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A reader had a very specific question in Personal Financial Concerns Survey 1.0. It was about calculations related to life insurance amounts.
This is what he had to say:
In past, I have bought insurance policies for saving taxes and investments. But now I understand that these should not be the main reasons for buying insurance. Hence, I want to buy the right insurance cover to secure my family. How much cover is enough for me? People say buying Rs 50 lacs or Rs 1 Crore coverage works. Is it correct?
Now that’s a question that many people have.
I have seen people earning in 7-figures and having insurance cover of 6-figures! 🙂 They believe that a 6-figure amount will be sufficient to take care of their family in case of their death. And these people don’t even have a lot of money saved up.
Tells of risks that people take with their family’s future.
Insurance is bought simply to ensure that insured person’s family does not have to make sacrifices with their standard of living, are able to achieve their future financial goals and close all outstanding loans. That’s it. Nothing more. Nothing less.
But I am not writing this post just to prove that buying life insurance is a must. I am rather concerned about addressing the reader query, which is:
How much Life Insurance to Buy?
It is not that difficult to calculate.
You life cover should be sufficient enough to take care of the following 3 parts:
- Provide enough money to foreclose all outstanding loans
- Provide enough money to help meet regular day-to-day expenses of your family for years to come.
- Provide enough money for your children’s education and marriage.
Lets take them up, one by one…
Part 1: Provide enough money to foreclose all outstanding loans.
This is pretty simple to understand. Just make sure to add any foreclosure charges that have to be paid in case of loan closure.
Lets call this as Amount-Loan-Closures.
Part 2: Provide enough money to help meet regular day-to-day expenses of your family for XX number of years to come.
(Caution – You need to be really sure about what XX is here – as it is the number of years, you think your family needs to be financially supported).
If you think your working spouse will take care of this part on her own, then that’s debatable. Just remember, that in a dual-income family, life style costs and regular expenses generally increase to use a larger part of the combined incomes.
So if suddenly one income stops, it can become a big problem to maintain the existing lifestyle.
Hence, it’s better and safer to make a provision for this as well.
Now how to calculate this amount?
Step 1: Estimate regular annual family expenses (exclude your individual expenses).
Step 2: Subtract the amount you think your spouse can manage on their own (better keep this as minimum)
Step 3: Understand that multiplying the above amount with the number of years (XX above) you wish to support your family won’t work. Why? Inflation. Inflation will increase these expenses every year. So take a safe inflation assumption (say around 8%).
Step 4: Understand that the amount your family gets from insurance company, will be invested and used to generate income. Don’t expect very high rates of returns from the investment. Lower your expectation are, better it is.
Step 5: Use this information to calculate the required insurance amount. This amount will provide enough money for your family to meet regular day-to-day expenses for the XX number of years.
Lets call this as Amount-Family-Expenses.
Part 3: Provide enough money for your children’s education and marriage.
Now it’s a personal choice here – Do you want to provide for your children’s education or marriage needs or not?
Assuming you want to, lets see how to arrive at this figure.
Step 1: Estimate the amount required for your children’s education and marriage, if it were to happen today.
Step 2: Since you children need funds in future, understand that inflation will increase the amount required. So if a MBA from good college costs Rs 15 lacs today, it might cost Rs 35-40 lacs after say 10-12 years. Calculate the amount in future using inflation numbers.
Step 3: You might have already saved some money for these goals. Calculate the future value of these savings and subtract the figure from amount calculated in above step.
Lets call this as Amount-Child-Goals.
Now we have calculated 3 figures for each part.
Add these three figures:
= Amount-Loan-Closures + Amount-Family-Expenses + Amount-Child-Goals
This is you current insurance requirement.
But you don’t stop here.
I am sure that you have been careful in your calculations.
But you see, in all calculations above, we had to make certain assumptions. Assumptions that require us to make predictions regarding rate of inflation, rate of return, etc. Now you know that even experts have trouble predicting the future. So at best, our predictions are mere educated guesses and not future realities.
We can always be wrong in our assumptions.
So in order to provide a buffer for mistakes in our assumptions, increase the amount you calculated above by atleast 10%.
Higher you bump it up, better it is.
I personally take it at 25%. (Even if it means that you family ends up with more money than they actually require, it is a good problem to be in. Isn’t it?)
This is the Gross Insurance Requirement for you.
Once you have calculated the figure, you need to subtract a few things from it. You might already have some other insurance policies, employer-provided insurance covers, existing savings and investments earmarked for some of these child_goals . Subtract these amounts from above figure.
This will give you the additional insurance cover you need to purchase.
You can use the following grid as a guide:
I am sure that once you are done with your calculations, a huge amount will be staring at you from your calculation sheet. Many of you who have endowment plans, moneyback plans, etc. as insurance covers, will even fear asking about the premiums for such large covers.
But don’t worry. Solution is there. And it is to buy plain term insurance cover. Its cheap and can provide coverage of almost Rs 1 crore for around Rs 10,000 – Rs 12,000. But remember one thing – term insurance has no survival benefits. You won’t get any money in case you don’t die within the insured period.
- Buying a term insurance does not mean that you don’t need to save for your future goals(retirement, kids education). It is only a backup plan in case you don’t survive that long. Insurance is not investment.
- You are smart enough to purchase the right insurance cover for your family. But are your family members smart enough to deploy the huge insurance amount correctly (which they get when you die)? Don’t bet on it. Make sure that you sit with them and educate them what insurance is. And more importantly, what to do when they get the big amount. Tell them where to put the money and when to withdraw it. One wrong decision on their part and they will lose the money (a part or whole, who knows). And worst is that this is inspite of you having taken care of everything. So make sure you educate them.
There is a way to reduce your insurance requirements. Suppose you want to provide for your family’s expenses for 25 years (Part 2 of the above discussion). But your child’s education goal is just 10 years away (Part 3). So if you follow the approach discussed in article above, it will mean that you are paying for providing risk cover for the child’s education goal, even after its completion (i.e. 25 – 10 years = 15 years).
Effectively, you might find yourself paying a premium for sum assured that is higher than what is actually required. But that is not completely wrong. As I said, being over-insured is any day better than being under-insured. In any case, your insurance requirements keep changing every year.
The problem (though wrong to call it that), is solvable through an approach known as laddering of insurances. Its an approach where one buys term insurance plans of different durations that correspond to major goals like kids education, marriage, etc. Once the period of shorter-term plan is over, it frees up cash that can be invested elsewhere. Its an interesting topic – Laddering. I will write about it in another post soon.