A report from Swiss Re indicated that the average working Indian has life insurance covering just 8% of his dependent’s future expenses. This amounts to a sum assured of just ₹1.3 lacs. In this article, we look at how you should calculate the correct sum assured towards your life insurance plan. We also look deep into the factors you need to consider while doing that.
Life insurance is NOT about putting a value on your life. Afterall, life is priceless
The key purpose of enrolling in a life insurance plan is to provide adequate financial resources to your dependents who can then provide for themselves if you were to meet an untimely death.
And one question I am often asked is – how much sum assured should I opt for in my term insurance policy?
The more I researched into this, the more I saw gaps in the consumer’s thinking process. In most cases, there was no scientific way of guesstimating the sum assured.
India and Underinsurance
The average Indian is grossly underinsured.
This is an under-statement of sorts. A protection gap report from Swiss Re says that the average working Indian has life insurance covering just 8% of his dependent’s future expenses. That’s a protection gap of 92% in terms of the coverage the average Indian should have and where he/she stands.
The report further reveals that this 8% translates to a coverage of just ₹1.3 lacs.
That’s it.
The average working Indian keeps aside a cover of just ₹1.3 lacs to take care of one’s family for the rest of their lives post his untimely demise.
Unfortunately the ₹1.3 lacs might not even add up to an year of expenses for the family. No wonder the math doesn’t add up.
A related problem we see is of consumers anchoring on an advertised sum assured. A number of consumers assume that ₹1 crore of term insurance is enough to take care of all financial goals & the family’s expenses after one’s demise.
₹1 crore may be enough or may not be enough. But the problem we are trying to solve here is to solve for the right life insurance coverage or sum assured one should have.
Lets look at a typical Indian household scenario in the coming section.
A typical Indian household and it’s life insurance needs
Vikas is 35 years old.
He lives in a 2BHK house in Gurgaon with his wife and two children aged 7 and 3 years. Vikas’s parents too stay with him.
His parent’s medical expenses plus the entire family’s food, utility bills, daily expenses, school fees etc. costs ₹60,000 each month. These expenses are totally unavoidable.
Additionally, Vikas continues to pay an EMI of ₹30,000 rupees each month for the 2BHK house. There is a current outstanding of ₹70 lacs on the house on account of a home loan.
So …
Vikas’s finances are stretched like that of many Indian households. And his untimely death would certainly put his family through many hardships.
Let’s start by building a life insurance coverage plan for Vikas
Step 1 – Start with Your Dependent’s Monthly Expenses
Vikas’s family monthly expenses are ₹60,000 rupees. This comes to comes to ₹7,20,000 per year.
It is generally recommended to provide a coverage at 10-15 times of the annual expenses
While this is entirely Vikas’s call, in his case, a multiple of 15 is suggested. This multiple takes into account for higher inflation due to rising education costs for the children & healthcare costs for his parents.
It is equally important for Vikas to factor that with the exception of his spouse (who might start working again upon his demise), the other 4 dependent members might not be able to contribute to the household earnings for the next 10-12 years.
At a multiple of 15 times, Vikas’s sum assured needs on the basis of future household expenses comes to ₹1.08 crores i.e. ₹7.2 lacs x 15
Step 2 – Add the Liabilities
The most difficult situation one can leave their family with is a pile of debt.
Vikas has an outstanding of ₹70 lac on his home loan. This is the primary burden that he needs taken care of in the event of his demise.
Adding the ₹70 lacs to the ₹1.08 crores takes Vikas’s sum assured coverage requirement to ₹1.78 crores
Great! I think we are moving in the right direction.
Step 3 – Factor in Important Life Events and Goals
Vikas has two young children who have a number of milestones coming up with their education and their marriage.
Vikas wants the best for his children. He has already started a monthly SIP of ₹7,000 rupees to create a corpus of ₹20 lacs over the next 15 years to manage their higher studies.
His untimely death will put his goals in a limbo. Hence it is wise to add this amount to Vikas’s life insurance coverage requirement.
This takes up Vikas’s sum assured estimate ₹1.98 crores now
Step 4 – Supplement a Retirement Corpus for Your Spouse
So far, Vikas has been calculating his sum assured on the basis of existential and unavoidable daily expenses. To this, he prudently added his existing liabilities and future visible needs like children’s education. All these are ‘expenses’ related – and none of it relates to savings.
The last variable to consider here for Vikas is to leave a corpus for his wife. The corpus should be such that it can grow over time so that she can manage her retirement.
This is important. Had Vikas been around he would saved and grown his wealth to support himself & his wife in their old age. With Vikas not being around, he needs to apportion some money now towards his wife’s future. The death benefit received now can can be invested in safe instruments which can grow in time to a respectable amount in the future. You can see the power of compounding in the SIP calculator I frequently use.
But how does Vikas calculate how much money needs to be apportioned?
For this, we will look at the rule of 9.
The Rule of 9
The rule of 9 says that you can generally double your money every 9 years assuming the average annual returns from your investments is 8%
This means the money will double in 9 years. It will grow by 4 times in 18 years and grow by 8 times in 27 years.
Let’s say Vikas wants his wife to have atleast 80 lac rupees towards her retirement kitty. This money should be available to her at the time when she is free of her obligations towards the children. In other words, the children are well-settled and don’t need monetary help from her. As his children are young, Vikas reckons this will be about 27 years away.
So we apply the rule of 9 on this.
27 years means 8 times
Hence, we divide ₹80 lacs with 8 and arrive at an amount of ₹10 lacs rupees. This is the amount Vikas needs to get coverage for currently to support his wife with ₹80 lacs during her retirement.
This pushes up Vikas’s calculation of his ideal sum assured on his life insurance plan to over ₹2 crores.
The new sum assured requirement is ₹2.08 crores
Have you noticed?
Note that to calculate how much sum assured you need for your term insurance is a science. But is certainly not an exact science.
I say so, because you are predicting into the future and making a few assumptions. It is not a bad idea for you to be conservative in your estimates. So if you think your family can do with ₹50,000 in monthly expenses, I suggest you nevertheless estimate ₹60,000.
Additional considerations in determining term insurance sum assured
While the math certainly helps, there are some other areas that need your consideration. These ensure that you are evaluating your life insurance needs properly.
1. Your age
Varun represents the orthodox Indian setup where the husband is in his mid-thirties with a wife, children and dependent parents. His life insurance requirement is on the higher side. And there is no doubt that he should invest in a good term life insurance plan.
But let’s say you are very young, say in your mid twenties. You are not married and, one or more of your parents is still working. How will your life insurance requirements be now?
The simple answer is that your life insurance requirement is not very high because you have less dependents. However, the insurance requirement goes up dramatically if both your parents are dependent on you. It stays high if there are existing liabilities like a home loan or potential liabilities like medical needs of parents. Do be vary of future needs within a 5 year period.
Let’s look at the other end of the tunnel.
You are in your early fifties. Your house is all paid for and your children have completed their education and are now gainfully employed.
With your spouse being the only dependent, your life insurance needs will revolve around her needs. In other words, you have to ensure that you have left enough of an inheritance for your spouse to cover his or her daily expenses. And don’t forget her medical needs.
2. Your wealth
We spoke about factoring liabilities like home loans, credit cards, business loans etc. while calculating the sum assured. These are monies that you owe to someone and hence should be considered in the calculations.
On the other side of your personal balance sheet is the wealth you have accumulated. These are the investments you have made over the years which can be accessed by your family on account of your demise. These include your provident fund, fixed deposits, stocks, mutual funds and real estate.
If the amount is sizeable, you can choose to deduct this amount while calculating the sum assured or term insurance coverage amount.
So, in the case of Vikas, he had been investing in a monthly SIP. He has kept apart ₹7,000 every month for his children’s education on ETMONEY for over 3 years. This has accumulated to ₹4 lac rupees. Vikas can choose to deduct this from the ₹2.08 crores we earlier estimated. This brings downs the requirement to ₹2.04 crore rupees for Vikas.
3. Your future plans
You are not married currently but have plans to get married. You have not opted for a home loan currently but have been inspecting 2BHK apartments during your weekends.
Marriage, children, buying a house, starting your own business .. are material changes to your life and lifestyle. If these are visible to you now, then do factor these in your sum assured calculations. As we can see, some of these lead to high current and future financial liabilities.
It is also probable that circumstances can change dramatically. For example – you bought a house in Delhi but you suddenly get transferred to Mumbai. This puts a heavy strain on your finances. Or, your business has gone through rough times. You had a positive cashflow situation last year but you are now neck deep in debt.
Not everything needs to be bad.
You might have started a new business which is doing extremely well. Or your salary might have increased by three times because of some smart career moves you made.
You can’t predict everything so it is always a good idea to evaluate your term insurance needs every 5 years.
Your Sum Assured Eligibility
What is this now?
First. I hope the requirements exercise we just went through would have helped you understand your future priorities and current standings with respect to offering financial stability to your family.
You would have also appreciated that every individual’s needs are different. No two persons will have the same term insurance sum assured requirement.
Yeah, got it. So?
Insurance companies find it difficult to support this kind of mass customization where one consumer’s requirement is different from the other.
As a result, instead of using expenses, loans, dependents, children’s education, retirement corpus … as we did … insurance companies calculate your term insurance coverage eligibility using a much simpler formula.
Variables to calculate sum assured eligibility in term insurance plans
Life insurance companies use three simple variables to calculate your sum assured eligibility for term insurance policies:
- Age
- Annual income
- Existing life insurance coverage
The formula employed by life insurance companies goes like –
[Your income multiplier * annual income]
minus
[existing life insurance coverage]
That’s it.
It’s that simple.
Now you must be wondering – hey, that’s not right. But in my view, this simplicity is not necessarily a bad thing. Afterall, it provides you with a thumb-rule based approach to evaluate your term insurance sum assured eligibility.
So, just hear me through for some more time.
While different insurers have slightly different logics, most insurers follow a rather simple grid. This grid offers an income multiplier according to your age. And once you have the multiplier, you can multiply it with your annual income .. and deduct the amount of term insurance you already have.
Income multipliers of life insurance companies
We averaged the income multipliers from the most popular life insurance companies. The average income multipliers offered by most life insurers in India are –
| Age | Income Multiplier |
|---|---|
| 18-45 | 20 |
| 46-55 | 15 |
| 56-60 | 10 |
| 61-65 | 7 |
We find that life insurers offer as high as 20 times of your annual income at lower age groups.
This is quite a good surrogate. That’s because at a younger age group you are more likely to need more protection as you have more dependents. Plus you might have just started to take on more financial liabilities like buying a house or starting a family.
For term insurance buyers who are middle-aged, the multiplier offered is relatively lower. The lowest multipliers are offered to term insurance buyers are aged 56 or more on account of them having paid off their home loan, having less dependents and also having accumulated reasonable wealth towards their retirement.
Let’s go back to Vikas to understand this further.
Vikas earns a salary of ₹1.25 lacs per month or ₹15 lacs rupees per year.
And he is 35 years of age.
Per the income multiplier grid, Vikas is eligible for 20 times of his annual salary. This comes to ₹3 crores of term insurance i.e. ₹15 lacs * 20.
Our calculation shows that Vikas’s life insurance needs are only ₹2.04 crores.
Now, that Vikas knows that his eligibility is more than his requirement, Vikas can look to choose a coverage between ₹2.04 crores and ₹3 crores for his first term insurance policy.
If I were Vikas, I would have settled for ₹2.5 crores of term insurance cover. Remember – I want you to have a conservative outlook when buying term insurance. Never underestimate your risks.
Actions if your sum assured eligibility were lower than the requirement
But this definitely gets us wondering.
What would Vikas have done if the eligibility was less than Vikas’s requirement?
And my answer to Vikas would have been to opt for an much life insurance that the insurer is willing to offer currently on the basis of his income.
This is the same strategy I employed a few years back for myself. Exactly 10 years back, I started with a term insurance plan with a sum assured of ₹1 crore when my income was low. Then once there was a good jump in income which generally happens over 4 to 5 years, I went for a second term insurance policy of ₹2 crores to ensure that my coverage requirements are taken of.
While we are at this point, a word of caution for users who have a traditional policy or ULIP plans. Traditional policies go by the name endowment or moneyback plan. A ULIP is a market-linked policy. I have nothing against these plans but am not happy with the utility of these in covering your life insurance gap.
The coverage offered under these plan is just 7 to 10 times of the premium you pay. In other words, these cover just 5-10% of your life insurance needs. In case you already have such a policy, it is advised to exclude that plan in your requirements calculation.
A Quick Summary
Let’s summarise what we have learnt thus far –
1. Most Indians are hugely under-insured but a proper assessment of your term insurance needs come a long way in building a financial independence plan for your dependents
2. There is a difference between your coverage requirement and your coverage eligibility. And you should endeavour to come closer to your requirements
3. And finally, we came out with a somewhat scientific way to evaluate your true life insurance coverage requirements. Remember, the needs of each individual is different and you have to calculate that number by yourself
I hope you found this article useful. Do write back to me using the comments box.
Additional Resources You Might Like
- 5 steps on choosing the right term insurance plan
- Why term insurance premiums are likely to increase next month?
- Complete SIP Investment Guide (over 8000 words compedium updated until 2020)
- Six benefits of term insurance plans
- The trillion dollar index fund story that John Bogle started in the 1970s
- Best SIP for achieving long term goals