How Much Insurance Do You Need?

Unpredictable investment and job markets are rough on retirement planning. They also complicate the issue of how much life insurance is right for you. Standard formulae – such as buying coverage equal to eight to ten times your annual income – are inadequate shortcuts. Online calculators tell you to raise your coverage even if you already have insurance.

The truth is that life insurance is a personal affair. Two couples may earn equal salaries, but it is silly to say that someone with four young children should have the same coverage as empty nesters with no mortgage and a substantial retirement fund.

Among the various financial decisions made in a lifetime, few are as complicated or as confusing as trying to determine how much life insurance should be purchased. Agents and brokers often push high coverage amounts that will be a big windfall for beneficiaries, but along with the huge benefits (both to the survivors as well as the broker) come significant premium costs. In fact, numerous surveys indicate that a large majority of individuals either have more coverage than necessary or are woefully underinsured.

Experts are of the view that the sum insured should be equal to an amount which, if invested at bank rates, should fetch a regular income for the dependants of the insured for them to be able to maintain their lifestyle. After considering the income side of the equation, the next step is factoring in future expenses. If an individual is responsible for any young children/dependents or is solely responsible for the support of a spouse, it is vital to have enough coverage to support them and their basic needs. Apart from these, another issue to consider is education expenses. Whether the intent is to fund an entire college education or only a portion, the policyholder must add this amount to his/her coverage total.

For example, if Mr. A has a housing loan of Rs 25 lakh, a car loan of Rs 6 lakh and his family requires Rs 40000 per month, the life insurance cover should be equal to the amount which will earn Rs 60000 per month (accounting for taxes) for the family and liquidate Rs 31 lakh towards his home loan and car loan.[PAGE BREAK]

In addition, the amount required to maintain the standard of living needs to be based on a comfortable projected monthly expenses indexed for inflation. If a person requires a certain amount towards monthly expenses, the actual requirement to be provided for in an ideal situation would be closer to 120 per cent of that amount to account for inflation and health-related expenses. For example, let us consider a male aged 30 years with current expenses of Rs 20000 p.m. who will retire at 60 years. Assuming an average inflation rate of five per cent p.a., his projected expenses at retirement will be Rs 87000 p.m. However, the average expenses per month during retirement at 120 per cent will be Rs 104000. Thus, the amount required at retirement will be Rs 1.90 crore (assuming no inflation and that the person survives for 15 years after retirement). The trick here is to start early in life, as the contributions required are lower and the power of compounding ensures a large body of savings.

Another method to calculate the amount of life insurance required is the Human Life Value (HLV) method. According to this method, one should buy insurance based directly on one’s economic value, otherwise known as the Human Life Value. In this approach, the effort is to estimate the future earnings of an individual and discount them with a reasonable rate of interest keeping in view the present inflation and bank rate. For example, suppose a person with a monthly income of Rs 20000 has personal expenses of Rs 6000. He would be able to provide Rs 14000 to his family every month. This translates into Rs 168000 on an annual basis. In order to provide this money to the family, he needs make an investment of Rs 2400000, which at a risk-free rate of return of let's say seven per cent, would generate Rs 84000. Hence, the HLV is Rs 24 lakh.

Yet another approach, usually called 'Underwriters Thumb Rule,' (UTR), wherein the life insurance need is calculated as a multiple of the individual’s annual income depending on the age (See table). As an indicative rule, for instance, individuals between 20 and 30 years of age should have life insurance worth 15 times their annual income, while those above 56 years of age can have insurance worth six times their annual income.

Age multiple of annual income as life insurance need:

Once the quantum of life insurance coverage is arrived at, you need to be clear about the reason why insurance is being bought. Safeguarding the needs of oneself/family, corpus building, income continuity and old age planning are some of the reasons for buying insurance cover.

Products which are suitable for buferring oneself/family from the potential financial troubles arising in the event of death, disability and dreaded diseases are term or whole life insurance with riders for critical illness, waiver of premium or accidental death benefit.

Corpus building plans include saving for children's education, marriage and/or getting them settled. It also includes saving for one's retirement. Suitable products in this category are endowment, money back and whole life plans.

Income continuity indicates that you have reached a stage close to retirement, where you have already accumulated a corpus and now desire to protect and grow it in a tax-favoured manner. Short-pay endowments, pensions and single premium policies are products suitable for such needs.

Finally, the prospect of old age planning arises when an individual reaches such a stage in life when one does not anticipate future inflows and he/she has to provide for a regular inflow out of the monies that he/she has gathered over the years.

Once you have understood the purpose behind buying insurance and the product required, you have to choose whether to buy a unit-linked or a traditional policy. Unit-linked plans provide a combination of risk cover and investment, giving you the flexibility of choosing between debt and equity in the investment component. The downside is that they do not have any significant guarantees. Traditional plans have guarantees, and hence, there is no downside. Whichever plan you choose, risk cover should score over investments for a person with dependants. If possible, however, investments could also be factored in.

Insurance is one of those things which you don't really need until you really need it. By then, though, it's often too late if you aren't adequately protected. ‘Get insured adequately’ is a mantra that most insurance companies propagate. However, if you log onto their websites or approach an insurance agent, in all probability no one will have an answer to the question ‘How much insurance is adequate for me?’

While the answer is hard to come by, it is in your own interest to make an effort and ensure that you are adequately covered. Remember that you can forgo life insurance only if you have won a lottery or if you are wealthy enough. Otherwise, you will have to insure yourself adequately and re-evaluate your life insurance needs each time your life situation changes significantly to make sure that anyone who would be financially affected by your death is taken care of.