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How to systematically calculate life insurance cover for your family?

Some take a cover that’s 10-12 times one’s annual income, while others are happy hitting a seven-digit figure (Rs 1 crore). But income keeps changing over a period of time.

Term insurance is the best way to financially protect one’s family in case of death of an earning member. If you are already convinced of it, the next step is to assess the extent of life cover that your family requires.

Some take a cover that’s 10-12 times one’s annual income, while others are happy hitting a seven-digit figure (Rs 1 crore). But income keeps changing over a period of time. Furthermore, a seven-digit figure of sum assured will not last more than 14 years for a household with monthly expenses of Rs 50,000 (and which increases by 6 percent every year). How would the family meet its other financial goals like retirement for the spouse, children’s education and so on?

Methodology

Human value indicator method is therefore recommended to scientifically evaluate your insurance needs. 

Just ask - What if the earning member had not passed away? Then, the family would have received a salary every month, which in turn might have grown every year till his or her retirement. And part of that salary would have been spent towards household expenses while the rest invested towards various financial goals like retirement etc.

Now, if the earning member dies prematurely, there is the loss of income which needs to be considered if the family has to maintain their lifestyle.

Using the above method, you calculate the total income that the individual is expected to earn over his lifetime. And it is discounted at a risk-free rate of return to arrive at the current value of all the future income. 

Should you buy insurance if both husband and wife are earning?

Yes. Assume a husband earns Rs 30 lakh per annum (LPA) while his wife earns Rs 20 LPA. In this scenario, the couple would get used to a lifestyle that is powered by a joint income of Rs 50 LPA (30+20). In the absence of a life cover, the demise of the husband would force the spouse to cut back on her lifestyle to Rs 20 LPA levels. 

Here is a step-by-step process to calculate your sum assured requirements:

1. Calculating income loss

You need to account for only that income which accrues to the family after paying taxes. So, if one’s annual gross salary is Rs 12 lakh, while take-home salary is Rs 10 lakh, you take the latter. 

2. Personal expenses

If we calculate insurance requirements purely on the basis of income, we will be overshooting a bit. That’s because a part of the income was serving the needs of the insured (say office transportation expenses) and that won’t be required anymore. 

For a couple, we cannot assume personal expenses to be half for each since a lot of expenses are common (kind of fixed costs, say rent). Empirical evidence suggests that more the number of dependent, lesser is the share of the insured in the total household expenses.

3. Can earning members make a difference?

Yes. After all, a husband earning Rs 20 LPA and a wife also earning Rs 20 LPA will need less insurance as compared to another couple where only the husband is earning Rs 20 LPA.

Therefore a robust model should include two more variables - number of dependents as well as total earnings of dependents.

4. Number of income years

The next step is to estimate the number of earning years. While it is reasonable to assume a retirement age of 60 years, thanks to increased lifespan and advancement of medical technology, considering a higher age might also not be off-the-mark. If you assume a retirement age of 65 years, in this case, a 40-year old would have 25 years of remaining working years. 

So, the insurance cover required will be equal to residual working years multiplied by estimated net annual income loss? Not really. 

5. Income growth

Your salary also keeps growing over a period of time. 

Income growth has a component of inflation as well as that of real income growth. As real income grows, one typically tends to improve their lifestyle. If you want to do that, then you need to grow income by the income growth rate (say 8% annually).

However, if one wants to just maintain an existing lifestyle in case of an unfortunate demise of the earning member, then income needs to grow by inflation only (say 5% annually).

Accordingly, estimate the loss of income for each of the years till your retirement.

6. Discounting factor

Once you have estimated all the future income, it will add to a big sum. However, this income will arrive only over a period of time. So, you need to find the present value of all the future income by using a discount factor, which could be a risk-free rate of return (say 6.25% p.a.). 

By doing this, you will finally arrive at the value of the sum assured that you need to buy for your term life cover (see example in the table). The assumption is that if that amount is invested in a risk-free market instrument, it’s monthly interest should be good enough to fulfil the current expenses as well as investments required for future purposes.

Takeaway

Ignore thumb rules while deciding sum assured for your term policy. Rather, follow the above methodology to systematically estimate future income loss for your family. 

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