C alculating 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
Life Insurance Premium: Rs 15,000
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
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: