Having a term life insurance policy is of extreme importance as it gives a financial cushion to the family / dependents in case of early demise of the bread winner. However, the most important question after one realizes the importance of having a term life insurance is "How much insurance cover one should buy?”
Now you can google this & get many articles & thumb rule formulas but none of that critically analyses the situation of person taking insurance along with his other financial commitments. Keep in mind that the ultimate reason of buying a term life insurance is to cover following things in case of untimely demise:
1) Passive income to provide for the basic needs of family.
2) Provide for the unfinished goals: Child education corpus, Child marriage corpus etc.
3) Provide for the outstanding liabilities: Home loans, car loan etc.
We have discussed about basics of term life insurance, who should buy term life insurance & when you one buy it in our previous post: Consider these 3 parameters carefully before buying life insurance
In the current post, we will discuss about the factors to be considered while determining the amount of term life insurance.
Passive income for basic needs of family
In case of demise of the sole bread winner, the very immediate problem that would arise is how the family would take care of their day to day expenses. Hence, the first part of term insurance should be to create a corpus that ensures a passive income that could take care of these day to day expenses.
Calculate all your monthly expenses like rents, household expenses, salaries for domestic help & drivers as well as annual expenses like school fees, property taxes, health insurance premiums etc.
Divide this amount by a post tax fixed deposit rate. Let us assume a fixed deposit rate of 5% of the sake of simplicity. This is the amount of corpus the family would need for basic survival.
Eg: Mr. A's monthly household expenses are Rs. 50,000 & lump-sum annual expenses are Rs. 1,00,000. Hence, the basic survival expense = Rs. 7,00,000 (Rs. 50,000 X 12 months + Rs. 1,00,000). So the term insurance required for this would be Rs. 1,40,00,000 (Rs. 7,00,000/5%)
Provision for unfinished life goals
This fund will ensure that all the planned goals are taken care of even when the income earner is not around. Suppose a goal of child education worth Rs. 50,00,000 was planned through regular investments but those investments stopped due to untimely demise of the insured. The term insurance should also have this goal amount as a part of coverage to mitigate the risk.
Provision for outstanding liabilities
To ensure that the family is not burdened with the debts, one should cover the outstanding loan amounts in term insurance policy. Most common type of loan would be a home loan. Home loan is of long-term nature & runs for 20-25 years. Usually the amount of home loan is quite high and this could put a financial burden on the family in case of unfortunate demise of income earner.
Finally, you take take a stock of your complete investment portfolio as those would be your financial assets that can be used in above circumstances. Mutual funds, equity shares, fixed deposits, post office schemes, cash in bank, cash in hand etc. are the financial assets. You should add up all these amounts & reduce it from the above total as this amount is already there with you.
Do not consider the value of your house in the financial assets as you don't want your family to sell the house & pay off the liabilities.
Let's take an example to calculate the term life insurance required by Mr. B with following details:
- Monthly expenses: Rs. 40,000
- Annual expenses (one time): Rs. 1,20,000
- Outstanding home loan: Rs. 40,00,000
- Child education goal: Rs. 30,00,000
- Child marriage goal: Rs. 10,00,000
Investments
- Fixed deposits: Rs. 5,00,000
- Mutual Funds: Rs. 10,00,000
- Savings account: Rs. 3,00,000
- Cash in hand: Rs. 2,00,000
Cost of basic survival = Rs. 6,00,000 (Rs. 40,000 X 12 months + Rs. 1,20,000)
Assumed rate of Fixed Deposit = 5%
Corpus required for survival = Rs. 1,20,00,000 (Rs. 6,00,000/5%)
Outstanding home loan = Rs. 40,00,000
Child education goal = Rs. 30,00,000
Child marriage goal = Rs. 10,00,000
Total financial commitments = Rs. 2,00,00,000
Total value of investments = Rs. 20,00,000
Total amount of term life insurance required = Rs. 1,80,00,000
Tip: We have not taken into account the rising costs due to inflation, one can take a conservative approach by increasing the above amount by 10%-15% to provide for rising future costs. Also this cover should be reviewed periodically to check if there has been an addition in any of the above commitments & top-up the cover if needed.
CA Rohit J. Gyanchandani is Managing Director, Nandi Nivesh Private Limited, A Pune based Wealth Management Company.
