How much life insurance coverage do I need?

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.

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).