So you want to buy a term insurance plan but are not sure how to calculate life insurance coverage you need?
Relax. This is a common situation. But rather than buying blindly, you should know how how much life insurance cover you exactly need. Else, you may end up being under-insured or over-insured, giving your family a lot of financial pain.
A thumb rule that many advisors recommend is as follows.
- Age 25-35 years : 15-18 times current annual income + outstanding loans
- Age 35-45 years : 10-15 times current annual income + outstanding loans
- Age 45-55 years : 5-10 times current annual income + outstanding loans
But this is too generic – your exact requirement could be a little different. Let me show a more accurate way to calculate life insurance coverage. Rather than the income approach, this uses the expense approach. The difference is that this gives you a bare minimum amount of life insurance cover you should have, rather than a range.
Note : You don’t have to pull out any documents to do this calculation. Just do it in Excel or on a piece of paper. Or better still, use the Free Calculator given at the end of this article.
Information Required for Calculation
A = Current monthly expenses, say Rs. 20,000. Only actual expenses, not investments and savings. Say annual income is Rs. 7 lakhs without tax deduction.
B = Inflation. The unavoidable, important, bad fellow. 6% is what we will assume. But this is very sensitive. If you increase or decrease it by even 1%, the calculation changes drastically.
C1 = Current Age in years, say 32 years.
C2 = Retirement Age, in years. i.e. When you are expected to stop earning, say 60 years.
C = C2 – C1, i.e. No. of years to go for retirement. i.e. 60 – 32 = 28 years.
D = Large expenses you will have later in life. e.g. Marriage expense for a child after 15 years, higher education expenses for a child after 12 years, Medical emergency fund, etc. Remember to account for inflation. If you have more than one child, add the expenses appropriately. For this example, let us take a total large expenses requirement of Rs. 22,00,000.
E = Existing Savings. Add only financial assets such as Bank balance, FD, RD, Mutual Fund, Govt. bonds, Shares, Stock options and arrive at the total. For this example, let us take it as Rs. 14,50,000.
F = Existing Liabilities. Add all outstanding loans. e.g. you had taken a housing loan of Rs. 30 lakhs 6 years back, and as on date principal of Rs. 27 lakhs is still outstanding. Include that Rs. 27 lakhs. Similarly add auto loans, personal loans and any credit card balances. For this example, we will take Rs. 16,75,000.
G = Existing Life Insurance Cover. If you have already taken some life insurance earlier and the policies are still continuing, add up the life cover (Sum Assured, not the premium) of those policies and total them. Let us assume that is Rs. 10 lakhs.
To keep the calculation simple, we are not including…
- Fixed Assets and long-term savings such as house, car, land, etc. and jewelry – they will be needed later in physical form (your dependents will always need a house to stay) and should not enter our calculations. Also PF, VPF, EPF, PPF, NPS and other long term investment instruments meant for post-retirement expenses are ignored – let them stay as they are, they are needed for when they are meant to be.
- Post-retirement expenses are not included in calculations – your dependents (mainly your spouse) will need money to take care of themselves after retirement. This will be high because of inflation. However, this is ignored because in case death does happen, the insurance money is received immediately and it can earn good interest which can be reinvested to take care of retirement expenses later.
Here’s a list of term plans available in the market today. Choose one that suits your requirements the best.