An integral part of financial planning is to secure your and your family’s financial future through insurance. Term insurance sum assured offers substantial financial protection for the family, in the event of the death of the policyholder. Your salary is an indicator of the sum assured you should go for, but not the only one. There are various methods and considerations that you must factor in while deciding your term insurance coverage.
One way of calculating a person’s term insurance coverage is to use one of the time-tested methods specifically designed for this purpose. We take a look at four such methods—human life value, income replacement value, expense replacement method and underwriter’s thumb rule.
Human Life Value - Human life value (HLV) measures the economic value of a person to the family. It considers the future salary, expenses, liabilities and investments associated with the person and his or her family. Future liabilities also include the expected future responsibilities. The expected inflation rate during the policy period must be considered while using this approach. HLV is used by policy buyers to ensure that the surviving family can maintain the present lifestyle of their family in the future years. You will find the online HLV calculator on most insurance websites.
Income Replacement - The income replacement method simply replaces the earnings lost due to the death of the policyholder. Accordingly, the insurance cover under the income replacement value is the present annual income X years left to retirement. A drawback of this method is that if you consider the future value of present income, the sum assured value may get very high.
Expense Replacement - The expense replacement method makes sense as the life cover is meant to cover the expenses which the policyholder would have otherwise covered. Under this method, the policy buyer calculates the day-to-day household expenses, liabilities and future financial responsibilities. The latter may include higher education expenses and financial support to dependant parents. The figure you reach is the total money that your family will need.
If you have investments and additional life covers, the same must be deducted from the arrived figure. However, investments which are in use, like house property, must not be deducted.
Underwriter’s Thumb Rule – Being a thumb rule, this method simply multiplies your present annual salary by a specific number of years. The common practice is to calculate the sum assured as 10 times the annual salary. Most insurance companies advertise 10 times the annual income as the life cover but many others also offer 15, 20 or even 25 times your annual income as life cover.
A higher life cover is a comforting assurance for the policyholder, but you must also remember that the premium will escalate with an increase in the sum assured.
Irrespective of the methods you choose, here are a few factors you must consider to find out the ideal term insurance sum assured.
Present Salary – The current salary of the policyholder ensures that the family can afford a certain lifestyle. This also means that your family can meet regular and unexpected financial obligations, like loan repayments, sudden emergencies, education costs, daily expenses, medical expenses, savings, etc. There is no way you can ignore your present income while calculating your life insurance term cover.
Financial Liabilities – Your life cover should meet the financial liabilities of your family after you are gone. Apart from the regular family expenses, your financial responsibilities should also be considered while determining the amount of life coverage. The insurance coverage must ensure that the surviving family does not face financial difficulty due to these liabilities.
Dependents and Future Needs – Another important consideration is the number of people who are dependent on you, and their financial needs. In the case of children, it could be their education and higher studies expenses, and marriage expenses. In the case of dependent parents, it could be their regular and medical expenses.
Inflation and Cost of Living – Any other calculation would be futile if you don’t consider inflation. It leads to a rising cost of living and reduced purchasing power. To ensure that the purchasing power of the insurance proceeds is adequate, you must factor in the inflation rate.
Existing Savings and Investments – Chances are that you may have already saved some money and made some investments as well. This will be the primary cushion for your family’s finances, along with the life insurance proceeds. As you calculate your sum assured, you must deduct the existing assets. The job of the sum assured is to bridge the financial gap. Not doing so will lead to being overinsured, which will also mean high premium expenses during your lifetime.
There may be changes in life during the term insurance that influence your insurance needs. Factors like income, expenses, and the financial needs of dependents are crucial in determining insurance coverage, and changes in them may trigger changes in insurance too. Here’s a look at the probable changes and their impact.
Salary Hike – With a salary increase the life insurance coverage may have to be reassessed. As income grows the lifestyle of the family changes. The family may get used to a certain lifestyle, which in turn means that your financial responsibilities also escalate. As a policy buyer, you would then rethink if the policy death benefits are sufficient to meet the financial needs of the family.
Salary Cut – As salary hike influences insurance needs, the inverse is also applicable. Agreeing to a salary cut means that the family goes through a drop in income. Ideally, a person must readjust the lifestyle of the family and the financial priorities. A lower salary means that you might end up saving less.
Therefore, you must maintain your existing life insurance coverage, and try to buy an additional policy to cover the risk of reduced investments.
Life Milestones – There are events in life that have a financial implication. It can be a change of job or profession, the marriage of the policyholder or children, becoming a parent, major investments like a house property, etc. The policy buyer must reassess the term life insurance coverage on these occasions.
A life insurance cover reminds us that nothing is permanent, and yet we can contribute immensely to our posterity with our good financial planning. By buying an adequate term insurance cover we can ensure that our immediate family comes to terms with life’s needs seamlessly. Using the calculation methods and factors we pointed out, get your ideal term insurance cover today, and put all your financial uncertainties to rest.
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