Modules for Beginners
All about insurance
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Calculating the life insurance coverage you need
Life insurance is a contract between the insured person and the insurance provider, wherein the latter agrees to provide a life cover to the former, in exchange for life insurance premiums that insured person pays to the insurer. This life cover is valid for a specified period of time, known as the policy term.
In case the insured person passes away during this term, the insurer pays out the sum assured guaranteed under the plan to the nominee. This payout may also include some other components like bonuses and loyalty additions.
However, if the insured person outlives the policy, they may or may not receive maturity benefits, depending on the type of life insurance plan chosen. Term plans do not offer maturity payouts, while endowment plans do. In the case of ULIPs, the fund value is paid out at maturity.
The amount of life insurance coverage
Getting a life insurance policy for yourself is the best thing that you can do to secure the future of your family. It can help keep them financially protected from life’s uncertainties. The payout that a life insurance offers can be used by your family to take care of themselves and provide for their needs and requirements.
But then, how do you go about choosing the right life insurance policy? The first step that you would need to take would be to calculate the amount of life insurance coverage that you need. Once you’ve ascertained the amount of coverage you need, you can then proceed to check out the various plans and their features and then use an insurance calculator to determine the premium that you would have to pay.
To help you calculate your life insurance coverage, we’ve come up with four different ways. And that’s what’s going to be in focus in this chapter of this module. Continue reading to find out what they are.
4 ways to calculate your life insurance coverage
Opting for a low coverage can lead to lower insurance premiums, but may not be enough to cover all of your family’s needs. Similarly, opting for a very high coverage can cover all of your family’s requirements, but is likely to make the premiums unaffordable. Therefore, the amount of life insurance coverage that you opt for at the time of purchase of a life insurance policy is crucial.
Here are four ways through which you can calculate the amount of coverage you need.
Through the Human Life Value (HLV) method
The Human Life Value (HLV) is a figure that is calculated by taking into account several factors such as the potential income, savings, expenditures, and liabilities. The HLV is supposed to give you clarity on how much life insurance coverage you would need to apply for.
The logic behind this method is that once you take away all of the potential expenses, debt, and liabilities that you’re likely to foresee in the future from the potential income and expenditures that you’re likely to generate, the resulting figure will be an accurate representation of the life cover that your family would need.
Here are some of the factors that you should take into account when determining the life cover through the HLV method.
- Your age
- Your gender
- Your occupation
- Your annual income
- Your employment benefits
- Your target age for retirement
- Your spouse’s and your child’s needs and requirements.
Here’s an example to help you understand just how you can calculate life insurance coverage through the HLV method.
Assume that you’re 35 years of age and that you plan to retire by the time you reach 60. Your annual income is around Rs. 8 lakhs, with annual expenses being around Rs. 4 lakhs. On top of this, you also have a home loan of Rs. 25 lakhs.
So, your ideal HLV should be at least Rs. 2.25 crores [(Rs. 8 lakhs x 25 years) + Rs. 25 lakhs home loan].
If you’re finding it hard to calculate the values on your own, you can always make use of a term insurance calculator that uses the HLV method to determine your life insurance coverage.
Through the income replacement value method
Although not as comprehensive as the Human Life Value method, the income replacement value method is also used by many to quickly ascertain the estimated life insurance cover. Here’s what you would have to do.
Life insurance cover = Present annual salary * Number of years till retirement
So for instance, say that your present annual salary is Rs. 4.5 lakhs. And that you have 30 years till retirement. The amount of life insurance cover that you would have to opt for would be Rs. 1.35 crores (Rs. 4.5 lakhs * 30 years).
Through the underwriter’s thumb rule
Again, this is another quick method that you can use to determine the amount of life cover that you require. According to the underwriter’s thumb rule, your life cover should be a multiple of your current annual income. This multiple factor is based on the age bracket that you fall under.
For instance, the rule states that if you’re an individual within the 20-30 age group, then your life insurance cover must be 25 times that of your current annual income. And in the case of individuals within the 40-50 age group, the cover should be at least 10 to 15 times their current annual income.
Here’s an example. Let’s say that you’re currently aged 45 years. Your present annual income is around Rs. 15 lakhs. Your ideal insurance coverage can either be 10 or 15 times your income, which would put the coverage anywhere from Rs. 1.5 crores to Rs. 2.25 crores.
Through the premium as a percentage of your income method
According to this method, the life insurance premium that you would have to pay should depend on a percentage (around 6%) of your annual income. And for every dependent in your family, an additional 1% should be added.
So for instance, say that your annual income is Rs. 10 lakhs. And that you have a spouse and a child (two dependents) to take care of. So this would mean that the premium that you should have to pay must come to around Rs. 80,000 [Rs. 10 lakhs * 6% + (Rs. 10 lakhs * 1%) * 2].
Therefore, when choosing the life coverage, you can opt for the maximum coverage that you can get for Rs. 80,000 of yearly premium. Here’s a note. If you don’t prefer the manual method of calculation, you could always make use of a dedicated calculator to calculate insurance premiums.
With this, hope you’ve now understood the importance and the different methods of calculating the right insurance coverage that you need for an insurance plan. In the next chapter, we’ll take a look at the different things that you can insure.
A quick recap
- The amount of life insurance coverage that you opt for at the time of purchase of a life insurance policy is crucial.
- Opting for a low coverage can lead to lower insurance premiums, but may not be enough to cover all of your family’s needs.
- Opting for a very high coverage can cover all of your family’s requirements, but is likely to make the premiums unaffordable.
- There are four ways through which you can calculate the amount of coverage you need - the Human Life Value method, the income replacement method, the underwriter’s thumb rule, and the premium as a percentage of your income method.
- The Human Life Value (HLV) is a figure that is calculated by taking into account several factors such as the potential income, savings, expenditures, and liabilities.
- The income replacement value method requires you to multiply your present annual salary with the number of years left for retirement to determine the life insurance cover.
- According to the underwriter’s thumb rule, your life cover should be a multiple of your current annual income. This multiple factor is based on the age bracket that you fall under.
- According to the premium as a percentage of your income method, the life insurance premium that you would have to pay should depend on a percentage of your annual income, with every 1% added for every dependent.
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