Planning to buy term insurance? Restrict premium to 5% of annual income

Calculate life cover by taking goals, expenses and spouse's retirement needs into account

A client of Kolkata-based financial planner Malhar Majumder called him and said he wanted to buy a Rs 5-crore term plan urgently. After experiencing a death in the family, the client wanted to ensure that his wife and kids were financially well protected in the case of his death. But when Majumder calculated the cover needed, it came to around Rs 2 crore. Such behaviour underlines the need to employ a rational approach when calculating a person’s life insurance requirement. 

Deciding what “adequate” life insurance cover is can be difficult. It varies, depending on the method chosen. Insurers work out the sum assured based on a person's income-earning potential. Financial planners usually decide the amount of cover based on expenses and goals. Then, there is the rule of thumb that those looking for simplistic solutions use. Moreover, insurance needs change at different life stages. “An individual’s goals, income, liabilities, and savings change with age and additional responsibilities. Hence, computing the amount of cover he needs until retirement is not easy,” says Majumder.

Whichever method you adopt, do not allow the yearly premiums to exceed 5-6 per cent of annual income. Financial planners also suggest that if you are buying a big cover — of over Rs 1 crore — split it among three-four insurers. This can prove slightly expensive, but doing so makes it easier to reduce your cover in the future as your needs decline.

The converse is also true — you may need to buy additional insurance at certain stages in life. A person should, therefore, keep evaluating his life insurance requirement every three years or after important life events such as marriage and becoming a parent, or when the individual takes up a significant liability, such as a home loan.

Financial planners advise that when calculating insurance requirement, a salaried person may consider his retirement age as 60, while business persons may keep it at 65. 

Insurers use a method called Human Life Value (HLV) to calculate how much cover a person needs. The concept primarily considers the present and the potential income a person would earn during his working life. The potential income is discounted to the present value, which becomes the cover. Many insurers provide HLV calculators on their websites. “We also look at family health history, education, occupation, and annual income to decide on the maximum sum assured and premiums when underwriting a policy,” says Sameer Joshi, chief agency officer, Bajaj Allianz Life Insurance. 

The cover calculated using the HLV method is usually higher. Financial planners employ a different method that relies on financial goals, monthly expenses, and spouse's retirement needs. Then, they discount these numbers to arrive at the present value. From this amount, they reduce the existing investments and savings to determine the coverage required. The cover comes out to be lower under this approach than under the HLV method. “Planners prefer this approach because a family's monthly expenses are lower after the bread earner passes away. Some goals, such as foreign holidays and fancy cars, cease to exist. That's why the cover arrived at is lower. This should be the minimum sum assured one should buy,” says Suresh Sadagopan, founder, Ladder7 Financial Advisories.

A popular rule of thumb says an individual should have life insurance equal to at least 10 times his annual income. But insurance industry sources and financial planners suggest avoiding such rules of thumb. “There is no logic to them. A 35-year-old could require a higher cover of even 30-35 times his salary, going by the HLV method,” says Mohit Garg, head of products, PNB MetLife India Insurance Company.