How much life insurance cover is sufficient for you?

Does your life insurance agent/advisor ask this very basic question before offering insurance cover?

Sadly, the answer is no in 98 per cent of the cases. Agents just get down to the business of selling products which earn them high commissions. More on that in my next article. Here, the basic point is that without getting a holistic perspective on your financial profile, an insurance product is sold to you. The end result might be you pay huge premiums and still remain underinsured.

 This article aims to educate you to determine life insurance cover on your own. A most common formula used is insurance cover equivalent to five or ten times the annual income.  However, this formula may not be relevant in most cases as individual needs and requirements differ. (For e.g., a permanent disability cover would be suitable for a single working woman with no dependants than a life insurance product.)

What is required is a more holistic method to estimate insurance which will which not only help to pay your ongoing household costs but will also cover liabilities and children’s future goals in your absence. All these can be subtracted from your liquid assets and existing insurance to arrive at a rough estimate of your life cover. Outlined below are seven steps to assess life insurance cover:

Step 1: Present value of future requirement, estimating family and home maintenance expenses :

A.Annual food, clothing, fuel, enterntainment, maid,utilities,repairs,maintenance, health insurance,medical costs and other personal expenses.

B.Number of years

C.Inflation rate

D.Investment return rate

E.Real rate of return (Inflation adjusted)

F.Total lump sum  to cover

Note: First we calculate the future value of total annual expenses with (I as inflation and N as the number of years). We then discount this future value with real rate of return to arrive at the present value of annual expense. We use real rate of return to calculate present value assuming that the proceeds of the insurance cover will be invested.

 Step 2: Estimating children’s education expenses:

              G.Education expense per child (school, college, post-graduation)

          H.Number of children

          I. Total Children's Education Fund (G+H)

Step 3:  Estimating children's marriage expenses :

          J. Total marriage expense per child

          K. Number of children

          L. Total Children's Marriage Fund (J+K)

Step 4:  Existing Liablities :

          M. Outstanding home/car loan debt

          N. Outstanding credit card debt

          O. Other liabilities

          P. Total existing debt (M+N+O)

Step 5: Total Expenses :

          Q. Sum of all expenses (F+I+L+P)

           Note : To keep things simple, inflation for school, college, higher education and marriage expenses has not been considered here.

Step 6: Present value of existing liquid assets and insurance cover :

          R. Existing Life Insurance Cover

          S. Gratuity, Provident Fund Balance

          T. Savings Account Balance

          U. Other liquid investments like Shares, Mutual Funds,  Bank Fixed Deposits

         V.Total liquid assets and insurance cover (R+S+T+U)

Step 7: Recommended Life Insurance Cover (Sum insured)

            Sum of expenses less existing assets and insurance cover (Q-V)

The figure arrived in Step 7 will give you an approximate idea of how much insurance you need to have.If the number arrived in Step 7 is positive, then you need not purchase additional insurance.

The insurance cover calculation involves a lot of assumptions. And, these assumptions are sure to change with time. So don’t get hung up on details. It is easy to get a big life cover but if you are over-insured, you are paying a lot of extra money over 15-20 years.  So, review your insurance needs periodically to make sure you are not over or under-insured.