We often hear it is a rule of thumb that life insurance cover must be 6 to 7 times as much as the yearly income. Suppose a person earning 4 lakhs per annum goes must decide on an insurance of 30 lakhs (more than 7 times the amount). If he has a family of four and an expense of 3 lakhs per annum excluding himself, that amount is supposed to provide coverage for around 10 years. But factoring inflation, it will actually be sufficient for 5 years only, after which his family will face severe financial crisis.
When it comes to insurance you must take into account factors like standing debts or standard of living. While calculating your insurance cover, you must follow some basic steps before proceeding any further:
Step 1. Calculate your total unavoidable expenses (TUE)
This is a major part of your insurance coverage. The main reason for getting insurance is to provide your dependents with at least the basic needs after your demise. So make sure to include the following costs, among others :
- Your child’s education costs
- Household bills
- Other insurance premium for your dependents, like medical, automobile and housing
- Medical needs, entertainment and other recurring expenditures
This gives the total unavoidable expenses (TUE) for one year. But the actual cost must also take inflation into account; for this purpose use an inflation calculator. Factor in an approximate number of years for which the money will be needed.
Step 2. Add Your Debts (D) and Subtract Your Assets (A)
Any outstanding loans, mortgages, credit card bills, or other types of debt must be added to the TUE. However, any disposable property, such as land, an extra house, gold, stocks and fixed deposits must be subtracted as they can be liquidated to meet immediate expenses. Make sure that you do not subtract the value of your current residence.
Step 3. Add Arbitrary Responsibility Expenses (ARE)
This step factors in large predictable expenses which are taken on by the policy holder as secondary responsibility, after meeting the family’s unavoidable expenses. This may include higher education and weddings for children, as well as your funeral which can also pose a considerable expense. This varies according to personal requirements, but remember to factor in inflation,over and above current prices.
After completing these 3 steps, make the final calculation:
This will give you an accurate idea of the minimum insurance cover you should opt for, given your current standard of living and long term goals.
Now that you have calculated the amount of life insurance coverage that you need, ask yourself some important questions before purchasing a policy…
How much do you save each month?
If you have a substantial retirement fund, then you may go for a smaller coverage amount as in case of your demise, those funds will be allocated to your dependents.
Will your dependents use the lumpsum, or reinvest it?
If your family does not encash the claim, but reinvests it to yield interest, then your coverage amount can be lower. The interest will then make up the deficit over time.
When are you beginning to invest?
If you begin investing at a younger age, you can avail a better coverage at a low premium.
How long are you investing for?
Ideally, life insurance should have coverage till at least 65 years. Depending on your insurance term, you can get a better premium rate for your required coverage.
Do you need insurance?
This question must be answered before taking any final decision. If you do not have any children and if your spouse has a high paying job, then purchasing insurance may not make sense. Conversely, if your children are older (say, about 16) and you have adequate educational funds in place for them, an expensive policy may not make sense for you.
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