How much life insurance do you need?

This article was first published in May 2020. We are now republishing this for the benefit of newer subscribers.

One of the very first questions you’ll be faced with after deciding to buy a life insurance plan, is – What’s the size of the term cover (what insurers call the sum assured) you’ll need?

Most folks don’t put much thought into this and go for the nice round number suggested by their insurance agent, which is usually Rs 1 crore. You can online calculators, but they can throw up widely diverging numbers.

For a 45-year old woman with Rs 15 lakh annual income, one insurer’s website suggested a term cover of Rs 1 crore, while another plumbed for as much as Rs 3 crore. Such numbers are based on the thumb rule which says that you simply need to multiply your annual income by a factor of 10, 15 or 20 to get to your desired insurance cover.

But given that your term insurance is unique to your life situation and family needs, it pays to put a little more thought into it. A very small number may leave your family under-prepared. A gargantuan one will be a needless drain on your savings, given that annual premiums you pay won’t come back.

If you are willing to put a little bit of maths into it, here’s a three-step process to arrive at a customised cover.  

There is a term-insurance requirement estimation calculator based on the process in this article. Check it out here: Term Insurance Calculator

Replacing income

The primary purpose of a term life cover is to replace your contribution to your family finances. The lumpsum that the insurer pays out needs to be sufficient to ensure that your family or dependants miss you, but don’t miss the money you were bringing home in the event of your death.

Therefore, the first step to calculating the size of your term cover is to estimate the monthly expenses your family or dependants need to maintain a reasonable standard of living in your absence. Here’s how you can arrive at this number:

• First, reduce your own contribution to the household expenses. If your household presently gets by on Rs 1 lakh a month and your personal spends are Rs 30,000 a month, you should budget to replace Rs 70,000 a month through a term insurance plan.
• If your spouse or other family member is contributing towards those expenses, you can deduct that from the required amount.
• Multiply these annual expenses by the number of years left in your working life, to arrive at the cover. This is the period for which you are looking to replace your income.  

To illustrate, take the case of Mr Rao who is currently 40 years old, has 20 years to go to retirement and has estimated his family’s expenses at Rs 100,000 a month, Rs 30,000 of which goes towards his own expenses.  A good starting number for his term cover would be Rs 1.68 crore (annual expenses of Rs 8.4 lakh multiplied by 20 years of his remaining earning capacity). If he were only 30, he’ll need a larger cover because he’ll need to replace more years of income. If Mr Rao was 50, he’d need less.

While the above calculation assumes that Mr Rao’s family can get by on their current level of expenses for the next 20 years, you have to admit this is unrealistic, because he’s not budgeting for inflation. To get to a realistic term cover, therefore, it would be desirable to adjust your family’s expenses for inflation for the period for which they need income replacement.

In the above example, if Mr Rao budgets for 5% annual inflation, his family would start at Rs 8.4 lakh a year but end up spending Rs 21.22 lakh a year 20 years from now. Adding up the likely expenses for the family over the next 20 years after budgeting for inflation, leads to a term cover requirement of Rs 2.77 crore to replace Mr Rao’s contributions.

The above number can further be reduced if Mr Rao expects any of his dependants to stop relying on him in future. Suppose his 10-year old daughter can be expected to become financially independent by the time she’s 25, Mr Rao can budget for his family expenses to shrink by say, 20%, after year 15. If he has dependant parents with a remaining life expectancy of 15 years, that could call for downward revisions too.

Even without getting into such nitty-gritties, you can arrive at a reasonable term cover by simply extrapolating your family’ expenses for your remaining working years, using an inflation assumption.   

Meeting goals

The above exercise takes care of your family’s living expenses, but what about their financial goals that you were hoping to fund with your future savings? These need to be funded by your term cover too.

Let’s assume Mr Rao was investing towards a Rs 30 lakh education fund for his daughter Mridula’s graduate and post graduate degrees when she turned 18. His early demise will leave this goal unfulfilled. That’s clearly not acceptable.  So, this risk must be mitigated by adding in the unfunded portion of Mridula’s education goal into his term cover too.

Suppose Mr Rao had Rs 10 lakh already invested in his daughter’s education fund, he first needs to estimate how much this would grow to, at a conservative rate of return when the goal comes up. Assuming Mridula needs the money when she’s 18, there are 8 years to go to this goal.

At a 6% rate of return, the Rs 10 lakh Mr Rao has already invested would grow to about Rs 16 lakh in 8 years’ time. Should Mr Rao pass away today, Rs 14 lakh if his daughter’s education goal would remain unfunded. This should be added to his term cover requirement. Including this, his term cover need is now Rs 2.91 crore.  

Outstanding loans  

Having planned so meticulously to take care of your family’s lifestyle and goals, you would surely not want your family to be faced with unpaid loans on your behalf after your passing. This makes it important for you to include the outstanding portion of all your loans – home loan, vehicle, durable, personal and credit card loans – in your term cover requirement.

This will ensure that part of insurance pay out your family receives can be used to settle debts and start off with a clean slate. While estimating your outstanding dues, it is enough to have accurate estimates of large liabilities like your home or car loan. For smaller loans such as personal loans or credit card debt, you can use a ballpark estimate of the likely dues.

In the above illustration, let’s assume Mr Rao has a home loan outstanding of Rs 40 lakh and a car loan of Rs 5 lakh that he’s been repaying out of his income. This would jack up his term cover need by Rs 45 lakh.

But then, in the event of his demise, Mr Rao’s beneficiaries would probably stand to receive his provident fund dues and other payouts from his employer. They would also receive control of his investments and the cash in his bank accounts. These can be used to partly or fully settle Mr Rao’s debt. Therefore, these assets on Mr Rao’s balance sheet need to be netted out from his liabilities before assessing his term cover requirement.

Suppose Mr Rao had total PF and other savings of Rs 35 lakh to his credit (excluding his daughter’s college fund), his net dues after adjustments for assets would be Rs 10 lakh. Only this needs to be added to his term cover requirement. Overall, Mr Rao’s family would be well covered at a sum assured of about Rs 3 crore. This is the size of the term plan he needs to sign up for.

The above illustration also makes it clear that the quantum of term cover you need is not frozen in time. It needs to change with your life situation, number of dependants, income levels and liabilities.

Therefore, its not enough to buy a term insurance plan once in your life and pay premiums faithfully. You need to re-visit and add to your life insurance after significant life events, to ensure that you have enough cover to keep your family protected.

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