I had initially
titled this article about you, dear reader. However, I have realized that the
insurance needs are always unique to an individual. Therefore, it makes sense
to talk only about my own case here.
Nevertheless, it is still quite likely that the assumptions and conclusions made here are equally applicable to you. And if you have dependents and are not already (super) rich, that will definitely be the case. More so if you live in India for most of assumptions like inflation numbers etc. are specific to my motherland.
To answer the question of “how much”, we first need to answer the question of “why” – why do I need life insurance? The main, rather sole, purpose of life insurance is income replacement.
Nevertheless, it is still quite likely that the assumptions and conclusions made here are equally applicable to you. And if you have dependents and are not already (super) rich, that will definitely be the case. More so if you live in India for most of assumptions like inflation numbers etc. are specific to my motherland.
To answer the question of “how much”, we first need to answer the question of “why” – why do I need life insurance? The main, rather sole, purpose of life insurance is income replacement.
It sounds
callous, and it is, but every human being is essentially a source of generating
income over its useful economic life period. Consequently, every human life has
an economic value and the life insurance should, ideally, match that amount.
This amount is called the Human Life Value (HLV). It also makes sense that the
duration of life insurance should match the useful economic life period of the
person concerned.
How long do I
need insurance?
It is
interesting to note that the useful economic life period of a human being is
different from and usually much smaller than the 70 ± 5 years (www.worldlifeexpectancy.com/country-health-profile/india)
a person of up to 50-55 years may expect to live. The standard retirement age
is only 60 years and it is not unusual to find people hanging up their boots in
their 50s or even earlier.
However,
retirement may not be the end of income generation capacity of an individual. There
are many financially educated persons who are capable of generating 12-13%
annual returns on their retirement corpus. In their absence, their dependents
may struggle to generate even 7-8% post tax returns. For such people, their
annual income generation capacity would equal around 4-5% of their retirement
corpus (and growing). This would be a significant number for most, if not all,
of such persons.
Does that mean
one needs to be insured till 100 years of age? Of course not! What it really
means is that one should be careful when assessing one’s own useful economic
life period. This is specifically more applicable to people who have “dreams”
and “plans” of an early retirement and who may end up convincing themselves
that they would not need any insurance beyond the age of, say, 40 years.
There are two
possibilities here. One, they ended up making a hell lot of money e.g. won
lottery, married a multi-crorepati’s progeny, built a valuable company (or
something easier and more rewarding). Two, they have saved a decent amount of
money that can generate enough income to take care of all their current and
future expenses, inflation adjusted. I call this amount the “retirement
ransom”.
In the first
case, there is no dependency on the person – the money will take care of
everything. In the second case, and this is truer if the hapless dependents are
not well versed in financial matters, there is some dependency on the person
concerned even after they have “retired”. A monetary value can be assigned to
such dependence and the insurance for that amount should continue even beyond their
retirement. This also implies that the insurance cover should be constant and
may decrease in later years.
The nominal
value of any such corpus will keep increasing over time and one cannot keep
taking more and more insurance especially in older age. Roughly speaking, no insurance
is needed beyond the point when the retirement corpus will become 15x-20x of the
maximum insurance value, determined today.
The downside of
not taking insurance is not big at this stage and it is better to route that
premium money into productive assets. For
example, if my desired retirement ransom is 30 lakh but the retirement corpus
is only 5 lakh, I need an insurance of 25 lakh. 20 years down the line, let us
assume these numbers are 2.5 crore and 1.5 crore respectively (do your maths). Obviously
I will need 1 crore of coverage in this situation.
But it is not wise
to take that 1 crore of coverage today. One, I would be spending 4x amount on
premium (this extra 3x invested every year could grow to be a big sum in 20
years). Two, and equally importantly, the insurance money is 85% of my
retirement ransom now and is critically needed; the same will be only 40% of my
retirement ransom (30% after considering the current coverage of 25 lakh) i.e. not
so critical.
There may also
come a point when the corpus is large enough to survive me despite sub-optimal
management. For example, if I am 65 and have been left with around 30 times of my
annual expenses in my retirement kitty, then even an FD will be able to provide
with sufficient income for 20-25 years. I do not need any insurance at this
stage. This would not have been true if I were, say only 45 years old in which
case the corpus must generate inflation beating returns for a sustained
duration of time.
Another way of
looking at this problem is from the point of view of handling my
responsibilities. Once my kids are educated, married and settled in their own
worlds, my retirement corpus is big enough and I do not have any other liabilities,
the only thing left in life is to enjoy the serenity of togetherness till death
do us part. Why would I need any insurance at this stage?
As a general
rule of thumb, nobody should need insurance beyond 65-70 or when their youngest
kid would be 30. For people planning early retirement, add at least 8-10 years
to your planned retirement age to account for any possible delays in executing
the dream plan and also to account for the period when the corpus will not be immune
to mismanagement caused by lack of financial knowledge, as explained above.
I close friend
took a coverage till 80 years of age with the logic that his family was almost
guaranteed to get the amount since he was not going to live that long. That’s a
nice argument but a flawed one. I am not getting into the underlying
mathematics here, but the alternative of investing the extra yearly premiums
and the total premium for later years of will also result into similar corpus
at 80 years of age.
There is no
amount of coverage I can afford (and get from any insurer) today that will not
look like peanuts when I am 80. Things double in price every 6-7 years and even
1 crore will be worth only 10-12lakh in 20 years or so. Imagine the price
levels 40 years down the road! And what if we lived beyond 80?
Insurance is a
bet that I want to lose and I won’t do the opposite unless there are
compelling, non-fraudulent, reasons to do so for the frauds will get detected
and the insurance claim will be rejected.
How to
calculate my HLV?
Let me first see
how not to calculate the HLV. There is a “rule of thumb” I can find blogs on
the Internet about taking coverage worth 5-6 times the annual income. This is
totally ridiculous and excessively low. There are other such rules of other
thumbs (rhymes with dumbs) and they are nothing but dumb.
Let me now think
from an insurer’s point of view. For what amount are the insurers ready to
insure me till they think that the ‘moral hazard’ will not come into play? Here
the term refers to the nominee getting the insured killed for claiming the
benefits (everybody is scared of murderous husbands and wives).
The numbers vary
across companies and range from 15 time the gross annual income (SBI Life) to
25 times the gross annual income (HDFC, Canara). The gross income refers to the
pre-tax income here and the final sum sounds ridiculous (again) and excessively
high. But I know the lower and higher limits now.
Since the idea
of insurance is income replacement, the ideal coverage should be nothing but
the sum of all my future incomes discounted to the present at an appropriate
rate. This is called the Net Present Value (NPV) and there is a function in
Microsoft Excel to calculate that. This is much better but still there is a
problem and this comes from inflation in a way I did not imagine or appreciate
easily.
The NPV of my
all future incomes today is less than the NPV of the same stream of income one
year later. Let us assume that my income grows at the same rate as inflation
and this is the same rate of return I expect my dependents to generate i.e.
rate of discounting is also the same. Therefore, for a 35 year old going to
retire at 60, the NPV of all future incomes is simply (60-35) = 25x the current
annual income.
Similarly, the
next year the NPV will be only 24x the next year’s annual income. However, the
income would have grown to 1.09x of the current value, assuming an inflation of
9%. So the actual coverage needed is 26.16x of the current annual income. It
can be seen that this number would keep growing for at least a decade till it
starts coming down. One needs to consider the maximum of all such number and
that will be a scary sum, to say the least.
This implies
that I need more and more coverage as I keep aging till I am very close to
retirement. This sounds demotivating but is actually true. So do I really need
insurance worth that high number Excel seems to be telling me? Fortunately not.
That number can only be a guidance of the maximum coverage I am going to need
and a host of adjustments can be made to the calculated amount.
Needs
analysis
The idea of
insurance is indeed income replacement but it is about the replacement of only
the critical part of my income. There will be a lot of non-critical money
coming my way, especially during the later years of my life. Money that I would
not need and will only fuel my discretionary expenses.
I do not need
insurance for that part of my income unless I want my family to enjoy those foreign
holidays in my absence. The downside of doing that is to lose out on my current
stream of income in the unnecessary premiums which may result into them (and
myself) not getting to enjoy those if I survive.
So the first
adjustment to make is to consider the amount of money I actually spend for
non-discretionary items like food, transport etc. including the investments for
critical goals. Anything above this is my lifestyle-income and I do not need to
take coverage for that part.
Another adjustment
to make is to take out the time-bound expenses like kid’s education and
estimate a single corpus for those. For example, if my kids are 10 and 12 years
old, I can simply keep 10x their annual fees aside. This should totally fund
their education and my current expense requirements get reduced too. Please
note that this is just an accounting exercise and no money actually needs to be
set aside.
The total annual
expenses so calculated will give a better clue about the needed insurance
coverage. One should have 30-40x this amount as sum assured. Add to this the
number determined for time-bound goals and any loans. Subtract from this the existing
insurance and also all the current savings and investments. The final number
should be a reasonable one and it is important to take coverage for that.
Life stages analysis
The final step
is to imagine the situation 5 and 10 years down the road and see if the
coverage determined above stays sufficient at those points too. If you are
20-30 years old, this will most likely not be the case and that is nothing to
be worried about. One needs to add to the insurance coverage till 40 years of
age, depending upon the change in socio-economic conditions. If you are above
40 and still find that you will need more insurance at 50, there is something seriously
wrong with your financial plan.
For those
between 30 and 40, like me, it is better to stretch a bit and take slightly
more coverage than needed so that one does not have to go through the medical
tests later in life – there is no guarantee that we will score A+. In any case,
the total coverage requirement should not come out to be less than 10x your
gross i.e. pre-tax annual income and it should never exceed 25x that number
(another matter that no insurer will offer you that coverage either).
Split coverage
There are many
blogs out there advising people to not diversify their insurance coverage. They
are all right but they miss one point. The insurance industry is in nascent
stage in India. There would be lot of changes going forward and the insurer you
choose today may not be operating under the same management for ever. Should
the claims settlement record of your insurer change for the worse, it will be a
disaster for your dependents. There is no point splitting a 10 lakh coverage
between five insurers. But it makes sense to split a 2 crore coverage between
two or three good
insurers.
Another reason
to split insurance is to take time-staggered coverage. For example, you may determine
that you need a total of 1 crore of coverage till 45 years but will need only
50 lakh coverage after that. Why not split the coverage under two policies and
save on the premium? Also, there are many insurers that are cheaper for longer
duration (Aegon, Max, Tata) and many other that are cheaper for shorter
duration (Canara, IDBI). Consider all the permutations and find out the most
cost-effective break-up. The hassle of managing paperwork and ECS mandate for
the three additional policies is worth it, in most cases.
Lumpsum
versus monthly income
There are many
insurers offering term insurance with a twist. Apart from the payment of a
lumpsum on the death of the life insured, a part of sum assured is also paid
out at regular intervals afterwards. This is a useful feature for those whose
dependents are not well-versed in financial matters. And even if they are,
imagine the situation when both husband and wife are gone and someone else is
taking care of the kids. A monthly income option would make it easier for that
caretaker and hence for the kids too.
There are some
insurers (HDFC, Max, Bharti) that also offer an increasing monthly income. This
is a much better option for it also takes care of the inflation factor. It
would be a good idea to take a cover for about double the current bare-minimum
monthly expenses under this option so that the amount stays reasonably
sufficient even 8-10 years down the road. As indicated earlier, no reasonable amount
of coverage taken today will look sufficient after 10-12 years due to high
inflation in India.
Summary
If you are 30 or
below, take as much insurance as you can get and reasonably afford (and review your
coverage when you cross 30). If you are 40 or above, 15-20x your annual take
home should be sufficient coverage (if it is not, there is something wrong with
you financial plan). For those in between, and not already rich, this is the
planning time but you have stay within 10-20x your annual pre-tax income.
Be very careful
for over-insurance will burn a hole in your pocket and under-insurance may
prove costly later when additional coverage will become more and more difficult
to get. Always fill in the proposal form as if your life depends on it for your
dependent’s does. And never sign a blank proposal form (that taking an offline
policy is already stupid, is another matter).
