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3 ways to calculate your insurance needs
Amar Pandit
February 21, 2007

Calculating how much life insurance you need is one of the most important financial decisions you will ever make. It should never be an isolated decision depending only on how much of a premium you can afford.

Having said that, there are many ways in which you can determine how much insurance you need.

Here we give you a few.

Income Replacement Value

This is one of the basic methods of insurance calculation and is based on your current annual income.

Insurance needs = annual income * number of years left for retirement.

Let's say your annual income is Rs 5,00,000. And you are 45 years old with 15 more years for retirement.

In this case your insurance cover equals Rs 5,00,000 * 15 = Rs 75,00,000.

Another way in which income replacement works is to multiply the annual income by 10 (also known as Income Replacement Multiplier).

Another variant states that the Income Replacement Multiplier changes with age. So between the ages of 20-30 years, the income multiplier is 5-10, and from 30 to 40, the income multiplier is 15-20.

It drops to 10-15 between the age of 40 and 50 and further to 5-10 between 50 and 60.

Some calculations also take into account any outstanding loan amount that you may have on your housing loan, personal loan etc.

Human Life Value (HLV)

This method of calculating life insurance is based on contribution that one makes and would have made to her/his family in case of sudden demise.

So HLV is defined as the present value of all future income that you could 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 through your planned retirement date.

Let's see this example for better understanding.

Ram is 40 years old and plans to retire at 60. His current salary is Rs 3 lakhs and is expected to remain same every year. His personal expenses, life insurance premiums that he pays and taxes are around Rs 1.25 lakhs. His contribution to his family is rest of his salary of around Rs 1.75 lakhs.

Here, Ram's Annual Life Value (his economic contribution to his family post his expenses) is Rs 1.75 lakhs.

Suppose Ram dies at 41, then the economic value  (namely Rs 1.75 lakhs) he would have added every year (from age 41-60) to his family is no longer there. So to protect this economic value, Ram can use life insurance as a safety valve so in case of his death, this economic value can come to the family.

Gross Total Income: Rs 3 lakhs

Less Self - Maintenance Charges: Rs 1 lakh

Tax Payable: Rs 10,000

Surplus Income Generated for Family: Rs1.75 lakhs

If this surplus income is capitalised at a discount rate (expected return rate) of 8 per cent per annum for 20 years, then the HLV will be = Rs 175,000*10.6 = Rs 18.55 lakhs.

In short, Human Life concept arrives at an estimate of insurance cover required as on date to protect the income earners' economic value to their families including their future earning potential and capacity.

This multiplier 10.6 above can be calculated using the Present Value Function in an Excel spreadsheet.

Go to excel spreadsheet; click on Insert tab; click on the 'Function' option; select function PV (that is the present value of your investment; it gives the total value of a series of future payments that is worth today).

A box opens up where in you can fill in the above values for rate (8%, that is the return one can expect over the next 20 years), period (20, assuming you will make payments for the next 20 years) and pmt (payment made every year and which cannot change during the next 20 years) and Type (a logical value which should be 1 at the beginning of the period; it becomes 0 at the end of the period, that is, at the end of 20 years).

Rate = 8 %

Period: 20 Years (Age 41-60)

Pmt: Rs 1 will give you this multiplier. If you put Rs 1.75 lakhs here it will give you the value of Rs 18.55 lakhs

Needs Analysis

In this method, you can assess your needs -- and the needs of your loved ones -- and make a calculated assessment.

The most critical factors are the number of dependents you have and their needs.

Other major factors to consider are:

• Loans
• Kind of lifestyle you want to provide to your family
• Provision for non-working spouse who would no longer get an income
• Child's education
• Child's marriage
• Providing for financially dependent parents
• Special needs
• Dreams and aspirations such as contributing to charitable causes

Once you determine the above factors, you run the following calculations:

1. Lump sum needs on Life to be Insured's death

a. Home loan payoff

b. Car loan payoff

c. Child's education

d. Child's marriage

e. Emergency fund post death

2. Monthly income needs

a. Monthly expenses

b. Income of Living spouse in case she earns, or rent or interest

c. Shortfall = (a-b)

Shortfall is a-b. Suppose, expenses are Rs 50,000 and spouse's income is Rs 30,000 post tax, then shortfall is Rs 20,000 (50,000-30,000).

d. Monthly income needs till child turns 21 or is self-sufficient:

e. Number of years to go: For the child to reach 21 and post that for the spouse till her age of 80 or 90 years

f. Annual income needs: Of spouse, children or dependents

g. Total income needs: Of spouse, children or dependents

3. Sum up the current invested assets and current life insurance cover. Now see how much this total differs by what you have calculated above. This will be the shortfall (considering that you die today) that you will need to get covered. But do note that invested assets exclude residence, car and other personal assets.

Picking the right one

The one that I prefer and is mostly followed by reputable financial planners for decades is the Needs Analysis Method. Once you determine the amount of life insurance need, just buy the lowest cost insurance plan that's available to you.

You should buy insurance after a thorough calculation of capital (lump sum needs on death such as paying off a loan, daughter's marriage or education) as well as the income needs of your family after you are gone.

Ask yourself: If something were to happen to you, what kind of corpus would your family need to maintain their current lifestyle, to fund your child's education as you had envisaged, retirement income for your wife etc.

Most middle-class individuals have insurance policies in the range of Rs 1,00,000 to Rs 10 lakhs. Some of the wealthier ones have more than this.

The question they need to answer is: How long would Rs 10 lakhs suffice?

Finally, remember that your insurance needs go down over a period of time. Hence if you find yourself with a sudden windfall or have accumulated enough wealth, then you can evaluate the need to altogether terminate your insurance policy.

Amar Pandit is a certified financial planner and runs the Mumbai-based firm My Financial Advisor