Life Insurance - How much ?
Most of us are aware of the need for life insurance cover to secure financial needs of the family. Earlier, given the lack of choice of financial assets to invest in, one of the first financial commitments an individual would get into would be an LIC policy for his dependents. Since then, the insurance landscape has changed quite significantly - both on the supply side in terms of the number and nature of policies on offer, and on the demand side with both partners in the family often working and being fairly independent financially. It is the latter aspect that we deal with in this article. This demand side situation has implications on the amount of cover an individual would need to go for.
Most insurance agents and some write-ups advocate a multiple-of-income approach. For instance - a cover of 10 times annual income. While it is no one’s case that insurance cover required can be computed accurately to the last decimal (like, say, tax liability), we believe this simplistic approach is too gross an approximation and neglects some important variables that could significantly impact cover requirement. For instance, for similar income, the sole bread-winner of a family of four would think about his insurance need very differently from a double-income-no-kids (DINK) couple. We advocate an approach that would take not more than 15-20 minutes to calculate a more accurate range within which the insured amount should preferably lie.
The approach essentially consists of calculating Net Present Value (NPV) of relevant expenses and liabilities -current and those expected in future.
- Living expenses: With a working spouse, a cover of 12 months of family living expenses would often suffice. However, with a dependent family, we would have to project living expenses with 5-7% inflation for at least the next 10-15 years.
- Uncovered key milestones in next 3-5 years: Families would have several goals planned over the next 3-5 years - such as child’s education, marriage, etc. It is advisable to add any amount that is not already saved to the outstanding loan amount. The choice of 3-5 years is typically optimum. It often takes a family at least that long to overcome the financial shock of loss of a bread-winner. Also goals beyond this horizon cannot be foreseen with much clarity and often change if one of the family is not around.
- Outstanding loan values: Most loans are taken for assets that we use on a regular basis (such as house or car), which quickly become part of the family lifestyle. These are typically illiquid assets that yield much lower value on distress sale. Thus, the total of outstanding loan amount should be the another number that adds up in the total insurance requirement calculation.
For example, consider a DINK couple with dependent parents who want to move into a Rs. 40 lakh house in the next 2 years for which they expect to make an down payment of Rs. 10 lakh. Their living expenses are Rs. 50,000 per month.
The cover that the couple should take is should take into account the living expenses of their parents. At 7% inflation and 6% expected return on investment; the couple should take a cover of Rs, 90 lakh on this account. To that they should add the upcoming milestone of Rs. 10 lakh. Hence, they should take a cover of Rs. 1 crore between themselves. Typically, the ratio of the cover would be defined by the income of each individual.
After the total cover required is computed using the above method, we can net off all existing policy amounts. Here, it is again important to be cognizant of all existing insurance covers. For instance, home loans often have the insurance option at an additional cost, several employers contribute towards group insurance, many credit cards have attached life or accident cover, etc. Once this amount is known, the additional insurance to be taken can be determined.I = (Outstanding loan amounts: prepayment value) + (Needs of 3-5 year milestones) + (NPV of 10-15 year family living expenses) - (Employer group insurance)
This approach is a quick and yet reliable way to determine life insurance requirement. There are several refinements that can be made to this - but there might be limited value in additional accuracy. For instance, outstanding loans keep diminishing as the EMIs are paid, but this is roughly compensated with increase in lifestyle. Thus, one might not need to revisit the cover every year, but only when there are significant developments in the family - such as a new loan, birth of a child, etc.There is one exception, however, to this method of calculation - one that applies to people nearing their retirement. Here, NPV of liabilities based approach would typically overstate the insurance cover required, since the remaining earning potential would typically fall below this. Moreover, by overstating the insurance requirement, the premium needed is likely to become extremely high, since premiums increase rather sharply with age. Thus, for such a person, estimation of NPV of earning projections till retirement would be a better estimate. A prudent person should have saved the money for all his milestones prior to retirement.
Having decided the amount of insurance required, the next step is to opt for the correct scheme. Here, a Term Insurance policy is invariably economically better than a Unit Linked Insurance Plan, Endowment Plan or a Money Back Policy. We, however, leave a detailed comparison of these options out of the scope of this article.