7 November 2021

A 10 step guide to the adequate insurance cover

If you are a regular reader of personal finance blogs, the odds are high that you know you need a term insurance cover. With step 1 sorted, investors make a mistake on step 2 - They buy a 1 Crore term cover. The Crorepati dreams were instilled in our minds while growing up and thus, Rs 1 Crore is a psychological number for the Indian middle class. But is a Rs 1 Crore term cover adequate? Probably not.

Consider a few points:

  • In your absence, will a Rs 1 Crore cover be sufficient enough to cover outstanding loans, credit card bills and other liabilities?
  • After covering the liabilities, will the left-over amount be sufficient enough to provide for monthly expenses of your family for a decade or 2?
  • After providing for monthly expenses, will the left over amount be sufficient enough to put your next generation through college?

The purpose of this post is to get you thinking on the correct lines. By the end of this post, you won’t know how much cover you need but you’ll know how to calculate the same.

What is wrong with a 1 crore term cover?

Insurance isn’t a one size fits all product. Your current situation may also not be the right parameter of calculating your financial needs.

For example, you are a 26 year old earning 12 LPA and then you go for an MBA. 18 months later, you’re a 27 year old earning 25 LPA and you also have an education loan of Rs 25 Lakhs. Would the same term cover you bought pre-MBA be adequate for your post MBA goals?

Or you’re a single 28 year old earning 15 LPA and 4 years later you’re married and have an infant and you’re now earning 30 LPA. Won’t the insurance requirement too have evolved over time?

A 10 step guide to calculate the adequate insurance cover:

Step 1: Open an excel sheet

Good old excel sheet

Step 2: Note down your liabilities

Preferably in order of the interest rate: Personal loan, EMIs, education and home loan. It is wiser to repay the loans costing more first. Also, bifurcate the share of loans between yourself and the co-payee (spouse, parent, etc.)

Step 3: Note down your investments

Note down the debt and equity funds, equities, PPF, Gold, etc. that you have invested in. Do not count your own house in this because you wouldn’t want your family to sell off their own house and go live on rent.

Step 4: Compute the net liability

Subtract the amount under step 3 from the amount under step 2. This is the amount that will be needed by your family to extinguish all liabilities.

Next, we need to compute how much money your family will need to meet their monthly expenses.

Step 5: Compute the monthly household expenses

This may sound like a budgeting exercise, but you will have to note down the monthly expenses incurred by your family: Groceries, school fees, electricity, fuel, medical expenses, health insurance premiums, clothes and accessories, etc.

At this stage, only consider the household expenses that are met by you. If your spouse is paying some bills then they would be able to continue paying those in your absence too.

Step 6: Decide till when should monthly expenses be met

If your spouse is working, then they should be able to save for their retirement. In this case, the monthly expenses would be required to be met till your youngest dependent turns 25 i.e., of an income earning age. However, if your spouse is not earning then the household expenses would have to be met till the spouse turns 80.

Step 7: Assume the inflation rate and portfolio returns rate

TLDR: Inflation 6% p.a. and portfolio returns 8% p.a.

Currently, the long term inflation is expected to range between 4.5% and 6%. This is the rate at which your monthly expenses will grow because of rising prices of food, fuel, etc. If your household expenses are Rs 75,000 p.m. today then they won’t be the same even after a year right?

For portfolio returns, one can assume 7% to 8% on a conservative portfolio of 60% fixed income (5% returns post tax) and 40% equities (10% returns post tax). You might think that your family will put all the money in a fixed deposit (least risk) but then it would be very tough to beat inflation in the long run.

Step 8: Dirty Math

  • Multiply the monthly household expenses with 12 to get the annual household expenses
  • Then multiply this annual expense figure with the Step 6 figure to get the corpus required
  • Now, compute the present value of this corpus by using the Present Value formula in excel
    • For PV formula:

      rate = [(1 + portfolio returns) / (1 + inflation rate)] - 1
    • period = Step 6 number
    • pmt = annual household expenses (negative as its a cash outflow)

This gives us with the corpus that your family will need to meet their inflation adjusted household expenses. We’re not done yet!

Corpus needed to meet monthly expenses

Step 9: Compute the amount required for long term goals

Would you need money to put your children through college, or your spouse to afford a 2bhk flat, or your elderly parents to have a monthly cashflow in your absence? While it is tough to predict the future, it is wise to think of the low hanging obvious goals.

Here, you can also factor in other points such as - If your spouse has investments of Rs 50 Lakhs, they can contribute some amount to your child’s education. If your parents have savings of Rs 30 Lakhs, then the monthly expenses contribution from your corpus would be lower. This is a personal finance situation that varies from person to person.

Critical life goals and the amount required

Step 10: A+B+C

Now add up the amounts from Step 4, 8 and 9. This gives you the ideal insurance cover that you require. In the example we have taken (the screenshots posted), the ideal insurance cover works out to ~ Rs 3 Crores (rounded down from Rs 3.18 Crores).

What if I am not eligible to get the required life insurance cover?

A lot of life insurance companies give you an option to take insurance coverage of 25x your CTC. If you’re not eligible to take the adequate coverage, you can adjust for factors such as long term life goals (your children can always go for an education loan to fund their college), check for possible reductions in monthly expenses, etc. and take the maximum eligible coverage. Once your income increases in a few years, you can go for a higher term cover too or take an additional term cover.

You can even consider opting for a separate insurance policy that covers your home / education loan and this would significantly reduce the cover required from the term insurance.

No comments:

Post a Comment