Term insurance is one of the most essential financial purchases you need to make in life. Ideally, you must obtain term insurance coverage right from when you start earning an income. This is because when you are younger (say, in your early 20s), you tend to be healthy and may typically qualify for lower premiums. That said, you need to make a smart decision about the amount of coverage you need to purchase.
To make an informed choice, it’s essential to first understand what term insurance coverage entails. So, let’s begin there.
What is Term Insurance Coverage?
Term insurance coverage is the sum assured under the term plan you purchase. It determines the extent of financial protection available to your nominee, in the case of your demise during the policy term. The total coverage offered by a term life insurance plan includes the sum assured under the base policy as well as any additional benefits from add-on riders.
It’s important to ensure that you have adequate term insurance coverage, so your loved ones are financially well-protected even in your absence. To ensure this, you can rely on some tried and tested methods to compute the coverage you need from a term life insurance policy.
Different Methods to Calculate the Term Insurance Coverage You Need
In the best-case scenario, your term insurance coverage must be enough to cover your family’s everyday needs, the cost of achieving their life goals, and the effects of inflation. Alternatively, you can also look at it from the income-oriented angle, which suggests that the coverage offered by your term life insurance plan must be sufficient to replace your income for a reasonable duration. Based on these different approaches, we have the following methods to compute the amount of term insurance coverage required.
1.Income Replacement Method
This method operates on the principle that your term insurance coverage should be enough to replace the income loss that your family will suffer in your absence. Here, the coverage is calculated using the following formula:
| Insurance Coverage = Current Annual Income x Number of Years Till Retirement |
For example, say you are currently earning ₹5 lakh per annum at the age of 30, and you wish to retire at the age of 60. You have 30 years left to retire. So, your ideal coverage as per this method will be ₹1.5 crore (i.e. ₹5 lakh x 30 years).
The downside of this method is that it does not account for inflation, and it may suggest a very high coverage amount because it takes into account all the years till retirement.
2. Expense Replacement Method
In this method, you need to account for the day-to-day expenses of your family as well as other major expenses like your children’s education, their wedding, and the like. You will also have to account for the needs of your dependent parents. Here’s how you can proceed with this method.
- Step 1: Compute the annual expenses of your family today.
- Step 2: Multiply this figure by their life expectancy.
- Step 3: Add to this any other major expenses for their life goals to arrive at the total money your loved ones will need to live comfortably.
- Step 4: Deduct the present value of your other investments and assets from the total money as computed above in Step 3.
- Step 5: The resulting figure is an estimate of the term insurance coverage you will need.
3. Human Life Value (HLV) Method
This method relies on the human life value, which is a figure that represents the present value of all your future income, expenses, debts and assets. It combines the income and expense replacement methods and also accounts for inflation. The process of computing the HLV may seem complex, so you can use free online calculators to arrive at the ideal amount of term insurance coverage using this method.
Nevertheless, it’s always a good idea to know how the HLV is computed. The steps involved are broadly as follows:
- Step 1: Identify your current annual income and to this, add any potential future increase in income that you expect.
- Step 2: From the above figure, subtract tax payments and your personal living expenses to arrive at the portion of your income used for your family’s sustenance.
- Step 3: Identify the number of years for which the loss of income may need to be replaced. Ideally, this could be the number of years left till your retirement.
- Step 4: Select an appropriate discount rate for computing the present value of your future earnings.
- Step 5: Using the figures obtained above (namely the net income needed for your family as in step 2, the number of years as in step 3 and the rate as in step 4), compute the present value of your future earnings.
4. The Underwriter’s Rule
This is an easy method that can help you roughly compute the amount of life insurance coverage you need for the foreseeable future. It is based on the suggestion from most financial experts that your insurance coverage should be at least 10 times your annual income. You can compute it using the formula shown below.
| Insurance Coverage = Current Annual Income x 10 |
For example, say you are currently earning ₹5 lakh per annum. As per this rule, the minimum amount of coverage you should buy at this stage in life is ₹50 lakh. Over time, as you start to earn more income, you can revisit the coverage you have and increase it accordingly, as required.
That said, some experts recommend a minimum cover of at least 15 to 20 times your annual income to account for inflation. You can choose the method that best aligns with your financial situation, goals and requirements.
Conclusion
This sums up the different methods you can use to calculate the amount of coverage you need from your term insurance plan. You can use any of the methods or a combination of two or more to get a comprehensive idea of the extent of coverage required. Also, keep in mind that you can extend your life cover with additional policies as your financial requirements evolve over the years.