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5 rules on how much insurance you need

July 18, 2008

If you are an earning member of your family, and there are members of your family who are financially dependant on you, you need life insurance. But how much life insurance do you need?

There are many factors that are relevant in determining the amount of life cover you should buy.

Need for minimum protection

It is essential that a particular level of income should be maintained for the family even when its breadwinner is not around. Suppose a family's present needs are Rs 25,000 p.m. The extent of life insurance for its earning members should be such that interest income from the sum assured can meet the family's monthly expenses of Rs 25,000.

If one also wants to provide for the future fall in the purchasing power of rupee due to inflation, one must necessarily take policies for higher amounts. No widow, they say, has ever complained that her husband bought too much insurance.

Current income level

Payment of insurance premium results in an outflow of disposable income. You may, therefore, not like to buy too much insurance. One might have to limit the quantum of insurance keeping in mind the cash flow problems that will be created as a result of the obligation of regular payment of insurance premia.

Tax benefits

You should also take into account the tax benefit under Section 80C.

Accumulating for specific needs

If you expect to spend a particular sum of money for the education and / or wedding of your children, you may like to buy an insurance policy for a specific sum to meet such a lump sum commitment.

Present age

Your present age is a critical factor in deciding the quantum of insurance that you can afford. The rates of premium go up with the advancing age of the life assured. Hence, one can buy more insurance for the same premium at a younger age than at an older age.

The final decision rests upon a careful consideration and balance of all the above factors. The need for minimum protection may be quite high, but the current need for disposable income may not immediately permit buying adequate insurance.

You then have to make a compromise and buy extra insurance as and when you can afford it.

The 5 simple rules

In the event of any misfortune, well-planned life insurance can protect your loved ones from financial difficulties. However, in most cases, people find it difficult to estimate the correct value of insurance they need.

Partly this is because life insurance needs change through different stages of life. Young people with no dependants may not have much need for life insurance.

As one's family responsibility grows, life insurance needs too increase. Thus, a periodical review based on your family circumstances is required in order to ensure that the coverage is adequate.

There are several simple methods available to broadly estimate your life insurance needs. Five simple rules are:

1. Income rule

The most basic rule of thumb is provided by the income rule which holds that individual insurance cover should be at least around eight to ten times one's gross annual income. For example, a person earning a gross annual income of Rs 1 lakh should have about Rs 8 to10 lakh in life insurance cover.

2. Income plus expenses rule

This rule suggests that an individual needs insurance equal to five times your gross annual income, plus the total of basic expenses like housing or car loans, personal debt, child's education, etc.

3. Premiums as percentage of income

By this rule, payment of insurance premium depends on disposable income. In other words, one should decide the quantum of insurance after meeting the regular outgo from salary.

From the first two rules, you can make a broad estimate of the minimum insurance you should have. The premium as percentage of income rule can help you fine-tune your cash flow by committing an appropriate percentage of your income for paying life insurance premium.

4. Capital fund rule

This rule suggests that if you need Rs 1 lakh p.a. for your family needs, and assuming you do not have any other income-generating assets, you may like to create a capital fund of Rs 12.5 lakh (Rs 1.25 million) which can yield Rs 1 lakh (Rs 100,000) annual income @ 8% p.a. You may therefore buy a life insurance policy of Rs 12.5 lakh.

5. Family needs approach

This rule holds that you purchase enough life insurance to enable your family to meet various expenses in the event of key earning person's death. Under the family needs approach, one has to divide his family's needs into two main categories: immediate needs at death (cash needs), and ongoing needs (net income needs).

Stage of Life

Needs

Assets

Initial stage. No family responsibilities.

Premature death leads to minimal needs like funeral expenses

No worthwhile assets. Just a beginning. May be some cash balance.

Married, with children.

Premature death causes serious financial problems, as most of the needs continue

Some assets available. Growing assets

Empty nest

The needs decline once children grow up and get settled. No major financial problems

Strong assets base, surpassing the financial needs

You may also like to keep in mind that if your family is reasonably wealthy and its protection needs relatively low, you can buy a smaller amount of insurance. Similarly, if your family members have independent earning capacity you may reduce your insurance.

There is a broad relationship between needs and assets over a period of time. Thus, not much life insurance is needed in the initial stage. The same is true in the empty nest stage.

The maximum need for life insurance arises during the mid-phase, when one is married and has children. In other words, one may go for life insurance so long as the asset-level is lower than the need-level. As highlighted in Figure 1, once the asset-level surpasses the need-level, the importance of life insurance declines.

Caution: Insurance is not investment You should always remember that life insurance is a protection and not really an investment because financial returns are rather meagre. (This is equally true of the life insurance portion of even a ULIP scheme.)

If you take inflation into account, there could even be a negative rate of real return at the time of maturity of your insurance policies. So, while it's important to secure your family's well being through adequate insurance of the lives of the earning members, over-investing is a mistake.


[Excerpt from Personal Investment & Tax Planning Yearbook FY. 2008-09, by N. J. Yasaswy, published by Vision Books.]

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