Calculating The Right Term Insurance Cover

Our family is our anchor during rough waters. When we have each other, we have everything. You buy Term Insurance to make sure you are there for them, every step of the way. And while buying it, there’s this one important decision you’d need to make - “How much cover will my family need?”

There’s no single answer to that question, but there are ways to make it easier for you. We’ll cover it all, in this article!
 

Why do you need adequate coverage?

The most important thing to be kept in mind when buying insurance is that - you are not buying it for today, but investing in it for tomorrow. You buy a term plan to cover your financial dependents or to pay off loans/liabilities - in the future, when you may not be around.

India's retail inflation has spiked to 7.41% in 2022. Food and fuel prices are increasing by the day, making life an expensive affair. The term plan cover you buy today should not be dependent on the present scenario but on the future value of the goals that you have decided for your family.

A sufficient cover keeps them financially strong and secure - against all the uncertainties life has to offer.
 

How to calculate adequate coverage?

If you are the sole breadwinner of your family, in your absence, your dependents might face financial instability. This is caused by the gap between the amount you leave behind and the amount your family actually needs. You can calculate this gap by subtracting the amount you owe from the amount you own.

1. How to calculate the amount you owe?

   By factoring in the following aspects -

   Living Expenses Fund	This fund will act like an income replacement for your family, and provide for their daily needs. For example - Short-term expenses, like daily needs, groceries, monthly bills, school fees, etc. Divide this total by the expected interest rate (take it as 3%, i.e. the current interest rate on FDs after cutting taxes).
   Major Expenses Fund	Large one-time expenses your family will incur in the long run. For example - children’s higher education, their destination wedding, etc.
   Major Liabilities Fund	Any loans or liabilities you’ve taken that your family will have to pay off in case you pass away. For example - home, business, and education loans.

2. How to calculate the amount you own?

   Factor in the existing funds you hold. This will include - the money you have, cash at the bank, and financial products you’ve invested in, like mutual funds, fixed deposits, etc.

   However, these funds will not be readily available to be used, so you will have to multiply them by their respective risk factors. Risk factors include interest rates, etc. - that keep fluctuating and changing the price of the financial instrument.

   Risk factors to be considered here -

   • Existing life insurance plans @ 100%

   • Savings, cash, fixed deposits @ 100%

   • Equity investments @ 50%

   • Gold and residential property @ 0% (You wouldn’t want these assets to be liquidated for grocery purchases or paying off loans/liabilities - so take them at zero value)

     Stock options @ 0% (These are high-risk investments - so take them at zero value.

     Also, it’s very important to factor in inflation and multiply the cover amount by 2.5 to 3X while calculating. This will ensure that the cover you buy today is sufficient for tomorrow.

     Therefore, the cover you need to buy = Amount you owe - Amount you own

     = (Living Expenses Fund + Major Expenses Fund + Major Liabilities Fund) - (Existing funds)

This is the most meticulous and scientific way to calculate the exact coverage your family needs. Random thumb rules, like - ‘20x your yearly income' - that are generally recommended for calculating cover do not factor in your specificities.

Let’s understand this better - with the help of an example.

Viraj, 30 years old, is an IT professional who earns a salary of Rs. 7 lakhs yearly. This is how his finances look at this point.

Let’s break them down to -

Money Viraj owes -

Money Viraj owns -

So the Term Plan cover Viraj would need will be the difference between his total liabilities and total existing fund. Therefore,

Total Liabilities - Total Existing Fund

= Rs. (1.9 crores - 28.5 lakhs)

= Rs. 1.615 crores

If Viraj went by the thumb rule of buying a cover 20X his annual salary, he’d only take a cover of (20 X 7) lakhs = 1.4 crores. This would leave his family with inadequate coverage - Rs. 21.5 lakhs short to be precise.

Please note: To simplify the example, the rate of inflation wasn’t considered. In real life, if you want to factor in inflation for the entire term, you should multiply your cover amount by 2.5 to 3X. This will give you the inflation-proof cover you’d need. Otherwise, it’s strongly recommended to opt for the increasing cover option available with all leading term insurance plans. This helps your cover increase systematically over a period of time - beating inflation.

We cannot put a value on our life. After all, it is priceless. But we can make sure our loved ones lead a good life - when we aren’t there to take care of them anymore. Monitor your expenses, goals, and liabilities, and maintain a personal financial record. Make your family a part of the process, and leave them a cover that will truly keep them protected - against all odds.