How Much Life Insurance Do I Need Rule Of Thumb?

If you are a breadwinner of your family and your family members are financially dependent on you, then you must have life insurance but How Much Life Insurance Do I Need? This is the first and the foremost question everybody has in their mind before taking the life insurance policy. Taking inadequate or insufficient policy not only deter the purpose of taking the policy but also result in a waste of money in terms of premium paid over the years.

The main purpose of taking a life insurance policy is to financially protect or safeguard your family or dependents at the time of the unfortunate event. So ascertaining the right insurance cover is as important as choosing the right insurance provider. There are multiple factors to consider while deciding the insurance cover but in general, three approaches are followed to decide the life insurance cover one should buy.

1. Income Approach
2. Expenses Approach
3. Capital Approach

Life Insurance Cover Calculation

Income Approach

Income approach for calculating the required life insurance cover simply takes the annual income/earning of the breadwinner into the account and as per the thumb rule, the insurance cover should be at least 10 to 12 times of the annual income of the breadwinner of the family. So in case the annual earning of the breadwinner is around ₹ 12 lakhs per annum the minimum insurance cover one should have is ₹ 1.20 crores to ₹ 1.44 crores.

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However, there is another rule which talks about Human Life Value (HLV) which says the insurance cover should be sufficient to the cover till your younger child completes the basic education i.e. till the age of 22 years in India. So as per this rule if the current age of your younger child is 7, the insurance cover should provide cushion to your family for 15 more years i.e. insurance cover should be ₹ 1.80 crores (₹ 12 lakhs for 15 years).

Apart from the above, the insurance cover may be enhanced by the amount of any major expenses like child marriage or personal debts. Suppose if breadwinner having personal loans amount to ₹ 40 lakhs and would like to save ₹ 35 lakhs for child marriage then the total insurance cover would go up another ₹ 75 lakhs.

Expenses Approach

Under Income Approach the whole income is considered for calculating insurance cover which also includes savings (if any) from the current income of the breadwinner. On the other hand Expenses, Approach takes only the current monthly or annual expenses including all the EMIs, child education and personal debt, etc. for calculating insurance cover. For example the current annual income of breadwinner is ₹ 12 lakhs but day-to-day annual expense are ₹ 6 lakhs i.e. ₹ 50,000 per month and having personal loans amount to ₹ 40 lakhs and would like to save ₹ 35 lakhs for child marriage then one need to take insurance cover of 10 to 12 times of the annual expenses in addition to the value of the personal loans, and child marriage expenses which comes to around ₹ 1.47 crores.

As per Human Life Value approach is considered, continuing the above example, the insurance cover should be ₹ 1.77 crores (₹ 6 lakhs for 15 years in apart from major expenses of personal loans and marriage as cited above), if both are to be included the insurance cover may boost up to ₹ 2.52 crores.

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Capital Fund Approach of Calculating Life Insurance Cover

The reverse calculation for the requirement of the funds is to be done under a capital approach for calculating required life insurance cover. Suppose you need ₹ 1 lakh per month which includes all your day-to-day expenses, EMI, child education, etc. and apart from this you have personal loans amount to ₹ 40 lakhs need ₹ 35 lakhs for child marriage and do not have any other income generating assets, and then the insurance cover should be equal to the amount which can yield ₹ 1 lakh per month at 7% p.a. comes to ₹ 1.72 crores plus the extra expenses of ₹ 75 lakhs totaling to the insurance cover of ₹ 2.47 crores.

Life Insurance Cover: Inflation Factor

You must be wondering what I have not considered inflation while arriving at the insurance cover in any of the above options. Here is the inflation factors comes into the calculation, we consider that the income or insurance amount grows at 7% p.a. and inflation would remain at 5% p.a. So the above calculation changes as follows:

Points to Ponder

You should also take into account that if your family members have individual earning capacity and are not dependent on you or you belong to a wealthier family and have other income generating assets then you don’t need to go for higher insurance cover because the need of protection is relatively low.

The maximum need for insurance cover is at the mid-phase when one gets married and has kids. As the age passes by the required amount of insurance cover also reduces due to a reduction in the expenses. In simple words, the one may go for the insurance cover equal to the difference between the asset-level and the need-level.

“Larger the gap between Asset-level and Need-Level, higher the insurance cover required and vice-versa.”

Also note that there may be chances that you may not get the calculated insurance cover as above because insurance companies consider several factors before proving insurance cover such as income, income sources, habits, history, family health history, etc.

Words of Caution

Do not ever mix insurance with investment. You should always remember that insurance is protection and should not be done for returns because returns are meager when you mix insurance with an investment such as in ULIPs, endowment plans. The IRR of these plans comes typically to 5% and if you see in longer time horizon, you may find negative returns if you take inflation into the calculation. Always go for Plain/Vanilla term plans for life insurance cover.