While buying a Life Insurance policy one of the very important steps is evaluating the right quantum of policy required by you. However, most of the people find this task difficult. It not only depends on the premium you afford to pay but also for the immediate cash needs and the future income requirement which will help your family to maintain a reasonable standard of living after your death.
Having said that, let’s discuss the methods to calculate Life Insurance needs in detail:-
- Human Life value approach:
According to this method, the amount of life insurance coverage one should buy is directly proportionate to the economic value, which means the present value of all future income that you could expect to earn less personal expenses, life insurance premiums and taxes through your planned retirement date taking into consideration the present inflation. Let’s understand this as an example-
Rahul aged 40 years, working in a private company draws an annual salary of 1 lakh INR. His personal expenses are 30,000 INR/annum which includes tax and insurance premium paid by him. His remaining salary i.e. 70,000 is left for his family’s expenses, which is also Rahul’s economic value. This money if invested over Rahul’ working span will translate into his HLV. The calculation is done as under:-
To arrive at the Human Life Value you can use Excel spreadsheet and follow the following steps-
Open the Microsoft Excel worksheet and apply the Present Value (PV) function and open the first bracket as shown below:
Then click the Function(fx) icon on the menu bar, the window as shown below will appear:
Insert all the figures given above in appropriate column as shown below:
Note: In the ‘type’ column ‘1’ denotes that the sum required at the beginning of every year.
Press ‘ENTER’ and get the result 742251.944.
- Needs-Analysis approach:
In this method, the calculation is done on the basis of day-to-day family expenses till the life expectancy of the youngest member in the family. The major factors to consider for assessment are:-
- Number of dependents and their needs
- Education of children
- Marriage of children
- Providing for non-working spouse and dependent parents
- Standard of living you want to provide your family
- Any other special need
After adding all the above expenses, you need to calculate the Present Value (PV) of the figure so arrived using the same steps as described above which will constitute needs of the family today, considering that you will die today. Then deduct the life insurance policy you already had and all your existing assets excluding residence and car. This new figure is the gap that you need to bridge.
- Income Replacement value approach:
In this method, the amount of Life Insurance coverage is based on your income. It is calculated by multiplying the no. of years left for retirement by your annual income.
Required Insurance Need= Annual Income * Number of years left for retirement
For instance, your annual income is 1 lakh and you are 30 years old and plan to retire after another 30 years. In this case, your required life insurance coverage is 30 lakhs (1,00,000*30).
- Underwriter’s Rule of Thumb approach:
This method is generally used by the insurance companies in determining the sum insured as well as the premium of the policy.
- Calculation of sum insured:
Under this approach, sum insured is calculated on the basis of different multiples depending on your age in the following manner:
The sum insured should lie between (Annual Income* Minimum Multiple) & (Annual Income* Maximum Multiple).
For instance, your annual income is 1 lakh and you are 30 years old then your sum insured should lie between 12 lakhs (1,00,000*12) and 15 lakhs(1,00,000*15).
- Premium as a percentage of income:
According to this method, 6% of the income-earners’ annual income plus an additional 1% for each dependent should be spent on life insurance premium.
Say, your gross annual income is 5 lakhs and you have three dependents — your wife and two children. Your life insurance premium should be 45000 (500000*6%+500000*3*1%).
Life insurance coverage needs change with the time, therefore, it is important to review your insurance needs regularly. However, Needs-Analysis approach the most appropriate method to determine the Life Insurance coverage needs.