Congratulations for making up your mind to take a risk cover for your life. Life Insurance is one of the most important things associated with a person’s financial planning and often one of the most ignored aspects. An essential step of taking a life insuranceis arriving at an appropriate level of cover (called as Sum Assured) and the objective of this article is to assist you in calculating it.
How Much Insurance Should you Take ?
The main motive of an insurance policy is to serve the dependents once the insured person dies. The more the insurance policy pays the dependents, the better would be their standard of living and their ability to meet their liabilities. This amount is determined upfront at the time of entering into an insurance contract while taking the insurance policy. In order to arrive at the sum
assured you need to perform a few computations to understand how much would be the expected costs of living for your dependents in case the unfortunate event happens. Most of the people either take too much or too little insurance cover. The basic thumb rule to arrive at the sum assured value is :
1. Compute The Monetary Liabilities
Sit down with a pen or paper (modern generation can use a PC / Laptop) and start jotting down list of liabilities which your family would need to pay every month. An easy way to start can be looking at your bank statement for past couple of months / one year and see the debits in your bank account. It would give an indication of the recurring monthly, quarterly or yearly expenses. Such expenses can be (just as an illustration):
- School fees;
- Utility bills such as gas, electricity, water, telecommunication, etc.
- Monthly mortgage / EMI payments for your house, vehicles, student loans, personal loans, etc.
- Insurance premiums for the life cover of your spouse / family members;
- Medical Insurance premiums for your family;
- Monthly grocery bills, and so on.
2. Value of your Assets
Arrive at the value of your assets at the time of taking the life cover. There are two kinds of assets :
a. Which can not be sold or dead assets. An example can be the home in which you may be living. Read our article Your House – A drain on your Finances. Other examples can be jewellery of your wife.
b. Assets which your family can liquidate for meeting their expenses. A few examples of such assets can be stocks, mutual funds, fixed deposits, balance in PPF / Provident Fund, etc.
3. Arrive at Required Liquid Funds Needed
In this step :
a. Obtain the amount derived from your calculations in step 1 as the starting point. For the purpose of this article, lets assume that your average yearly outgoings is Rs. 600,000. You may want to add another 10-20% to this amount to meet any additional costs.
b. Take Long term interest rates prevailing in the country. In India this is generally 8% p.a.
c. Using the interest rates, arrive at a fund value which would be required to provide a yearly cash flow mentioned in step a. above. The simple formula can be:
Average Yearly Cashflow Needed X 100
In our example, this would 600,000/8 x 100 = Rs. 75,00,000. The idea behind this figure is to allow your family to put this amount on interest to get a regular source of monthly income.
4. Arrive at the Sum Assured
Once you have arrived at the liquid funds needed to sustain the cost of living of your family from Step 3 above, you can easily arrive at the sum assured needed. In our example, either you can have your sum assured as Rs. 75,00,000 or you an add on an extra amount to allow your family to pay off any lumpsom liability such as a housing loan / mortgage or to create an extra buffer.