How Much Life Insurance Cover Is Enough?

While there exist certain thumb rules that can determine the necessity of ample life insurance cover, the most rudimentary method would be multiplying your annual earnings by 10-12 times.

Insurance is the most viable financial tool for protecting your loved ones and assets from your unforeseen demise. Many of us would wonder about just how much life insurance cover would suffice. We might even have multiple insurance policies, but may still not be adequately insured. A vast majority of Indians are either uninsured or even underinsured. This guide will help you understand in simple terms exactly how much life cover would be right for you.

Reaching the balance is important because too little of life cover would result in financial insufficiency of the surviving members of the policyholder’s family, whereas too much life cover would mean spending too much on premiums rather than on necessary matters of life and lifestyle. However, reaching that adequate cover is not easy since there exists no single formula for deciding that.

For the laymen, the thumb rule would be to calculate the sum insured to be equal to such an amount, which upon investment would fetch the usual regular income for dependants, helping them maintain a similar lifestyle, to the one before the wage earner’s demise. In the case of there being liabilities, those amounts ought to be added to the estimated insurance requirement.

One approach towards such estimation would be financial need analysis. This approach would take care of the specific requirements of any individual, the basic objective being sufficient financial support which provides for the dependents. The requirements should also include any financial liabilities like home loans or car loans. There should be consideration of the required funds towards familial support for the desired timeframe. The money required for the ward’s education or marriage can also be included.

Let us look at an example. Mr X has housing loans worth Rs. 40 lac, car loan worth Rs 5 lakh and monthly familial requirement of Rs. 50,000/- in case of his demise, the life insurance should provide a monthly Rs. 50,000/- to his family as well as liquidate the outstanding loans.

Another approach would be to choose a cover for a policyholder with dependants with ‘risk cover’ being of utmost importance and then the concern of ‘savings. The cover amount factors in income, paying capacity, job nature, earning period, existing liabilities (loans whether personal or housing) reduced by existing savings and investments.

To start with that, assessing the financial needs while considering life stage, dependants, risk profile, disposable income as well as liabilities is necessary. This helps to identify the need for protection as well as savings. The protection has to provide for existing liabilities and take note of the future earning potential of the insurance claimant so that it ensures that there is no significant change in the lifestyle of the dependants. Financial goals determine savings.

Therefore, the required amount for maintaining living standards would depend on inflation. The comfortably projected monthly expenses would refer to an actual requirement, which is closer to 120% of the current amount while accounting for inflation and health-related expenses.

Let us take another example. Mr X currently aged thirty with expenses of Rs. 20,000/-each month and retiring at sixty would have to consider the average inflation rate per annum, which is 5%. His expenses projected at retirement would be Rs. 87,000/- per month. However, the average expenses each month during retirement at a rate of 120% will be Rs. 1,04,000/-. Hence the required amount would be Rs. 1.90 Cr, if there is no inflation and Mr X survives till 75 years.

Financial planning needs to start early since contributions are lower and compounding ensures larger savings.

Another approach is HLV or the Human Life Value method. In this, the insurance amount directly depends on the economic value of the policyholder, also known as ‘Human Life Value’. This is unique to people since it is the capitalisation of net earnings of any individual for his entire work-life.

This approach estimates future earnings of any individual and capitalises it with an appropriate discounting factor which is a reasonable rate of interest, considering present inflation and interest in banks. Total future earnings as estimated in the present is the whole economic surplus that is available to the dependents. This surplus amount excludes the individual’s expenses, taxes, as well as existing premium towards life insurance.

If Mr X has a monthly income of Rs 10,000/-, personal expenditure of Rs. 3000/- then he provides Rs. 7,000)- to family each month. Annually this becomes Rs. 84,000/-. Upon his demise, to provide this amount to the family, he needs an investment worth Rs. 12,00,000, which provides risk-free returns at 7% per annum, hence Rs 84,000 per year. Therefore, HLV becomes Rs. 12 lacs.

Another approach is known as ‘Underwriters Thumb Rule,’ considers life cover as a multiple of the annual income depending upon age. As an indicative rule, individuals between twenty to thirty years should have life cover worth fifteen times their current annual income. Individuals above fifty-six years may have six times of their current annual income.

Need analysis is of fundamental importance towards choosing the correct life insurance plan. These needs could be protection, accumulation and maintenance of wealth and retirement.

Protection needs are for death, dreaded diseases and disability, which are ruled out with the help of term/whole life insurance plans with critical illness riders, WOP or Waiver of Premium and ADB or Accidental Death Benefit. Wealth accumulation involves children’s education, marriage and settlement, as well as saving for retirement, with the help of money back, endowment and whole life plans.

Insurance is not merely to guard one against a  short life but preparing one for a long life too. The correct insurance cover will have both must protection and investment benefits. Life insurance ought to be seen as a long-term financial plan with an allocation of a minimal 20% of monthly savings towards this asset class of great importance.

However, deciding upon the need, product and mechanism isn’t enough. Before signing up for the life insurance policy, clarify how exactly the product fits in with the need, and understand which illustrated amount is guaranteed or not. Insist upon seeing this. Do not accept the illustrations based upon historical returns, since they are indicative and can not guarantee returns in the future.