How Much Life Insurance Do You Really Need?

For years there have been many ways to evaluate how much life insurance you need. There has been a thumb rule that says that your life insurance should be some multiple of your annual income. While this thumb rule is good, a better way to evaluate is to use the Income Replacement Method. This is one of the best ways to calculate the insurance amount you need based on your current age, current income, expected growth in income every year and retirement age. The Income Replacement Method takes into consideration your current income and future income growth as well covers the most important reason for taking life insurance – securing your income in case of any unfortunate event. Let us understand each step of calculating the insurance coverage along with an example and the reason for that step. We will take an example of a 35-year-old person who is earning Rs 1.20 lakhs per month.

Step 1: Evaluate Contribution to Family’s Income : Based on the present income of Rs 1.20 lakhs per month, calculate how much is the contribution towards family and personal expenses. Let us assume Rs 20,000 of the income is spent on personal expenses and the rest of the salary i.e. Rs 1 lakh is for the family. So the monthly income that needs to be covered is Rs 1 lakh as the family will need this money for their regular expenses and savings.

Step 2: Calculate Total Income up to Retirement: If the retirement age is 60, then for the coming 25 years the family will receive income every month from the salary. This income also grows every year and hence it is important to consider annual growth in income. Usually, you can assume 5–8 per cent annual growth in income though a lot depends on the profession and profile. In our case, let us assume an average salary increment of 8 per cent every year. So, up to retirement, the total income earned will be Rs 9.51 crore.

Step 3: Today’s Value to the Projected Total Income up to Retirement : If Rs 9.51 crore is the total amount of income that will be earned up to retirement, how much will be the value of this amount if it is invested in a low-risk investment portfolio that generates 7 per cent per annum? This step ensures that if the life insurance claim happens today or anytime in the future, the claim amount can be invested in a low-risk portfolio and every month the family can withdraw Rs 1 lakh along with 8 per cent annual growth in this monthly withdrawal. So, today’s value of projected income up to retirement is Rs 1.75 crore. This amount becomes the insurance cover required as of date.

Step 4: Deduct Existing Insurance Cover and Add Outstanding Liabilities : Existing insurance cover has to be deducted from the above calculated insurance amount. If the existing life insurance is Rs 50 lakhs then the additional insurance will be Rs 1.25 crore (Rs 1.75 crore less Rs 0.50 crore). In case of no insurance cover, the required insurance will continue to remain Rs 1.75 crore. Many people may have an outstanding home loan which could be long-term in nature and therefore the outstanding loan amount should be added to the insurance cover as the responsibility of repaying the liability gets passed on to family members in case of the absence of the breadwinner. If there is an outstanding home loan of Rs 75 lakhs, this amount gets added in the required insurance. So now the total insurance required will be Rs 2 crore (1.75 crore less Rs 0.50 crore plus Rs 0.75 crore).

The steps to calculate total life insurance amount can be referred to in the below table as well.