Very few people get this right. You will soon know why.
The big idea behind insuring your life is to provide enough and more to your dependents so that they need not bother financially, in your absence.
This problem can be approached with 2 methods.
- One, Income Replacement method
- Expense Replacement method
Income replacement suggests that your dependents should get as much as you would have likely earned yourself, if you were alive and continued to make the contribution.
Then there is the expense replacement method. As per this method, all the key regular expenses as well as the big goals, including payment of any loans, has to be provided for in your absence. Inflation has to be taken into account too. This is a more realistic approach, in my view.
Calculating Life Insurance cover required
For your reference, here is the excel workbook, you can use to calculate your own required life insurance cover. We discuss the 2 methods subsequently with illustrations.
Method 1: Using Income Replacement
Have a look at the following illustration.
As you can see, the current annual income and a growth rate on it is used to calculate the lifetime income. You deduct any insurance cover already taken as well as existing assets and investments to arrive to the balance life insurance cover required. The required additional sum assured in this case is approx. Rs. 1.87 crores.
Method 2: Using Expense Replacement
As you can note, the driving factor here is the expenses – regular as well for major events such as Kid’s education / marriage, etc. The required additional sum assured in this case is over Rs. 2 crores.
This also appears to be the correct number to target. Use the excel calculators to find out your own number. This is one of the most important things you will do today.
So, why do most people get this wrong?
Because they don’t use the method and rely on opinion, salesmen, gut feel or thumb rules, which is good to start but not enough.
Another important point. When we underestimate the insurance requirement, our product selection also tends to go haywire. Once you know the right life insurance cover to have, your only choice will be a Term plan and not an endowment, money back or ULIP.