How much life insurance do I require?

I have heard people say 1 crore term life insurance is good. Some others say 10 times annual income is required. Another school of thought says 20 times annual income is very good to have. Is this the thumb rule for everyone? What if I no dependents? What if I have a large corpus already created? What if I have a large liability in terms of business loan/home loan?

You need to be make sure that the life insurance that you are taking for your family’s protection is sufficient. How do I calculate what is the sum of life insurance required to be taken?

How to calculate the term life insurance required

The amount of life insurance cover required depends on the economic value that can be attached to human life. This is called Human Life Value (HLV). This is the value that insurance needs to compensate for the loss of life or disability which results in reduction in the ability to generate income. HLV is the present value of the expected income over the working life of the individual that is available to the dependents. This is arrived at after considering the future value of the assets already available that contribute to this value. There are different ways to calculate HLV.

Income Replacement method

In this method the HLV is calculated as the present value your future earnings.

Let us take an example of Amar, who earns Rs. 10 lakhs per annum. He is 32 years old and likes to retire at the age of 55. We assume the yearly salary increase as 5% and the returns on investment as 8%.

The amount of insurance required is the sum of money invested today at a return of 8% replaces Amar’s income considering that the salary would have increased 5% per annum. The amount has to take into account that the return is 8% and it increased by 5% every year. We can use the Excel PV function to calculate this.

The adjusted rate is ((1 + Investment rate)/(1 + increment rate)) – 1

In our case, the adjusted rate is ((1 + 8%)/(1 + 5%)) – 1 = 2.86%

Now, you can use the PV function to calculate the required corpus as below:

a.       Rate = 2.86%

b.       Nper = Number of earning years which is 55 – 32 = 23

c.       PMT = This is the current annual income which is Rs. 10,00,000

d.       PV function gives the required corpus as Rs. 1,66,85,547

As per Income Replacement method, the required corpus is Rs. 1.67 Crores

As you can see, this method does not consider the present assets and liabilities. It also does not consider the future goals. So to improve the calculation, we require a better method.

Need based Approach

This method calculates the amount of insurance required considering the needs and goals of the family. This includes the living expenses, EMI payments, rent, loans, medical expenses, education expenses, schooling, maintenance costs and emergency funds. This approach considers the assets already accumulated like EPF, gratuity and investments. Insurance will be required for the remaining value.

Let us continue with the same example of Amar earning Rs. 10 Lakhs per annum. In the absence of Amar, his wife Jaya, aged 30, housewife has household expenses of Rs. 30,000 which includes school fees for their only son, Sudheer. Amar has a home loan outstanding of Rs. 30 Lakhs. He has mutual fund investments which is worth Rs. 5 lakhs. Their goal is Higher education for their son which is expected to cost Rs. 20 lakhs presently, after 12 years. Their son’s marriage is expected to cost Rs. 5 lakhs as of today in 20 years’ time. The living expenses for Jaya is expected to decrease to Rs. 20,000 per month (as of todays’ value) after 20 years. Life expectancy for Jaya is 90 years.

The present value of the future goals can be calculated as below:

S.No

Goal

Present cost

years

Inflation

Future value

Present value @ 8% discounting

1

Son’s Higher education

₹ 20,00,000

12

10%

₹ 62,76,857

₹ 24,92,626

2

Son’s Marriage

₹ 5,00,000

20

6%

₹ 16,03,568

₹ 3,44,043

 

Total

       

₹ 28,36,669

As a first step, we require the inflation adjusted rate of return. This is calculated with the formula ((1 + investment return)/(1 + inflation)) – 1. In our case, it is ((1 + 8%)/(1 + 6%)) -1 = 1.89%

S.no

Item

Formula

Amount

1

Present value of Goals

 

₹ 28,36,669

2

Annual Family Expenses for 20 years @ Rs. 30,000 per month

PV(1.89%,20,30000*12)

₹ 59,49,484

3

Annual Expenses for wife after 20 years for 40 years @ Rs. 20,000 per month

Calculate future value of Rs. 20,000 per month after 20 years at 6% inflation which is Rs. 64,143; then use PV(1.89%,40,64143*12)

₹ 2,14,67,934

4

Home loan outstanding

 

₹ 20,00,000

5

Less mutual fund value

 

₹ -5,00,000

 

Total

 

₹ 3,17,54,087

The requirement for term life insurance is 3.18 Crore which is a much better number to protect your family.

Conclusion

I recommend you to use the Need based approach to calculate the present value of your future goals, the present value of future monthly expenses and the assets and liabilities to arrive at the correct sum assured which is required for your family’s protection.

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