Life insurance is a type of insurance that provides financial aid to nominee/beneficiaries in case of death or critical illness of policyholder.
Life insurance does not provide financial aid for the loss of life. Life cannot be measured in terms of money. Companies provide insurance based on the earning capacity of the policyholder.
How much Life Insurance do you need?
We will discuss two methods:
- Thumb rule
- Need based Analysis
Determining life insurance based on thumb rule
Life insurance should be 10 times your yearly income and child’s education expenses.
If your monthly income is Rs. 60,000.
Currently you don’t have any child.
Then, life insurance should be 72,00,000 (60,000*12*10)
This rule doesn’t take into consideration family needs, existing liabilities, future expenses.
It is widely used method in personal finance domain. The logics used are very relevant and to the point.
It takes into consideration existing investment, liabilities, No. of dependents, expenses of dependents, till how many years dependent would start earning, child’s marriage, child’s education, special need etc.
Calculate onetime payment required in case of death of the insured:
- Loan payments
- Child education fees
- Child marriage fees
- Emergency fund after death
This are expenses which could be borne by the policy holder, if he/she was alive. But after death, such expenses should be taken care of and should be included in life insurance.
Calculate monthly expenses of the family in case bread earner is dead.
If other family member are also earning, that income should be reduced from monthly expenses. Assumptions are very crucial here. It will have a lot of effect on your life insurance value.
If you have a child of 2 years. The assumption may be made that at 23 years, he will start earning and monthly expenses can be taken care of by him. So, you should fund monthly expenses for 21 years only.
Generally, financial advisor makes this assumption after having a discussion with the client about their life planning and life values.
Calculate the current Invested amount and current life insurance cover.
Life Insurance needs= Lumpsum expenses (+) Monthly expense requirement (-) Existing assets and life insurance cover.
I have tried to give you logic. You can place your numbers and work on it.
Some Special cases:
I case you have a dependent, who is differently-abled, special care is required for them financially. You need to also allocate for medical expenses.
One time payments:
|Child education when he turns 20||10,00,000|
|Pending Home loan||15,00,000|
Suppose Ramesh’s, current Income: Rs. 50,000
In case of his death, Rs. 50,000 will be shortfall that should be replaced.
Ramesh’s wife income: 30,000
Net shortfall: Rs. 20,000 (50,000-30,000)
Rahul, child of Ramesh, is 5 years old. When he turns to 23 years, he will be able earn money. So, additional monthly income need is for 18 years only. After that, he would be bread earner.
Rs. 43,20,000 (20,000 * 12 months * 18years)
Spouse’s current age is 35. When Rahul starts earning at the age of 23, she would be 53-year-old and won’t be working any more. So, again there will be shortfall of Rs. 30,000 will be created for 27 years (7 years pre-retirement + 20 years post-retirement)
Rahul’s current Income= Rs. 40,000. So, shortfall of Rs. 10,000 (50,000 – 40,000)
I.e. Rs. 32,40,000 (10,000 * 12 months * 27 years).
Other Income Need: 13,40,000.
|Current Investments:||Rs. 30,00,000|
|Existing life insurance policy:||Rs. 10,00,000|
Extra Life Insurance required = 80,00,000
Working: 31,00,000 (+) 43,20,000 (+) 32,40,000 (+) 13,40,000 (-) 40,00,000
(Step1 + step2 – step3)
For calculation of life insurance, I have not considered Inflation. Calculations will become too complex and it would be difficult to show here. Anyone, important is to understand why such calculation is done rather than going with exact numbers.
Life insurance requirement will change every year. Every year new investments will be made, the loan will be repaid, expenses will increase. So, life insurance should be monitored continuously.
Some useful tips:
- Buy term plan early. The premium for young people is low compared to older people.
- Go for highest age available for the term plan period. If at 25 years you buy insurance till 60, then later at 60 premium amounts will be too high to afford.
- Don’t keep more than 2 to 3 life insurance policy in your portfolio. Too many policies do not make sense and it will be burden on your family.
- If you don’t have any dependent, you don’t need life insurance. Many people are doing this mistake by taking life insurance of their children
- Make your family member aware of insurance policies. Otherwise, all your efforts will be wasted. Because your family member won’t know how to use insurance amount.
- Talk with your family, that in case of your death, how insurance amount should be used. Tell them to contact the insurance agent in case they don’t understand it claim procedure.
- The tax benefit is just complimentary. It should not be base for buying a life insurance policy
There cannot be standard answer how much health insurance you need. It depends on lot many factors. I am trying my best to generalize it. But believe me, working with a financial advisor will help you a lot. These days you can get financial planning services at a cost of 15,000 per annum.
Anyway, let’s discuss different methods we can use to determine health insurance.
Firstly, you should be aware of your family medical history. Is it that your great grandfathers and grandfather had a critical disease? Chances are that heredity may continue.
Also consider the city in which you live and medical facilities available. If you prefer to go to Apollo, you may incur more expenses. So, hospitals also play an important role.
Methods to determine health insurance:
- Premium Payment
It is important to note that you can’t pay a large sum of money in premium. So, premium payment capacity is an important aspect to look after.
Health insurance premium(per year) should be equal to 2% of your annual income.
- Annual income percentage
This method suggests that you should have health insurance equals to your annual income.
- Past medical expenses
As per this method,
You should have a certain portion of your annual income and previous years medical expenses.
Health insurance amount= 50% of your annual income (+) previous 2 years of medical expenses
I have discussed all three methods. Choose whichever is suitable to you.
Today’s mail was lengthy. I tried to keep all the concepts as simple as I can. Understanding this concept are very important if you are planning for F.I.R.E. (Financial Freedom & Retire Early).
Do comment your learnings.
(This article is part of my 7 Days email series course on Personal Finance Blueprint)