Insurance is an important tool of risk mitigation and a critical aspect of financial planning. Life insurance allows an individual to ensure that his loved ones and financial dependents can continue to lead a decent life and meet their expenses.
Life insurance is an agreement between an individual and a company to provide financial compensation in case of death of an individual in return for payment of a specified premium.
Sadly, most life insurance products are sold as investments/savings instruments and tax savings options. They are neither of them. Life insurance is a Risk Mitigation instrument to provide for your financial dependents. Nothing more.
So how much life insurance do you really need? There is no magic number that suits everyone. Like everything else in financial planning, the cover required is dependent on individual circumstances and requirements of their dependents.
We follow our calling, passion and professions to earn a living and provide for our loved ones. No matter what our income levels are, we earn so that our families can get the best living, enjoy the best facilities, get good education and travel to places that fascinate us.
But we fail to estimate what happens if that income stops suddenly. Will our loved ones be able to live the same quality of life, do they have alternate sources of income and if no, how soon can they get back to earning the same kind of income.
How to arrive at the required life insurance cover?
Two popular ways of arriving at Life Insurance Requirements are Income Replacement Method and Need Based Method. Let’s look at each of them.
Income Replacement Method
When the primary earner for a family dies, the family goes through a financial shock. When analyzing the amount of life insurance cover required you can look at below important pointer;
Your Annual Income
What is your annual post tax income from all sources? If you are salaried, look at your EPF and other mandatory deductions that get invested. Consider only those income where the income is solely dependent of your capacity to earn. For instance, passive incomes like rental and royalty income will continue even in your absence.
Active working Life
One needs to assess for how long they will continue to work. If one as estimated that they will retire by age 50, they will need to consider their income generation only till that age. If you are 30 years old now, you will have to factor in an active working life of 20 years in this case.
Growth of Income
Depending on your income profile, it is important to realistically assuming a growth rate for your income. Professionals that see a shortage of talent and sustained depends for their work can assume a greater growth in their income levels. It would be safe to assume a growth rate of around 5% for most individuals. A 30 year old having income of 20 lakh per year, will have an income of ₹ 7.14 crore over the next 20 years. The present value of such an income growing at 5% invested at 7% for the next 20 years will be ₹ 3.36 crore.
Need Based Method
For individuals that have an different sources of income, the actual life insurance requirement might be lower than others. Typically they need to bridge the gap in their income to fund the required expenses. A family that has a monthly rental income or other passive incomes of let’s say ₹ 1 lakh, while their monthly expenses are around ₹ 1.5 lakh, will require to fund the gap of ₹ 50,000 every month.
Lump Sum Expenses
While we looked at funding the difference in income and expenses above, it is important to look at one time major expenses as well. A couple with young children will have to look at funding education and marriage expenses to ensure that they have adequate life insurance.
It is important to ensure that you have adequate insurance to cover your housing loans and other loans you might have taken. In the event of death, we have seen many young individuals in deep trouble as they failed to take adequate life insurance to cover their loans. The family is forced to sell the house to be able to repay the housing loan. With reduced income and no house, there is increased expenses in the form of rental costs.
Providing for dependents
The entire purpose of taking insurance is to provide for your financial dependents. It is important to know the number of dependents you have to provide for and for how long. You will have to provide for aged parents, your spouse and for your children. If your spouse/parents are working or have other sources of income, the insurance requirement might be lesser.
One has to assess as to the period they will support their children, are your factoring in only education till they are graduates, will you fund their higher education. Are you factoring in only basic expenses, do you want to factor in discretionary expenses. These questions and assessments help you arrive at the ideal insurance cover your family needs.
Value of Assets
People with substantial assets, physical or financial, might require no or less insurance. If one is able to liquidate your assets and utilize the funds towards meeting various expenses, no insurance is required. For those who do not want to liquidate their assets or have maintained assets for different purposes, higher insurance cover might be required to sustain the family’s expenses and needs.
Insurance is only for those who have financial dependents. If the family members are financially independent, taking insurance and paying premiums might not be required. While you do get insurance, it is important that your paperwork is flawless. Ensure that your disclosures and other important information is declared to the insurer.
If you already have insurance and are considering to increase your cover through a new insurer, it is important that you disclose that you have insurance to your new insurer. While nominating it is important that you provide for all your dependents. It is important that you provide for your spouse, children and parents to ensure that each of them have sufficient corpus to take of their necessities.
Remember, we have unique situations, do not hesitate to get help of a SEBI Registered Fee Only Financial Planner or a Qualified Insurer to assess the amount of insurance required for your family and circumstances.