Firstly, it is important to understand that you need life insurance only if one or more persons are financially dependent on you. If you don't have anyone who benefits from your income except your own self, you ideally don't need any insurance. Now if you do have dependents, the next question is how much insurance should you really have? While you may come across thumb rules such as ‘x' times your income or expenses, there is more scientific way to derive your correct insurance need.
There may be different ways of computing the coverage required but basically the objective of computation is to ensure that in your absence, your spouse (or any dependant) will have enough money to maintain a decent standard of living till her life expectancy, be able to pay off any outstanding liabilities and also be able to meet all critical goals such as the need to educate children, their marriage etc.
Let us take an example to understand the computation. Samrat, aged 35, is married with two children. His wife and children are dependent on him. Their annual expenses are Rs 6 lacs of which personal expenses of Samrat are around Rs 1 lac. They need to plan for certain critical goals such as education of both their children and their daughter's marriage. Samrat has recently taken a home loan of Rs 30 lacs. Samrat has an insurance of Rs 50 lacs, but he knows it is insufficient. Let us compute how much insurance does he need and what is the shortfall.
Samrat's wife's current age - 28 years
Her life expectancy - 80 years
Number of years till her life expectancy - 52 years
Current household expenses excluding Samrat's personal expenses - Rs 5 lacs
Inflation on household expenses - 6%
Rate of return expected - 8%
Present value of future household expenses (for 52 years) - Rs 1.68 crores
Outstanding home loan liability - Rs 30 lacs
Present value of critical goals such as education and marriage of children - Rs 55 lacs
TOTAL INSURANCE REQUIREMENT
Rs 2.53 crores
Money set aside for above goals - Rs 5 lacs
Existing insurance - Rs 50 lacs
SHORTFALL OF INSURANCE - Rs 1.98 crores
Some important aspects to relating to the above computation are -
The amount of Rs 1.68 crores basically means that if this amount were invested at 8% and the household expenses were drawn from it and these expenses increased at 6% annually, this amount would be enough till Samrat's wife is 80 years old.
Adding liabilities and current value of critical goals is important because these are over and above the regular household expenses.
Current investments towards goals, other investments and existing insurance can be reduced from the insurance requirement to find the shortfall.
Hence as seen above, the right amount of insurance for Samrat is Rs 2.5 crores of which can be reduced by his existing cover and his investments to find out the shortfall. Ideally, insurance requirement changes over a period of time and may eventually keep coming down as investments increase. Therefore, breaking the total cover into 2-3 policies makes sense since a policy may be discontinued if the cover needs to be reduced. This kind of cover can be bought only through term insurance to ensure that the premium payments do not result in a big hole in your pocket.
Treat life insurance premium as an expense to cover the risk to your life; expense is a sunk cost. Once you are adequately insured through a term plan, which is a pure risk cover, you can then look at investment options, whether in the form of insurance plans or otherwise.
Courtesy: Perfios Money Manager