Do You Need Life Insurance ? If Yes , Then How Much?

– By Meghashyam Sinkar
We have discussed about wealth protection in our earlier blog ( Click here to read it : Have you protected your non-material wealth ? ) . Life insurance is one of the part in wealth protection but the most important part of it . Off course it can’t replace emotional loss but can protect financial loss .

It is very usual for people to put off life insurance discussion . We come up with all sorts of excuse to avoid it or postpone it . Often , we see and realise that it is important but not urgent especially if our health is good .

Do you need Insurance?

Let us address below questions

  • What keeps you going to job or business every day ?
  • What keeps you think about the future ?

If it is your family , your love ones who are dependent on you . Then you need to answer “ what will happen to your family if you are not there ?”

Thinking deep on above question will give you the answer whether you need an insurance or not .

How much you need ?

This is mostly unaddressed question as lot of people simply take Rs 1cr or Rs 2cr of life cover without actually calculating how much they need .

There are different approach to arrive at the insurance amount .

1) Income replacement Value Approach 

Its say that you should take life insurance cover of 10 to15 times of your annual income. E.g. If someone is earning Rs 10,00,000/- of annual income then he/she should have the insurance cover of Rs 1,00,00,000/-  to Rs 1,50,00,000/-  .
Extended version is to add outstanding loan amount to above figure . Suppose there is a housing loan of Rs 35,00,000/- and car loan of Rs 5,00,000/- then Rs 40,00,000/- should be added to above cover amount .

However such random number or rule of thumb may not be the right way to calculate the insurance amount . It does not take person’s financial goals & responsibilities into consideration.

2) Human Life Value Approach 

It is most commonly used method to calculate life insurance amount . This calculation works on a simple formula of time value for money. Basically, it’s a present value of all the future income that you are expecting to earn in rest of the years till you retire.

e.g.  The person at an age of 34 who wants to retire at an age of 60 has net income ( salary/business) of Rs 25 L . The income growth rate is an average of  6% over these 26 years ( Retirement age minus current age ). Assuming his personal expense of Rs 5 L and the portfolio growth rate is 8% , the human life value would be calculated in excel with the function called ‘PV’ ( Present Value ) as below .

PV(rate,nper,pmt,fv,type)

Now  Rate = [( 1+g)/(1+r)-1] x 100

wherein g = Growth rate of portfolio in the event of death = 8%
r = Growth rate of Income = 6%

So , Rate =[(1+ 8%)/(1 + 6%) – 1] x 100 = 1.887 %

nper = Period for which his income is going to come which is Retirement age minus current age = 26 .

pmt = Income which is going to come to his family i.e. Net income minus his personal expenses = Rs 20,00,000/-

FV = 0 and  type = 1

If you put all these figures , then you get the PV as Rs 4,07,99,997/-. The person should deduct the existing life cover and financial assets which are liquid to arrive at actual life insurance amount . In absence of it , the life insurance amount is required as Rs 4,07,99,997/- .

This method still has its limitations as it is not easy to predict the income for next 20 – 30 years .

3) Goal Based or Need Based Approach

It is the most effective way of finding the right amount of life insurance . One can find it difficult to predict the future income but can be certain  about the cash flow requirement of his goals . It actually calculate the Net Present Value ( NPV ) of all the goals outflows which he / she wishes to cover . It is up to an individual to cover its which goals because goals can be mandatory , lifestyle or aspirational .

E.g.Mr. A has below goals

  1. Child 1 & Child 2 : Graduation goal and post graduation goal with an inflation of 10%
  2. Child 1 & Child 2 : Marriage goal with an inflation of 8% .
  3. Vehicle : Replacement of car every 8 years with an inflation of 5% .
  4. Household expenses :  increasing at an inflation of 8% every year .
  5. International vacation : planned at defined interval with an inflation of 5% .
  6. House refurnishing : planned after 6 years and inflation is taken at 7% .

Now the current expected value ( Today’s cost ) of these goals should be taken to their respective year of occurrence with mentioned inflation rate which will look like as below ( Please refer the table )

Then Mr.A needs to answer the coverage ratio of all these goals. e.g. Mr A wants to cover child education and marriage goal completely and vehicle replacement to 50% . Household expenses would be covered to 75% as Mr. X’s personal expense is taken as 25% .  Aspirational goal of international vacations is not covered by Mr. A . Similarly he needs to find out what & how much of the goal amount needs to be protected

Goals Calendar
Coverage
100%
100%
100%
100%
100%
100%
50%
75%
0%
50%
Calendar Year
Mr. A Age
Marriage
Vehicles
Others
Child 1
Child 2
Child 1
Child 2
Replacement / Upgrade
Household expenses
Internation Vacations
House Refurnishing
Graduation
Post Graduation
Graduation
Post Graduation
2018
40
-1496712
2019
41
-1631416
2020
42
-869219
-1778243
2021
43
-1938285
-534000
2022
44
-2112731
2023
45
-2302877
-647891
2024
46
-2510136
2025
47
-2736048
2026
48
-2982292
-437000
2027
49
-3250698
2028
50
-1670899
-1258309
-3543261
2029
51
-1837989
-3862155
2030
52
-2021788
-4209749
2031
53
-2223967
-1141247
-4588626
2032
54
-3057955
-1255371
-5001602
-984000
2033
55
-3363750
-1380908
-4281372
2034
56
-1518999
-4581068
2035
57
-2088624
-4901742
2036
58
-2297486
-2428770
-1859096
-5244864
2037
59
-5612005
2038
60
-2662648
-6004845
2039
61
-6425184
2040
62
-6874947
2041
63
-7356194
2042
64
-7871127
2043
65
-8422106
2044
66
-9011653
2045
67
-9642469
2046
68
-5158721
2047
69
-5519832

Now , the entire year wise cash outflows should be discounted to present (current )year with expected rate of return which will give the  Net Present Value ( NPV ) . This value is the actual amount of life insurance required to cover all the goals which Mr. A wants to achieve or fulfil whether he is there or not .

Note : 

  1. Insurance is not an investment . Its a protection . So don’t mix Insurance with investment or don’t confuse insurance over investment.
  2. Insurance is an expense and not an asset or savings. You are essentially renting insurance for the period of time ( insurance term ) your have chosen.

Remember that “you don’t buy life insurance because you are going to die, but because those you love are going to live” .

Happy Investing !!!