Introduction
Life insurance is one of the most valuable financial instruments that gives your family financial security in the event of your premature death. It serves as a cushion, so that your loved ones are able to continue their lifestyle and fulfill their financial commitments even without you.
One of the most daunting challenges, though, when buying a life insurance policy is finding out how much coverage they need. Although having too little coverage can mean that your loved ones are going to be financially burdened, too much coverage will result in the payment of unnecessary premiums.
To come to a well-informed decision, you need to start by evaluating your current finances, future commitments, and what assets you currently have. In this manual, we will guide you through a step-by-step calculation on how to calculate the right life insurance coverage that is appropriate for your personal needs.
Step 1: Understand the Purpose of Life Insurance
Before jumping into calculations, it’s important to know why you require life insurance. Life insurance has two main goals:
- Income Replacement: If you are the single or main breadwinner in your family, life insurance allows your dependents to maintain their lifestyle without financial hardship.
- Debt Protection: If you have existing loans, a life insurance policy will ensure your family is not left with a debt burden.
Life insurance can further assist in:
- Funding future expenses like education for children, wedding expenses, or retirement planning for your spouse.
- Paying for final costs, which may include funeral expenses, legal charges, and unpaid medical treatment.
- Leaving a financial legacy for your descendants.
Now that you have a sense of why you require life insurance, you can move on to the calculation.
Step 2: Consider Your Present and Future Financial Obligations
The initial step towards finding out your life insurance coverage is to look at your financial responsibilities. Both your current and future responsibilities should be taken into account. Here’s the division:
1. Exceptional Liabilities (Loans & Debts)
If you have outstanding loans, e.g., house loan, vehicle loan, personal loan, education loan, or credit card payments, your life insurance must cover such debts so that your family members are not left to inherit them.
Example:
- House loan: ₹50,00,000
- Vehicle loan: ₹5,00,000
- Personal loan: ₹3,00,000
- Credit card debt: ₹2,00,000
Total Outstanding Debt: ₹60,00,000
2. Your Family’s Daily Living Expenses
Your family will require money to sustain their day-to-day life, including expenditures such as rent, food, electricity, transport, medical expenses, and so forth.
To calculate:
- Approximate your family’s monthly expenditure. Let’s take it as ₹50,000 per month.
- Decide how many years your dependents will be in need of financial assistance. If your spouse is unemployed and your children are young, they will be in need for at least 15 years.
Annual Expenses: ₹50,000 × 12 = ₹6,00,000
Total Required for 15 Years: ₹6,00,000 × 15 = ₹90,00,000
3. Future Financial Goals (Children’s Education, Marriage, etc.)
If you have children, you must plan for their higher education and wedding expenses.
For example:
- Cost of higher education: ₹20,00,000 per child
- Cost of marriage: ₹10,00,000 per child
If you have two children, the total future expense will be:
(₹20,00,000 + ₹10,00,000) × 2 = ₹60,00,000
4. Retirement Fund for Your Spouse
If your spouse is financially dependent on you, you must make sure that they have sufficient money to live comfortably after retirement.
A good estimate of this can be ₹50,00,000 – ₹1,00,00,000, based on the lifestyle and life expectancy.
5. Emergency Fund & Final Expenses
Besides life insurance, it’s a good idea to have another emergency fund for unexpected expenses like medical emergencies, lawyer fees, or other unexpected financial requirements.
A rough estimate for this can be ₹10,00,000 – ₹20,00,000.
Step 3: Subtract Your Current Savings & Investments
Now that you have arrived at the total amount needed, subtract your current assets. These could include:
- Savings in bank accounts
- Fixed deposits (FDs) & recurring deposits (RDs)
- Mutual funds & stocks
- Employer-provided life insurance
- Provident Fund (PF) & gratuity
- Rental income (if applicable)
For example, if you have:
- ₹20,00,000 in savings
- ₹15,00,000 in investments
- ₹10,00,000 from employer-provided insurance
Total Assets: ₹45,00,000
Now, subtract this from the overall amount needed.
If your overall financial need is ₹2,60,00,000, your ultimate coverage need would be:
₹2,60,00,000 – ₹45,00,000 = ₹2,15,00,000
Step 4: Account for Inflation
Inflation depletes the purchasing power of money with time. If you are calculating the financial needs of your family considering today’s expenses, you need to account for inflation.
For instance, if inflation is 6% annually, a sum of ₹1 crore today will be worth approximately ₹50-55 lakhs in 15 years.
To make sure your family has the same lifestyle, include an extra 20-30% buffer in your coverage.
So, if your computed coverage is ₹2.15 crores, include an extra 25% for inflation:
₹2.15 crores + 25% = ₹2.68 crores
Therefore, you should ideally go for a life insurance policy of at least ₹2.7 crores.
Step 5: Use Quick Estimation Methods (Thumb Rules)
If you prefer the convenience of a quick estimate without detailed calculations, your financial experts suggest the following thumb rules:
- Income-Based Method
- If you have a dependant, your cover must be 10-15 times your yearly income.
- If you are unmarried, coverage can be 7-10 times your yearly income.
Example: If your yearly income is ₹10,00,000:
- Minimum coverage: ₹10,00,000 × 10 = ₹1 crore
- Maximum coverage: ₹10,00,000 × 15 = ₹1.5 crores
- Expense-Based Method
- Compute your family’s yearly expense × the number of years they will require financial assistance.
- Add all liabilities and future goals.
- Subtract existing assets.
Learning About Various Types of Life Insurance Policies
Having determined how much life insurance coverage you require, the next question is what kind of policy to select. Life insurance policies are available in many shapes and sizes, with each form designed to meet specific financial objectives and requirements. Below is a summary of the most prevalent types of life insurance policies:
1. Term Life Insurance
Best for: Those seeking high coverage at a low premium.
Key Features:
- Offers coverage for a specific period (10, 20, or 30 years).
- Pays a death benefit if the policyholder dies within the policy term.
- No maturity benefits if the insured survives the policy term (except in case of a return of premium plan).
- Least expensive and costliest mode of life insurance.
Example: A person of age 30 years can have a ₹1 crore term insurance for about ₹10,000 – ₹15,000 per annum.
Who Should Buy?
- New-generation working professionals who have dependents.
- Persons who have excessive financial commitments and obligations.
2. Whole Life Insurance
Best for: Individuals seeking lifetime coverage as well as savings advantages.
Key Features:
- Offers coverage for the whole life (99 or 100 years).
- Offers a death benefit and a maturity benefit.
- Has a cash value component that accumulates over time.
- Pricier than term insurance because of lifetime coverage.
Who Should Buy?
- Individuals looking to leave an inheritance.
- People who want life insurance with investment benefits.
3. Endowment Plans
Best for: Those who want both life insurance coverage and a savings component.
Key Features:
- Combines insurance and savings.
- Offers a maturity benefit if the insured survives the policy term.
- Lesser death benefit as compared to term insurance.
- Increased premiums in view of the savings element.
Who Should Buy?
- Those in search of guaranteed savings in addition to life insurance.
- Individuals who want safer investments.
4. Unit Linked Insurance Plans (ULIPs)
Best for: Investors seeking returns linked to the market in addition to life insurance protection.
Key Features:
- Offers insurance as well as investment in market-linked funds.
- Premium is bifurcated into life insurance and investment in equity, debt, or balanced funds.
- The return varies based on the performance of the market.
- Has a 5-year lock-in period.
For Whom To Buy?
- For persons who can adjust to the market risks.
- For long-term investors who require creation of wealth.
5. Money-Back Policies
Best for: Those looking for periodic returns along with life cover.
Key Features:
- Pays a portion of the sum assured at regular intervals.
- Provides a death benefit in case of demise during the policy term.
- Suitable for individuals looking for liquidity at different life stages.
Who Should Buy?
- Individuals requiring regular payments for future expenses.
How to Select the Right Life Insurance Policy?
While choosing a life insurance policy, keep the following points in mind:
1. Your Financial Objectives
- If your sole objective is financial security, term insurance is the ideal choice.
- If you wish to have insurance as well as savings, opt for endowment plans or ULIPs.
- If you require lifetime protection, opt for whole life insurance.
2. Your Budget
- Term insurance offers the lowest rates for maximum cover.
- Save or investment-enabled policies (ULIPs, Endowment, Money-Back) cost more.
3. Policy Duration
- If coverage is required till retirement, a 20-30 year term insurance is ideal.
- Whole life is more appropriate if you prefer to be insured throughout your lifetime.
4. Riders & Additional Benefits
- Critical Illness Rider: Pays a lump sum when you have a severe illness.
- Accidental Death Benefit Rider: Pays additional sum if accidental death occurs.
- Waiver of Premium Rider: Waives future premiums in the event of disability or critical illness.
Common Errors to Avoid When Purchasing Life Insurance
Underestimating the Coverage Amount
- Most people choose a lower sum assured to save on premiums, but this can make their family financially exposed. Always determine coverage based on your true needs.
Not Factoring in Inflation
- ₹1 crore today won’t be the same value 20-30 years later. Always account for inflation while calculating cover.
Postponing the Purchase
- The cost of premiums goes up as you get older. The earlier you purchase it, the lesser the premium.
Not considering Riders
- Riders supplement your policy cover at a small additional cost. Add critical illness and accidental death riders for enhanced protection.
Not Reviewing the Policy Periodically
Your financial obligations evolve over time. Check your cover every 3-5 years to make sure it is in line with your needs.
