How much insurance do i need and how to calculate insurance cover amount?
Let me start by telling you a story of my friend Rahul, who is under the impression that he is adequately insured. He is paying an annual premium of around Rs.1 Lakh under 3 insurance policies. He complains about the lower bonus rates and poor ULIP performance. When I calculated the sum insured under these 3 policies, the story was different. He is having a ULIP with annual premium of 50,000, where the insurance cover is Rs.5 Lakhs. In another Endowment Policy with annual premium of Rs.32,000, insurance cover is Rs.10 Lakhs. He is having another policy on the life of his wife with a premium of Rs.18,000 and a cover of Rs.6 Lakhs. I asked him a simple question – Is it enough to protect your family, when you are not around? In reply, Rahul told me that he does not know “How to calculate insurance cover” and how much insurance does he need?
What happens in case of his unfortunate death?
Since, he is the sole earning member, all the expenses are met from his income. Let us assume that the household expense including rent is around Rs.30,000/- pm. What will happen to his family members, in case of his unfortunate death, other than the psychological trauma? His family will get Rs.15 Lakhs from the 2 insurance policies, which is not sufficient to meet their basic needs. They will face financial crisis in the future. And guess who suffers in case of his death, HIS OWN FAMILY.
What can be done to avoid such situation?
Having enough insurance cover is the only way to avoid such situation for the family.
He must have a backup plan which can give his family the same kind of income even in his absence. He should have insurance cover,which is good enough to pay all loans outstanding and other major financial goals.
How to Calculate Insurance Cover Amount ?
To define, what is Enough Insurance, let`s see the monthly income & expenditure of Rahul.
The monthly household expense of Rahul is around Rs.30,000/including house rent. He is 30 yrs old. His family includes his wife and 2 sons aged 5 and 2. All of them are dependent on him. He has investments worth Rs.5 lakhs in Mutual Funds and PF.
In case of his death, how will his wife manage the monthly expenses and other financial goals?
The family requires at least Rs.7 Lakhs each (in today’s value) for the child’s education and Rs.5 Lakhs each for their marriages.
They need Rs.30,000 * 12 = Rs.3.6 Lakhs per year for household expenses. Imagine the family can manage to get 8% return on bank deposit.
Let Y be the amount of Insurance required for providing for the household expense alone.
Y x 8/100 = 3, 60,000 or Y= 3, 60,000×100/8 =45 Lakhs.
To this value, add Rs.14 Lakhs for the children higher education (Rs.7 Lakhs each) and Rs.10 Lakhs for their marriage expenses (Rs.5 Lakhs each). The total comes to Rs.69 Lakhs (45+14+10 =Rs.69 Lakhs) and this is the minimum insurance requirement for Rahul. You can deduct the current savings in Mutual Funds and PF of Rs.5 Lakhs and his current insurance of Rs.15 Lakhs from this to arrive at the net insurance required for Rahul. So Rahul should go for additional insurance of Rs.49 Lakhs. (69-15 -5 = Rs.49 Lakhs)
Effect of Inflation
To make the calculation simple, I have ignored the effect of inflation in the above calculation. If we assume the inflation at 6% and the risk free return from investments as 8%, the corpus required to ensure a payment of Rs.30,000 will be around Rs.1.04 Crore. I have assumed his wife is also aged 30 and taken a longevity of 75 for her. This Rs.1.04 Crore cover will ensure an inflation adjusted monthly withdrawal of Rs.30,000 till she is 75. If we go with this calculation, Rahul should insure his life for additional 104 Lakhs. (1 Crore+ 14 Lakhs+ 10 Lakhs – 5 Lakhs-15 Lakhs = 104 Lakhs).
If he insures for an additional Rs.104 Lakhs, his wife will get the amount of Rs.104 Lakhs from the insurance company in case of his unfortunate death. She will get another Rs.15 Lakhs from the existing insurance also. Along with the Rs.5 Lakhs savings in PF and mutual funds, she will have Rs.1.24 Crore with her. She can invest Rs.14 Lakhs for the child’s education, Rs.10 Lakhs for their marriage expenses and the balance Rs.1 Crore can be set aside for an inflation adjusted monthly income of Rs.30,000.
This shows that the adequate insurance cover for Rahul is not Rs.69 Lakhs but Rs.1.04 Crores. If he goes for this insurance cover, he can lead a peaceful life, because his family can continue the same standard of living even in his absence.
So before starting any investments, he should have this cover,the most important responsibility for him as a husband and as a father. He must understand that this is not an investment or for any monetary benefit later in his life, but it is for his family’s protection and welfare in his absence.
How to plan for this insurance cover?
The life insurance market is flooded with lots of insurance plans to select. He can go for Term Insurance, Endowment Policy, Money Back or ULIP.
Very high premium almost unaffordable!
Let us discuss the age-old Endowment Policy for Rahul for Rs.1.19 Crore. He is paying Rs.32,000 for a Rs.10 Lakhs policy. So, if he wants to go for additional Rs.104 Lakhs, it will cost him around Rs.3.32 Lakhs, which is not affordable.
So what he will do? He will go with a kind of cover for which he can pay premium easily. He is now paying now Rs.1 Lakh premium and is not possible for him to pay any more premium.
It might also happen that he is compromising on a lot of small things which are important at this moment in life, like buying a car, which they can’t buy because of the huge insurance premium commitment.
So what should he do?
Term Insurance Policies
He should go for a Term Insurance Policy. In Term Insurance Policies, the sum insured is payable only in case of death during the term of the policy. The premium is very low for Term Insurance Policies. Online term plans are available now, with lower premium. Rahul can discontinue the existing costly policies and can go for an online term policy for Rs.1.25 Crore. The annual premium for this will be around Rs.10,000 only. It is providing the basic need of good cover and low premium.
Go for a Term Policy of adequate value and invest the balance for long-term wealth creation.
Now Rahul knows, how to protect his family, when he is not around.
What is your way to protect your family, please share.