How to compute sufficient and adequate Life Insurance?

How to compute sufficient and adequate Life Insurance?

by 5paisa Research Team Last Updated: Nov 15, 2021, 01:02 PM IST

Insurance planning is the most important section of financial planning. An individual should possess sufficient and adequate insurance in order to protect against any uncertain events.

We live in a world full of uncertainties, surrounded by risks right from morning till we go to bed at night. So, as much as it's essential to save money for a future livelihood it is equally important to protect such savings that they don’t get used up due to uncertain mishaps.

How do we protect against such risks? The answer to this question is insurance. Insurance is the means through which an individual can protect himself and his family against any unfortunate event and offer financial assistance during such situations. Insurance planning is the most important section of financial planning. There are a variety of insurance policies available covering different types of risks such as Life insurance, Health Insurance, Motor vehicle insurance, Liability insurance, Renter’s insurance, etc.

Life insurance is designed primarily to protect the dependents or beneficiaries in case of the insured’s unexpected death. Ideally, life insurance should be bought by individuals who have dependents or he is the sole breadwinner of the family. Through life insurance, the beneficiaries will have the financial resources to protect their future income and pay for immediate and future financial obligations.

Purchasing adequate insurance cover is very important; underinsurance, as well as over-insurance both, can be risky. Underinsurance can lead to great financial stress in case of unfortunate events. On the contrary, over-insurance can lead to higher monthly premiums, which may hamper your current finances. With this, we come to know the importance of purchasing sufficient and adequate insurance cover, which won’t cause financial stress and support in hard times.

There are two popular ways of estimating insurance cover:
 

  1. Needs-Based Approach 

  1. Human Life Value Approach
     

For instance,

Mr and Mrs Yadav aged 34 and 30 years have a life expectancy of another 45 years. Their data depicts the following information:

• Mr Yadav is the sole breadwinner of the family and has no children.

  • Current investments have a market value of Rs 20 lakh.

  • Annual expenses of Rs 2.5 lakh (including Rs 50,000 of Mr Yadav's personal expenses)

  • Mr Yadav’s income post-tax is Rs 6 lakh. He will retire at the age of 60.

  • The inflation rate of 6% per annum, salary growth is 4% and returns on investment are 8% p.a.
     

Let’s see what insurance cover Mr Yadav will require using both the abovementioned methods
 

  1. Needs Approach:

Annual expenses = Rs 2.5 lakh 

Less: Mr Yadav’s expenses (as after the death of Mr Yadav, these expenses won’t be required and so, it will get deducted) 

Net annual expenses = Rs 2 lakh (Rs 2.5 lakh - Rs 50 thousand) Mrs Yadav will require in case Mr Yadav dies.

Inflation rate = 6% p.a.

Investment rate = 8% p.a.

Real rate of return = 1.887%

Life expectancy of Mrs Yadav = 45 years (Mrs Yadav will require annual expenses for 40 years in case Mr Yadav dies).

The current investment that they already possess = Rs 20 lakh (will deduct this amount as insurance is needed are in excess of investment).

Therefore, life cover required = Rs 41,42,630.12. 

  

2. Human Life Value Approach 

The post-tax annual income of Mr Yadav = Rs 6 lakh (Mrs Yadav will require income replacement of Rs 6 lakh, which will be growing by the salary growth rate in case Mr Yadav dies). 

Salary growth rate = 4% p.a.  

Investment rate = 8% p.a.  

Real rate of return = 3.774% p.a.  

The current investment that they already possess = Rs 20 lakh (will deduct this amount as insurance is needed in excess of investment). 

Therefore, life cover required = Rs 90,68,484.12  

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