How much life cover do you need? Here's how you can calculate the amount

Twenty-five-year-old Chandru, who is employed in a reputed firm, earns around ₹30 lakh per annum. He is married and his wife is pregnant. Until recently, Chandru had not taken any life insurance coverage. However, keen to protect his family in case something happened to him, he approached an insurance agent to discuss a life insurance product.

After describing various products, the agent suggested that he take a life cover for ₹3 crore. Chandru was curious about how the agent had arrived at that particular — and substantial — amount. The agent told him it was the standard rule — that life cover should be 10 times the person’s annual income. Chandru remained confused.

Wrong product, wrong cover

Often, a wrong product is suggested to clients: either it is inadequate or excessive coverage. The purpose of insurance is also not properly explained to clients. Very rarely is the right product with the right amount of coverage provided to the prospective insured.

Life insurance is clearly for the purpose of ensuring the financial safety of dependents of the breadwinner. It need not be a saving instrument. It may help a person to save tax but the main goal of life insurance is not tax saving but financial protection for the family.

The quantum of life cover required is similar to taking the right dosage of any medicine. An inadequate dosage may not help fight the disease, and an overdosage can  also be harmful with side effects. In the same way, a right amount of insurance is required, as lesser coverage will not serve the full purpose of protection and over coverage will be a wasteful resource.

Here are some of the wrong reasons people take or sell life insurance products:

Also read: Your insurance agent will never suggest a term plan; here’s why you should insist on one

For tax saving purposes

Many people approach insurance agents at the end of the financial year and are eager to take a policy to get income-tax exemption. At that point of time, insurance agents are also enthusiastic since they have to complete their sales target and their aim is to get the maximum amount of cover and maximum premium amount. This defeats the purpose of insurance.

Arbitrary amount

Many times, people take insurance for some arbitrary round figure like ₹25 lakh or ₹50 lakh, by way of endowment policies. In this case, the aim is to get back some amount (maturity amount plus bonus) at the end of the policy. Here, the purpose of insurance, that is, life cover, is sidelined and the approach is to save through an insurance product.

Cash flow availability

Some others calculate how much they can spend on insurance. Based on this amount, they take coverage. Here, the amount of coverage may be more or less. If it is more, that will be a waste of money. If it is less, then the purpose of insurance will not be served.

How to decide the quantum of coverage?

Now, let us check out the different methods by which amount of coverage required can be calculated:

Thumb rule

Most insurance companies promote insurance cover on the basis of the principle of 10 times a person’s annual income. That is probably the reason it has become a thumb rule. However, this is a bit arbitrary as well. Some insurance advisors are of the opinion that the minimum cover should be at least 15-20 times the annual income of the person who wants to get insured.

The basic purpose of insurance is to get indemnified against any loss. Though the value of human life cannot be quantified, the insured cannot be allowed to get coverage with any profit motive. That is why insurance companies specify restrictions on the amount of coverage.

For example, the restrictions can be on the following lines:

For adults 40 years and younger, coverage is limited to 25 to 35 times the annual income. For those aged 40 to 50 years, coverage is limited to 20 to 25 times the annual income. For those in the age group of 50 to 60 years, coverage is limited to 10 to 20 times the annual income. For senior citizens aged 60 to 70 years, coverage is limited to five times the annual income.

Also read: ULIP is not efficient; term insurance plus MF is a good alternative

Coverage based on human life

Under this method, the coverage is based on the present value of all future incomes. If one knows the number of years a person is likely to earn, the average annual earnings during these years and the likely amount of personal expenses like taxes, cost of employment etc., the coverage required can be calculated.

For example:

– Earning years: 35
– Annual income: ₹30 lakh
– Personal expenses: ₹7.5 lakh
– Present value of ₹22.5 lakh (₹30 – ₹7.5) payable annually for 35 years, assuming an interest rate of 6 per cent, is ₹3.26 crore. This may be the coverage required.

Let not the math confuse you. Most websites of life insurance companies provide ready reckoners. If you feed the required data, they will let you know the coverage required.

Coverage based on needs

In this case, the present value of the different needs of the family are added. With this, the present liabilities are also added. The needs can also be grouped under cash needs, income needs and special needs.

One’s medical bills, funeral expenses etc., will be under cash needs. Income required for the family after the demise of the insured will be under income needs. Liability clearance, children’s education/marriage etc., can be categorised under special needs.

For example:

Cash needs like funeral expenses, medical bills, etc: ₹3 lakh
Income needs: ₹15,000 less pension of ₹4,000; ₹11,000 per month for 50 years; present value ₹21 lakh
Special needs: Liability ₹10 lakh
Existing assets: ₹22 lakh
Life insurance required: ₹3 lakh plus ₹21 lakh plus ₹10 lakh minus ₹22 lakh, which works out to ₹12 lakh.

Note that the figures have been arrived at as mere estimates and used just for explanation purposes. There are ready-to-use charts available on the net. Use the tools needed to make an informed, precise decision on life cover.

(The writer is a retired banker.)