Everyone wishes they were a crorepati and this seems apparent from the sum insured chosen for a term life insurance policy! Why is everyone buying a "one crore" policy? Because it is a large sum? One followed by seven zeros (ten million) is just a number. It may or may not be the right number for your family. Here is why it is important to calculate to the life insurance policy cover you need before you purchase a term life insurance policy.
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The answer to how much life insurance you need is simply common sense. If you are the sole breadwinner of the family then the sum insured is a proxy for your income given to them in a lump sum. If you are part-breadwinner, then it is a share.
This means that sum insured should handle their current and future expenses.
Before we look at the many ways in which the sum insured would be useful, it is important to recognise that there is a limit to which a person can be insured. Most companies are 'okay' with offering a life cover = 15 or 20 times the current annual income.
So before we go ahead with an elaborate calculation it makes sense to first shortlist a couple of insurers, find out the maximum amount that they are willing to offer as life cover and use it as a reference. This figure may change when you apply and they find some risk factors - occupation, health issues etc. We will then have to revise the calculation.
The point is before we buy, we must have a rough idea of how the money should be divided and used for various needs. Allow me to explain.
Imagine for the moment, that you are no longer around and list all the expenses your family will have to face:
- They will have to generate an inflation-protected income to handle monthly expenses for the next 10,15, or 25 years depending on how old your children are, whether your spouse can work, your existing wealth, etc.
- School fees for you children
- College fees and if you wish their marriage expenses too.
- Any loans that needs to be closed out.
You can use the insurance calculators linked below to find out if you have adequate insurance. First, a couple of examples to illustrate my point.
Suppose the monthly expenses of your family (exlucing your expenses) are about Rs. 35,000 a month. If your family needs to generate an inflation-protected income with part of the lump sum received as the claim amount then,
if the lump sum is invested in a portfolio earning say 10% and the inflation is 10% (we will have to account for the families lifestyle enhancements too) and if this money is needed for the next 20 years, (until the children become old enough to support themselves and your spouse),
the lump sum required = 20 x 35,000 x 12 = 84 lakhs.
Here 35,000 x 12 = current annual expense. This thumb rule is valid for any portfolio return which is equal to the inflation (real return = 0%).
For such a situation lump sum required = annual expense x tenure.
So if we get a term insurance of 1 Crore, 84 Lakhs from this is necessary to just provide monthly expenses. Please do not assume that your family will invest the amount in DSP Blackrock nanocap fund and earn 45% return year after year. You won't be around to manage the portfolio like a pro that you are.
What about the kids' school fees? What about their college fees? Do you think the remaining 16 Lakhs from the claim is enough to handle this? What if you had two kids and other committments? Get my point?
Not only must we calculate the sum insured by taking into account all the future needs of our family, we must also create an action plan as to how the money should be divided up and used. Preferably, the contact number of a SEBI registered fee-only financial planner should be attached with the policy document so that the family can consult them for counsel. Otherwise, some overenthusiastic relative will volunteer to play fund manager and, you know what would lead to!
Note: I am not saying get more than 1 Cr term cover. I am saying, calculate how much you need, before buying. Who knows, it may be less than 1 Cr too!
Suitable for both young earners and parents. Will work in any spreadsheet software. Also see: Things to do AFTER you take a term insurance policy!
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