Deciding whether you require a life insurance plan is easy. If you have dependents relying on your income, or you have financial liabilities, you most certainly need life insurance cover. Once you have decided to purchase a life insurance policy, the next step is to determine the amount of insurance cover (or the sum assured) that you/your dependents will need.
Ideally, the sum assured amount should be able to (in your absence):
- Serve as a replacement for your income
- Cover your outstanding debts
- Support your family to maintain their standard of living
- Support your family to accomplish various life and financial goals
That said, you might find it difficult to accurately predict your family’s exact financial needs at the time of purchasing a pure life insurance plan (term plan). One of the ways to arrive at the required insurance cover is to multiply your annual gross income by 10 (by a higher value if you are a young investor).
However, this calculation may lead to a high ballpark figure which may not be the answer to your family’s financial realities and their dependence on you.
Hence, a more methodical approach to arriving at the appropriate insurance cover /sum assured is shown in the step-by-step guide below:
Step 1: Begin with expected future earning years
Consider the number of years starting from now that you expect to be earning. Since, life insurance serves as an income replacement tool, the years of income it needs to replace will impact the appropriate sum assured. For instance, if you are 30 right now and wish to retire when you’re 58 your future earning years is 28 which impacts the required sum assured.
Step 2: Chart out sum of all annual expenses
The objective here is to identify your likely recurring financial outgoes.
Factor in all current and ongoing expenditure such as rent, school fees, fuel bills, healthcare expenses, grocery and utility bills, and other miscellaneous (discretionary) expenses on hobbies and entertainment. Also consider, periodic spends such as vacations, gifts and purchase of white goods.
Your insurance coverage should be able to cover for these expenses on a year-on-year basis even as inflation leads to these outgoes increasing each year. Hence, a) Plot the recurring outgoes year-on-year including expected inflation, b) Calculate the present value of the same using current interest rates (say FD rates) for discounting.
Step 3: Account for major life stage goals and changes
Chart out the various landmark stages in life wherein your family might need large lump-sum amounts. These include weddings, higher education expenses, overseas travel, retirement, etc.
If you are already saving for the same through regular investment, add the expected recurring savings to the cash-flows plotted in Step 2.
Ensure you add the expected savings amount to meet your goals which may be more than what you are currently saving.
If you foresee an increase in the recurring expenses, add the same into the cash-flow projection. For instance, if you want to welcome your first child 3 years from now, the additional monthly expenses (e.g. additional rent, cost of child care etc.) that you would incur post your child is born should figure in your calculation.
Step 4: Add all liabilities, subtract savings and investments
Stack all your liabilities – car loan, personal loan, home loan, other debt — and add the amount to the present value calculated in Step 2 and adjusted for life stage goals in Step 3.
Subtract existing life cover (guaranteed death benefits of your life insurance policies), if any. Also subtract the value of your investment portfolio from this figure.
The final total that you will arrive at, by the end of this guide, should be the sum assured that you opt for when buying a life insurance (term) plan.
Human life value calculators are also available online can help you with your calculations to arrive at the insurance cover for your family.