How much Life Insurance do you need?

While purchasing life insurance, we merely stick to an impressive round number say Rs 50 lacs or Rs 1 crore. One of my friends has 5 insurance policies with combined life cover of Rs 50 lacs and has an outstanding home loan of Rs 55 lacs. It is easy to see that he is underinsured. Have you ever tried to calculate your life insurance requirements? You may fall in the same category. Even though most of us realize the importance of an adequate life insurance cover, we do not spend enough time gauging our life insurance requirements. That’s why most of us stick to a round number. The problem is that a number of us don’t even understand how to approach this problem. In this post, we help you understand how to break down the problem in parts and provide you with an excel based life insurance calculator to assess your life insurance requirements.

How to approach the problem?

You buy life insurance to ensure that your family does not have to make compromises with their standard of life even if you are no longer around. Therefore, your life cover should be enough to cover all your existing liabilities (any outstanding loans etc) and help your dependents maintain the standard of living. It should also be sufficient to provide for important events/financial goals in your life.

Your life insurance requirement keeps changing

All of us have certain financial goals and we start saving / investing for those goals. The more we have saved for that particular, the less support we need from life insurance proceeds to provide for that goal.  Hence, even if you have done your homework well and identified your goals and expenses well, your life insurance requirement will keep changing as the time passes. This is because your savings/investments for the goal would have increased by the time and you would need less support from life insurance proceeds to achieve that goal. For expenses, as the time goes by, you would have to provide for the same expense for lesser number of years. Therefore, requirement for life insurance will keep going down (unless you assume any additional responsibilities). Hence, you may find yourself paying premium for higher than required sum assured in the later years of our policy tenure. Laddering of policies (multiple policies with different tenures) can be an answer but we will take this matter up in a subsequent post. In any case, being over-insured is a much lesser evil than being under-insured.

How much life insurance do you need?

When one wishes to purchase life insurance, one should assume a situation where he/she were to die tomorrow. In such a case, how would financial needs of his/her family be taken care of? There are typically three approaches to calculate life insurance requirement.

1. Thumb rule: Take insurance equivalent to 10-15 times your annual income
2. Replacement of income: Under this method, you calculate enough cover that will provide cash flow sufficient to replace your income for rest of your life.
3. Provision for expenses and liabilities (Needs based): The coverage amount should be sufficient to square off all the loans. The amount remaining after repaying loans, if invested, should be able to provide regular income sufficient to meet inflation adjusted expenses and financial goals of your family.

In the first two approaches, the focus is on your income. In the third approach, the focus is on the financial needs of your family. Though the first two approaches are fine, we feel focusing on income to assess insurance needs may not be a good idea. For instance, just because a person is earning less does not mean he has lesser financial responsibilities. We feel more comfortable with the third approach because it requires you to do a much deeper analysis about your liabilities, goals and expenses. This approach also focuses on what you are financially responsible for. Hence, the third approach is likely to present a more accurate and relevant answer.

Under the third approach (need based), you can find out your life insurance requirement in the following manner:

1. Calculate all outstanding loans
2. List down all the important financial goals and amount required in present terms to meet those goals
3. List down monthly expenses and find out amount (in present terms) needed to provide regular income to meet monthly expenses after adjusting for inflation
4. Calculate life insurance requirement by adding amounts identified in (1), (2) and (3)
5. Subtract existing life cover from the amount in (4) to arrive at insurance shortfall.
6. Purchase fresh life cover for the 120% of the amount of shortfall.

During the exercise, you will have to make a number of assumptions including but not limited to inflation, return on your funds, present cost of a goal etc. Changing the assumed value for these parameters will alter your life insurance requirements significantly. For example, a lower value of inflation and a higher return on your funds will reduce your life insurance requirements. On the other hand, a higher assumed value of inflation and a lower return value will increase life insurance requirements. What should you do? Even the finest economists cannot forecast these values. In such cases, you are advised to be conservative i.e. assume a higher value of inflation and a lower value for return on funds. Your family can do with more money but will struggle with less money.

Since there are so many assumptions involved, we recommend taking insurance cover that is 20% greater than the assessed amount. This extra 20% will also take care of any expenses that you might have missed out during the exercise. You may even be required to spend more than expected in case of any emergency, medical or otherwise. It is acceptable to err on the higher side. For instance, if your life insurance requirement is assessed at Rs 80 lacs, it is acceptable to have an insurance cover of Rs 1 crore. However, you cannot afford to err on the lower side i.e. you end up purchasing a life cover of only Rs 60 lacs if your assessed requirement is Rs 80 lacs. You will put your family through a lot of financial pain and misery if you do that.

Download our excel based life insurance calculator  to find out about your life insurance needs.

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We have taken utmost care to prepare calculator to assess your life insurance needs. However, we would still advise you take help from a financial planner or an investment adviser. A planner/adviser can help you probe your goals/events and expenses deeper. Thus, he/she can help you with an accurate assessment.

Do not mix insurance and investment. Under investment linked insurance products, sum assured is typically a multiple of your annual premium. Hence, your life cover may be restricted by your ability to pay premium. If you go with investment linked insurance products, not only do you run the risk of getting sub-optimal returns but you may also end up being underinsured. Opt for a pure term life cover. We must also point out that passing wealth/investments to your family is not enough. You must also pass on the financial knowledge. You can leave sufficient wealth for your family. However, if your family does not have enough skill to manage your investments/wealth, they may still struggle financially. We have discussed this point in one of our earlier posts.

Finally, even if you have bought adequate life cover, it is important that you maintain investment discipline and keep saving for your long term goals. You would want to outlive your insurance policy, won’t you? In that case, your investments and not your insurance policy would help to meet your financial goals.

Image Credit: Ken Funakoshi, 2008. Orignial image and information about usage rights can be downloaded from Flickr.com

Deepesh is a fee-only financial planner and Founder, www.personalfinanceplan.in. For any clarification/feedback/inputs on the life insurance calculator, please write to us at support[at]personalfinanceplan.in