Calculating how much life insurance you
need is one of the most important financial decisions you will ever make. It
should never be an isolated decision depending only on how much of a premium
you can afford.
Having said that, there are many ways
in which you can determine how much insurance you need.
Here we give you a few.
Income Replacement
Value
This is one of the basic methods of
insurance calculation and is based on your current annual income.
Insurance needs = annual income *
number of years left for retirement.
Let's say your annual income is Rs
5,00,000. And you are 45 years old with 15 more years for retirement.
In this case your insurance cover
equals Rs 5,00,000 * 15 = Rs 75,00,000.
Another way in which income replacement
works is to multiply the annual income by 10 (also known as Income Replacement
Multiplier).
Insurance
terms you must know
Another variant states that the Income
Replacement Multiplier changes with age. So between the ages of 20-30 years,
the income multiplier is 5-10, and from 30 to 40, the income multiplier is
15-20.
It drops to 10-15 between the age of 40
and 50 and further to 5-10 between 50 and 60.
Some calculations also take into
account any outstanding loan amount that you may have on your housing loan,
personal loan etc.
Human Life Value
(HLV)
This method of calculating life
insurance is based on contribution that one makes and would have made to
her/his family in case of sudden demise.
So HLV is defined as the present value
of all future income that you could expect to earn for your family's benefit.
It also includes other value you expect to contribute, less personal expenses,
life insurance premiums and taxes through your planned retirement date.
Let's see this example for better
understanding.
Ram is 40 years old and plans to retire
at 60. His current salary is Rs 3 lakhs and is expected to remain same every
year. His personal expenses, life insurance premiums that he pays and taxes are
around Rs 1.25 lakhs. His contribution to his family is rest of his salary of
around Rs 1.75 lakhs.
Here, Ram's Annual Life Value (his
economic contribution to his family post his expenses) is Rs 1.75 lakhs.
Suppose Ram dies at 41, then the
economic value (namely Rs 1.75 lakhs) he would have added every year
(from age 41-60) to his family is no longer there. So to protect this economic
value, Ram can use life insurance as a safety valve so in case of his death,
this economic value can come to the family.
Gross Total Income: Rs 3 lakhs
Less Self - Maintenance Charges: Rs 1
lakh
Tax Payable: Rs 10,000
Life Insurance Premium: Rs 15,000
Surplus Income Generated for Family:
Rs1.75 lakhs
If this surplus income is capitalised
at a discount rate (expected return rate) of 8 per cent per annum for 20 years,
then the HLV will be = Rs 175,000*10.6 = Rs 18.55 lakhs.
5 things
your insurance agent won't tell you
In short, Human Life concept arrives at
an estimate of insurance cover required as on date to protect the income
earners' economic value to their families including their future earning
potential and capacity.
This multiplier 10.6 above can be
calculated using the Present Value Function in an Excel spreadsheet.
Go to excel spreadsheet; click on
Insert tab; click on the 'Function' option; select function PV (that is the
present value of your investment; it gives the total value of a series of
future payments that is worth today).
A box opens up where in you can fill in
the above values for rate (8%, that is the return one can expect over the next
20 years), period (20, assuming you will make payments for the next 20 years)
and pmt (payment made every year and which cannot change during the next 20
years) and Type (a logical value which should be 1 at the beginning of the
period; it becomes 0 at the end of the period, that is, at the end of 20
years).
Rate = 8 %
Period: 20 Years (Age 41-60)
Pmt: Rs 1 will give you this
multiplier. If you put Rs 1.75 lakhs here it will give you the value of Rs
18.55 lakhs
Needs Analysis
In this method, you can assess your
needs -- and the needs of your loved ones -- and make a calculated assessment.
The most critical factors are the
number of dependents you have and their needs.
Other major factors to consider are:
- Loans
- Kind
of lifestyle you want to provide to your family
- Provision
for non-working spouse who would no longer get an income
- Child's
education
- Child's
marriage
- Providing
for financially dependent parents
- Special
needs
- Dreams
and aspirations such as contributing to charitable causes
Once you determine the above factors,
you run the following calculations:
1. Lump sum needs on Life to be
Insured's death
a. Home loan payoff
b. Car loan payoff
c. Child's education
d. Child's marriage
e. Emergency fund post
death
2. Monthly income needs
a. Monthly expenses
b. Income of Living spouse in
case she earns, or rent or interest
c. Shortfall = (a-b)
Shortfall is a-b. Suppose, expenses are
Rs 50,000 and spouse's income is Rs 30,000 post tax, then shortfall is Rs
20,000 (50,000-30,000).
d. Monthly income needs till
child turns 21 or is self-sufficient:
e. Number of years to go: For
the child to reach 21 and post that for the spouse till her age of 80 or 90
years
f. Annual income needs: Of
spouse, children or dependents
g. Total income needs: Of
spouse, children or dependents
3. Sum up the current invested assets
and current life insurance cover. Now see how much this total differs by what
you have calculated above. This will be the shortfall (considering that you die
today) that you will need to get covered. But do note that invested assets
exclude residence, car and other personal assets.
Picking the right one
The one that I prefer and is mostly
followed by reputable financial planners for decades is the Needs Analysis
Method. Once you determine the amount of life insurance need, just buy the
lowest cost insurance plan that's available to you.
Planning
to stop your insurance policy?
You should buy insurance after a
thorough life
insurance premium calculator to calculate
capital (lump sum needs on death
such as paying off a loan, daughter's marriage or education) as well as the
income needs of your family after you are gone.
Ask yourself: If something were to
happen to you, what kind of corpus would your family need to maintain their current
lifestyle, to fund your child's education as you had envisaged, retirement
income for your wife etc.
Most middle-class individuals have
insurance policies in the range of Rs 1,00,000 to Rs 10 lakhs. Some of the
wealthier ones have more than this.
The question they need to answer is:
How long would Rs 10 lakhs suffice?
Finally, remember that your insurance
needs go down over a period of time. Hence if you find yourself with a sudden
windfall or have accumulated enough wealth, then you can evaluate the need to
altogether terminate your insurance policy.
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