Life Insurance - How Much Cover Is Enough?

Life Insurance is not a one-size-fits-all financial product.

Once you are done with answering whether to buy or not to buy life insurance, you'll be confronted with another important question - how much insurance do you needall

Each family has different needs and different amount of assets. It needs no explanation that greater your financial needs, more insurance coverage you should opt for. But depending on the assets you own, the insurance coverage needed might be less. So, how much life insurance do you need? The answer isn't really how much life insurance you need... it's how much investment capital your family will need at the time of your death. The ideal amount of life insurance would allow beneficiaries and dependents to invest the insurance payout and then draw down the account over time to maintain the standard of living that they would have enjoyed had the income provider been alive and earning.

Insurance cover need is also dependent on your life cycle. Generally at the beginning of your career, you should have high insurance cover as there are not adequate investments to take care of exigencies. However, the insurance requirement keeps reducing over time as you keep on accumulating assets / investments.

You can use any of the three methods - ranging from rudimentary to detailed - to compute the appropriate level of life insurance coverage:

1. The Rule of Thumb OR Multiplier Approach

This is the most basic technique estimating your life insurance needs to be somewhere between 8 to 12 times of your annual salary. Remember, for calculations the net take-home income (after taxes) is considered as that is the real income you live on.

Though very simple to use, the approach lacks subjectivity and precision. If you think that multiplying annual income by 8, 10 or 12 gives you the right life insurance figure, think again! It is pure blind mathematics and fails to take into account your unique situation and financial obligations. What if you have outstanding home loan of 40 lakh and your thumb rule calculation says 60 lakhs insurance is enough? On the other hand if you apply the same logic on a person having a networth in excess of 100 crores, earning a couple of crores per year, he would require something around 15 to 20 crores of life insurance cover according to the thumb rule approach. But in reality, such a person may not require protective life insurance at all.

Hope you must be clear by now why using the multiplier approach is not a rational solution for computing life insurance needs. Life insurance is too serious a matter to be decided by a simple five second calculation. The 8x/10x/12x multiplier approach could be a good starting point for life insurance evaluation but it lacks the clarity and subjectivity needed for different clients with varying financial needs and net worth.

2. Human Life Value Approach

The human life value concept deals with human capital, or an individual's income potential. This approach tries to attach a financial figure to your insurance needs based on your future income earning potential. It works on a premise that the financial loss to the family due to demise of an earning member is equal to the loss in future income the deceased would have earned. Under this approach the required life insurance cover amount is calculated as the present value of all future income that you expect to earn for your family's benefit. It also includes other value you expect to contribute, less personal expenses, life insurance premiums and taxes till your planned retirement date.

The approach has its roots in 'indemnity principle' which is not applicable in case of life insurance policies. It doesn't take into account the actual needs and future aspirations of the family. The approach suits those with regular and predictable income. But, calculating human life value of a business man or a self-employed individual with irregular income is difficult and error prone.

3. Needs Based Approach

This technique computes the life insurance requirements of an individual based on their actual future needs (or expenses) like children's education, spouse retirement, emergency fund, debt / mortgage payoff etc. Under this approach, emphasis is on maintaining the current life style of the family into the foreseeable future. This approach ensures that all the current and future obligations of the family are sufficiently taken care of without any cutbacks.

This is the most detailed approach to life insurance as it requires some real thought to determine what expenses you need to cover and how much of those expenses are going to cost years (or decades) from now. You also need to evaluate the liquid assets you have in place. Once you have figured out the total future financial needs of your family in current value terms, you arrive at the final insurance figure by deducting the value of your current liquid assets.

The risk in this approach lies in underestimating the future expenses and hence under-insurance. Intensive nature of this approach makes it difficult to quickly arrive at a figure in a single sitting. Your family's income requirements could be disparate and spread along different time periods making calculations difficult. This is where an experienced Certified Financial Planner can help you with the computations and identifying your family's future needs.

Concluding Remark

Most of our clients were having insurance policies in the range of Rs 1 lakh to Rs 10 lakhs, a few had more than this but we are yet to come across any client being adequately insured. With this kind of life cover, the question one need to answer is: How long would that Rs 10 lakhs suffice? Remember that no survivor ever complains about receiving too much in life insurance benefits. You should try to strike a balance between what your family might need and what you can afford to buy.