How to Evaluate Life Insurance Needs
Decide on a cover for your term insurance that works for you as the one paying premium every year, and works for your dependents who should receive a large sum if something were to happen to you
Things to ponder over
Apparently, most people tend to be under-insured. That's because what generally happens is that they get approached by some Life Insurance agent who works on a commission basis that throws around some jargon(despite what the advertisements say, this still happens), shows you an amount that looks 'big enough' on maturity or death. You ask how much premium is required, you take a cursory look at your monthly savings and wonder if you can go for it, you arrive at a plan that you think is affordable and boom, you pat yourself for being a responsible adult. More often than not, it is NOT GOOD ENOUGH.
There are other things that happen too. Let's look at what happened with the Mumbai Terror attacks of 2008.
- 1.The Government announced a 2 lakhs compensation for the victims who were killed. 1 lakh for the ones who were seriously injured. Ask yourself this, how long will your family last on 2 lakhs?
- 2.A family member of a victim said in an interview "My brother had a policy but I do not know the details of the same or where he has kept it." This is a more common occurrence that you would think. People tend to take life insurance but keep the details of these to themselves. May be it's because of cultural reasons. (For example: I don't have a spouse, so when I announced to my parents that I had taken a life insurance and enlisted them as beneficiaries, my mother went 'Tu chup kar, aisi baathein nahi karte!' (Don't talk about such things). I just told my father about which company that I was insured with. They have no idea about the amount of benefit they are entitled to in the event of my death. For those of you who are insured, ask yourself this : Do you know exactly what amount of money your family will receive in the event of your death? and then Does your family know how much benefit they are entitled to and how to go about it?
- 3."Is terrorism covered?" On the life insurance platform, insurers pay the sum assured for basic life insurance in case of death due to reasons other than suicide. This means that a life insurance policy will pay in case of death due to terrorism. However Additional riders(for which you pay a little bit extra premium for), like personal accident (PA) rider, which usually pay double the sum assured, will not cover acts of terrorism in most cases. Major surgical benefit, too, may not be paid if a policyholder undergoes surgeries arising out of a terror attack. Ask yourself this, what are the different ways in which you could possibly die/get disabled, does your policy and additional riders cover all these scenarios?
Here's hoping that I now have your attention, we will now move towards the fundamental question, how much insurance do YOU need?
In my opinion(humble ofcourse), Life Insurance should not be about saving tax nor should it be about making an investment or maturity amount. It should quite simply be, a means providing for your family, protecting their lifestyle if you are not around and ensuring that the goals for which you have worked so hard are achievable if you drop dead. Which ofcourse implies that everyone's needs are going to be different.
Now there's multiple ways of doing this which have been broadly labelled as 'Income method', Human Life Value Method and 'Needs Analysis Method' . Let's start with my favorite:
Needs Analysis Method
Step 1: Determine the one-time expenses of your dependants (like clearing off your loans, siblings/children's education and/or marriage, etc.). Let's call this amount 'A'
Step 2: Estimate your dependant's annual recurring expenses. This is 'B'.
Step 3: Estimate survivor's annual income. Do your parents/spouse/siblings also work? Cool. 'C'
Step 4: 'B' - 'C' = 'D' (Annual shortfall)
Step 5: Multiply 'D' by the number of years you expect the youngest dependant or child to become independent and after that until your spouse is 80 or 90 years old. 'E'
Step 6: 'A' + 'E' = 'F'inancial Risk that you NEED to cover.
Step 7: Calculate the total investments and assets that you own. 'G'.
Step 8: Amount of current life insurance. 'H'
Step 9: 'F' - 'G' - 'H' = 'I'nsurance cover that you'll need to buy. If 'I' is negative, you don't have to do anything.
Now, the challenge with the above method is guesstimating exactly how much money you're dependants are going to need on a yearly basis. You will have to factor in inflation and the averate rate of return on your investments. It's a huge exercise but if you truly louve and care for your dependants and all that, it is worth the effort.
The Income method is more like a rule of thumb method and it goes like this.
Take your NET Annual Income and then:
If you are below 35 years, multiply it with 15.
If you are between 35 and 50, multiply it with 12.
If you are over 50, multiply it with 10.
That's it. The resultant amount should be the amount of cover you ought to have.
Human Life Value Method
This one's a little technical but shouldn't be a problem if you understand the concepts of Time Value of Money,
Life ProTip: Learn the concepts of Time Value of Money. If you have an average IQ, it won't take more than a day
The most common definition of HLV is the expected life time earnings of an individual, i.e. what is the total income that the individual is expected to earn over the remainder of his working life, expressed in present Rupee terms.
Step 1: Find your current income. Deduct all expenses. 'A'
Step 2: Find your remaining working life or Years left to retirement. 'B'
Step 3: Find the discounting factor rate. (For example, the rate of interest assumed for capitalisation of future income/salary growth rate). 'C%'
Step 4: Find out the present value of required income stream by using inflation adjusted return.
In Excel, this would be =PV(C%,B,A,0,1)
Once you've ascertained the amount of insurance you'll be needing, the next step is to evaluate the different types of insurance products that are out there.
Remember, Insurance planning is an integral part of your overall retirement planning which in turn is a part of your overall Financial Planning. You do not necessarily need a personal Financial Planner to get this right. One of the objectives of this subreddit is to ensure that you make all your financial decisions independently.
Here's hoping this post moves you into action. If it doesn't, just try not to die.