How to choose the right amount of cover for life insurance?

Life insuranceIf you are buying life insurance, you need to go for the right insurance amount so that you are neither under-insured nor over-insured.

So, how does one arrive at the right amount of insurance cover? Here are some simple methods to help you decide.


Life insurance is something one cannot do without in life. It is a small step to show your near and dear ones that you care. If you are the sole bread earner of your family, life insurance becomes all the more important for you. It helps you to make sure that your family does not face financial distress in the unfortunate event of your early demise. And there is no better way to provide financial security for your loved ones than buying a term insurance plan.

That said, how much amount will your family need to live comfortably after you are gone? The first method is to derive the amount as a multiple of your annual income. Ideally, one should have insurance cover of 10-12 times your annual income. We can understand this with different examples.

Example 1:

Anil, a 40-year-old employed person drawing a salary of Rs. 50,000 per month. He has a family consisting of mother, father, wife and two children, all dependent on him. Therefore, the minimum term insurance cover for him would be Rs. 50,000 x 12 x 10 = Rs 60. lakh. So, if Anil dies any time during the tenure of the insurance policy, his family would receive the claim amount of Rs. 60 lakh from the insurance company. From this amount, the family can keep aside a lump sum of, say Rs. 10 lakh, to meet its expenses for the subsequent two years and invest the balance amount of Rs. 50 lakh in liquid funds, fixed deposits of banks for short and long duration debt funds,debentures, etc. and get reasonable returns.

Assuming that the family’s expenses are Rs 5. lakh per annum, the insurance amount can sustain the family for about 12 years after Anil’s demise. However, if the family has to incur expenses on any unforeseen contingencies, the number of years that the family will be able to sustain itself on the insurance amount will decrease. Also, the rate of inflation and the rate of return on investments will determine the sustenance period for the family.

The above insurance amount of Rs. 60 lakh would be sufficient for Anil’s family assuming that he has no liabilities. However, if Anil has outstanding liabilities such as home loan, car loan, personal loan, medical insurance premium, etc., these will eat up a big chunk of the insurance amount.

Example 2:

Let us suppose Anil has left behind total outstanding loans of Rs. 20 lakh (home loan-Rs. 15 lakh, car loan-Rs.  3 lakh and personal loan-Rs. 2 lakh). Now, the family can keep paying the EMIs or prepay the three loans. Since, the family has no source of income after Anil’s death, prepaying the loans would be a prudent option as it will save the interest cost.But pre-payment of all outstanding loans would leave the family with net amount of Rs. 40 lakh (Rs 60 lakh-Rs 20 lakh=Rs 40 lakh). This amount may not be enough for the family to sustain for a period of 12 years to enable the children to complete their education and start earning. Therefore, Anil has to increase the sum assured amount by. Rs 20 lakh i.e. from Rs 60 lakh to Rs 80 lakh.

Thus, when you plan to buy a life insurance policy, as a thumb-rule ensure to take an account of all outstanding liabilities while determining the sum assured. Yes, the life insurance premium amount will increase due to the increase in the insurance cover.

Example 3:

Now, let us assume that Anil has none of the liabilities listed above. On the other hand, being a savvy investor, he has investments in diverse asset classes such as shares, mutual funds, public provident fund, fixed deposits, debentures, property (land,shop and residential house) gold coins and gold jewellery, etc. In this case, he can reduce the amount of sum assured and thereby reduce his life insurance premium. Suppose the current value of all the above assets (except the residential house, which the family needs for own residence) works out to Rs. 30 lakh. Out of these assets, if the value of the assets that can be easily disposed off by the family is Rs. 20 lakh, the sum assured can be reduced to Rs. 40 lakh (Rs 60 lakh-Rs 20 lakh=Rs 40 lakh) if required. However, it is advisable to get insured for maximum Sum assured which is allowed as per his/her income eligibility.

The second method is to calculate the insurance amount by taking into account your total annual outgo, which will include all expenses and repayment liabilities. Your life insurance sum assured can be computed as 12 to 15 times the total annual outgo. The monthly expenses could include expenses on food, clothing, utility bills, home rent/society charges, entertainment/leisure, car fuel and maintenance expenses, school/college fees and other educational expenses, insurance premiums (life, medical, car), etc. Add to these the recurring liabilities such as home loan EMI, car loan EMI, personal loan EMI and monthly repayments of any other loan. If the sum total of all these expenses and liabilities works out to Rs. 6 lakh per year, it would be prudent to buy term insurance cover of Rs. 70 lakh to Rs. 90 lakh.

In addition to income, expenses and liabilities, you also need to take an account of other factors to determine the amount of your life insurance sum assured.  Some of these variables include your present age, age of your spouse and children, your lifestyle, inflation rate, interest rate, etc.

Conclusion:

The bottom line is, your life insurance sum assured should be good enough to take care of your family’s needs in your absence. If tomorrow you aren’t around, your life insurance sum assured should be able provide your family the comfort of the lifestyle they are accustomed to living during your lifetime.

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