would be the insurance cover required to keep dependents’ standard of living intact.
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Laddering involves purchasing goal-oriented policies. It may be used in conjunction with the expense method to determine the adequate amount of sum assured. Laddering involves buying term insurance policies in a manner that premium payment liability does not continue even after achievement of life goals for which the policy was purchased. Therefore, you match the policy tenure with the investment horizon of the life goal.
Consider situation one; you have a 6-year old kid who studies in 1st standard. You wish to provide for his school education and marriage. His education expenses would continue for another 12 years till he completes 12th standard. He may get married after 19 years from now say at 25 years of age. Conventionally, you may think of clubbing both the goals under one term plan and may buy a term plan for 19 years. Such that first 12 years of policy provides for school education in case of your demise, and if there’s no such contingency, then the policy will extend to the marriage of the child. But the problem here is that your life goal of child’s education would be over in the first 12 policy years but as your policy tenure is 19 years in total, you would have to continue premium payment and provide for the completed goal till 19 years. It means that your funds are being blocked which you could have freed after 12 years.
Now, you may think “Is it possible to stop providing for a goal after you have achieved that goal?”I would say it is possible using laddering. Under this, you buy two term plans of 12 years and 19 years respectively. The first plan provides for 12 years of child’s school education. The second plan of 19 years provides for child’s marriage till he attains 25 years of age. When the first policy matures after 12 years, your premium payment liability ends which otherwise would have continued for the whole of 19 years as outlined in the first situation. The funds thus freed may be used for investment in some other goal. Now your only premium payment liability would be towards child’s marriage.
In this way, laddering helps in providing for goals as well as in financial management.
Also read: How to choose a good term insurance policy that suits you best