How much life insurance is adequate

The basic concept of life insurance is fairly simple. Most of us are familiar with insurance and own one or more life insurance policies. Yet there are several misconceptions and lack of understanding of various considerations in life insurance that we will aim to address in a series of articles. The most question as far as life insurance is concerned, is how much life insurance do you need? There are several factors that are relevant in determining the amount of insurance cover. We will examine those factors in this article, but before that we should touch upon some important points.

Do you need life insurance?

There is a misconception that everybody needs life insurance. If you have dependants you definitely need life insurance. However, buying life insurance does not make sense for everyone.

• If you have no dependants and do not plan to have in the foreseeable future, you do not need life insurance.


• If you are working and your spouse does not work, she does not need life insurance. The premiums that you will pay for her life insurance, is better invested in products that give much better returns


• If you have children, you do need to buy risk cover on the life of the child. You should buy adequate risk cover for your own life and invest systematically in child plan mutual fund or even in a diversified equity fund, to secure the future of your child


• If you are debt free and you have assets that generate enough income to meet all the financial needs of your family, then you do not need life insurance. We have to be careful here, of the definition of assets. If you own a house and are occupying it, it is not asset for this purpose, since you are not generating any income for your family. Let us illustrate with an example. Let us assume your annual income is Rs 10 lakhs and you have assets of Rs 1.5 crores. Assuming a post tax annual return of 8%, the income from your asset will be sufficient to meet your needs even after factoring 5-6% inflation. In that case, you do not need insurance. You are better off growing your assets by investing in products that give better returns.

However, if your family depends on your income or if you are carrying debt, then you will need life insurance. Now that you know whether you need insurance or not, and most probably you do, let us move to the next point.

Will you get life insurance?

A second misconception regarding life insurance is that, as you grow older it is harder to get insurance. Young policyholders are more profitable customers to the insurance companies because the mortality odds are low and some insurance agents deliberately create this misconception to get young people to buy insurance. But in reality it is not difficult to get life insurance as you grow older. As you grow older, your premiums are definitely higher than when you are young, and therefore it is definitely advantageous to buy life insurance when you are young. But if you need to buy insurance at any point of time, it is not difficult to qualify for insurance.

Now that you know that you will be able to get insurance, the next question is how much life insurance should you buy? Is it a good investment?

Life Insurance will help in meeting your retirement needs

The third misconception about life insurance is that, it is seen as retirement planning solution. If you compare returns from life insurance to other investment options, it simply does not make sense as an investment. If you are a young investor with a long time horizon, equity is the best wealth creation instrument. Over a 20 year time horizon, investment in equity funds through SIP will result in a corpus that is at least three or four times the maturity amount of life insurance plan with a 20 year term, with the same investment. Life insurance should always been seen as protection for your family, in the event of untimely death. Investment should be a completely separate consideration. Even though insurance companies sell Unit Linked Insurance Plans (ULIPs) as attractive investment products, for your own evaluation you should separate the insurance component and investment component and pay careful attention to what portion of your premium actually gets allocated to investments.

How much insurance cover should I take?

A large part of choosing a life insurance policy is determining how much money your dependents will need. You need to consider several factors in deciding how much insurance cover is adequate for you.

• How much debt do you have: If you are the single earning member of your family, your family will not be able to service the debt obligation, in the event of your untimely death. Home loan, car loan, credit cards and personal loans must be paid off in full. For example, if the outstanding principal balance on your home loan is Rs 25 lakhs and your car loan is Rs 5 lakhs, you need a minimum insurance cover of Rs 30 lakhs plus a little extra for accrued interest (not paid). If your spouse is also working, you should determine how much loan can he or she service, the balance must be paid off in full.


• Income needs of your family: This is the biggest determinant of how much life cover you need. In the event of death, the income earned from the investment of the policy pay-out (also known as sum assured) should replace your current income. For example if your current income is Rs 20 lakhs, assuming a post tax annual return of 8%, you will need an insurance cover of Rs 2.5 crores. You should always add an additional amount, as a guard against inflation. As a thumb rule you may add your annual salary as the additional inflation guard. Your total cover, including inflation guard, in the example above should be Rs 2.7 crores. So if you have loans of Rs 30 lakhs and an income of Rs 10 lakhs, you total insurance cover or sum assured should be Rs 3 crores.


• Future obligations: You also need to factor in your future obligations, like children’s education, marriage etc. For example, if you need Rs 5 lakhs for your child’s higher education, you should include that when you are calculating how much cover you require. So, carrying on the above example, if you have loans of Rs 30 lakhs, income of Rs 20 lakhs and you need Rs 5 lakhs for your child’s education, then your total sum assured should be Rs 3.05 crores

You can see the above method of calculating insurance cover factors in how much funds you will require immediately, how much funds you will require on an ongoing basis and how much will you require at a future point of time, in the event of an untimely death. To summarize, please see the chart below on how much insurance cover is needed in the above example (all amounts in Rs Lakhs)

Insuring other members of your family

If your spouse is working, he or she should also take life insurance cover based on the above considerations. As a rule, you should insure only people whose death means a financial loss to your family. The death of a child though emotionally devastating, does not imply a financial loss, and therefore as discussed earlier in the article, it does not make sense to get life insurance for your children, as long as they are dependent on you. There are better investment options to secure their future.

Conclusion

Getting adequate life insurance is one of the most critical requirements in your financial plan. It is very important that you understand how much cover you will require. Unfortunately, on an average most people in India are under-insured. It may seem to you, based on the premium rates of some insurance plans, that you cannot afford the premium. Fortunately there are lots of good options available for life insurance, like term plans, where premium rates are low. We will discuss more on various insurance choices in subsequent articles in this series. You can also discuss with your financial advisors, the various options available in the market for you to buy the cover that you need. As with investing, educating yourself is essential to making the right choice.